Founding and growing a startup is a very expensive operation. While your own personal investment and any bootstrap funding from friends and family may give you a foundation, you likely need to begin looking for angel funding or formal venture capital investments – especially if your product shows potential in the marketplace and you want to scale quickly.
As you start expanding with staff, software subscriptions, and office space, understanding your “burn rate” will become critically important. If you’re in the startup world, you’re likely already familiar with the concept – it has nothing to do with employee burnout or lost opportunities but can create major problems if left unchecked.
What is “Burn Rate?”
In the simplest terms: Burn rate is the amount of money your startup is losing in a given period to stay in business. Typically burn is spoken about either on a monthly basis in terms of the actual rate or accompanied with a figure indicating how many months of cash the company has left.
The easiest way to think about this figure is:
- Burn Rate = (Total Collections) – (Total Disbursements)
- Runway (roughly) = (Total Cash Balance) / (Burn Rate)
Startups are often unprofitable in their early days, and some even post-IPO. Whether it’s because a company is pre-revenue and doubling headcount or still figuring out how to sell effectively, it’s a common feature of most early-stage companies. Most early-stage ventures will almost always operate “in the red” (sometimes called a net operating loss) as they work towards profitability for years.
As a result, new and even mid-sized startups often find themselves competing against their “burn rate” to hit that next product of investor milestone.
Why Does Burn Rate Matter?
On the surface, burn rate and your runway timing are just numbers you need to know about your business. If you have a high burn rate (i.e. not collecting on revenue as quickly as projected, expenses scaling too fast), your startup will burn out far quicker than you pitched your most recent investor and employees, making it much harder to raise future funding and run a steady ship. What the ‘right’ burn rate is differs from company to company and is dependent on what stage of the investment lifecycle you’re in. For example a Series A company will burn more than one in the Seed Stage. Having said all that, a low burn rate should be good then, right?
While having a low burn rate may seem like a good thing, and for a nearly-profitable company it can be, it can also indicate that the company isn’t growing as quickly as it could. This is more of a management and board decision, as far as how quickly to grow a company or reach profitability, but typically startups raise funds with the express understanding that it will tide them through 20-24 months. This generally includes a growing burn rate too, as companies will often grow expenses far faster than revenues.
Many venture capitalists and angel investors use both current and future burn rate projections to determine if they should invest in a startup, and to what degree — alongside other criteria like market size, team, metrics, and more. Startup investing presents a huge risk to early-round investors, especially if a company runs out of money before it can start turning a profit. If your burn rate doesn’t correlate with your growth plan, investors may walk away from what they see as a “dangerous” investment. Remember, the second most common reason for companies to fail is running out of cash, so this will be a critical part of any investment conversation!
Is a High Burn Rate Good or Bad?
Determining the ‘right’ burn rate is a difficult task, especially in the context of a rapidly growing business with heaps of uncertainty. While frugality goes a long way in the startup world, spending money to quickly advance a profitable product to market, get your sales team in order, or optimize expenses isn’t necessarily a bad thing either.
While founders want to believe that their idea is unique and could change the marketplace entirely, it may mean very little without evidence, including patents or patent filings, and a plan to drive market share away from the current competition. The commonality? All of these actions require you to spend cash on them.
If your burn rate is high because you are hiring engineers to bring a new software package to life, or you are adding a national sales team to drive business, investors will likely not see it as a negative as long as there are educated assumptions behind the business decisions. In theory, a higher burn rate leading to faster profitability could be seen as an asset, as early investors stand a better chance of getting a stronger return.
On the other side, if your burn rate is slower because your team is doing market research to optimize market entry strategy, or surveying a target audience to determine product viability or launch features, investors may look favorably upon your due diligence as you will be making educated spend decisions.
The key to managing burn rate is to spend smart on moving your business forward quickly. If you’re not spending money in the right places, early-round investors could determine your startup to be a risky investment or might not have faith in your team’s ability to execute.
How Do I Properly Manage My Burn Rate?
Although it may all sound very dangerous and scary, burn rate is not to be feared but to be understood. Everyone expects startups to lose money in the beginning. Your burn is a natural part of growing your business. The key is to make smart decisions with that money and show how your spending today leads to strong gains in the future.
If burn rate is becoming a real concern for your startup, it may be time to call in the financial experts to help you navigate what next steps look like. airCFO can help you understand your burn rate, what levers you can pull, and create a pathway to reducing your burn, no matter what stage of investing you’re in.