Raising capital is difficult, even for the most experienced of entrepreneurs. However to achieve the growth and scale that is needed to amplify business operations, raising capital is critical to offset burn rate.
The injection of capital from an investor affords opportunities to develop products, hire staff, expand geographical horizons, or to integrate new technologies, but how do you measure the effectiveness of the cash? How long will the cash last before the company runs dry? These are questions investors frequently raise during pitches. Often, a solution lies with how well an entrepreneur knows her business’s burn rate.
What is Burn Rate?
In terms of raising capital, burn rate defines the rate at which a company is spending (losing) money before they become cash-positive. It is usually quoted in terms of cash spent per month and is a measure of negative cash flow. A company which has a burn rate of $50,000 a month means that that company is spending (burning) $50,000 each month on operations. This rate is vital to understanding efficiency and sustainability of your firm. If your company has limited sources of cash and a constant burn rate, it will run out of money.
Burn rate can be either defined as gross burn rate and net burn rate. Both allow you to forecast when you’ll run out of money and when you could be able to invest in an opportunity.
Gross Burn Rate
Gross Burn Rate is the total amount of cash that your company spends each month on operations. This does not include expenses relating to COGS.
For example, an internet startup (per month) has:
Revenue = $20,000
COGS = $10,000
Rent = $2,000
Wages = 13,000
The gross burn rate = $2,000 + $13,000 = $15,000.
Net Burn Rate
Net Burn Rate, on the other hand, is the difference between the cash flow out and in of your company each month. Profitable companies have a negative net burn rate – meaning they are taking in more cash each month than there is cash flowing out. Net Burn Rate is simple to calculate if you have your financials up-to-date; on your company’s Profit & Loss statement, it is simply your Net Income. To calculate it from scratch you add up all cash revenue for the month and subtract all costs for the month.
So, considering the same internet example,
The net burn rate (or net income) = Flow Out – Flow In =
$(10,000 + 2,000 + 13,000) – ($20,000) = $5,000
This means the company is losing $5,000 per month.
Why Burn Rate Matters
Understanding (and being able to describe) your firm’s burn rate is beneficial to understanding how to present your firm effectively to the investor. By just calculating the gross burn rate, you may understand how your firm is allocating its funds operationally – where each dollar is being spent in run the company day to day. However it may give a distorted view of business operations. By additionally calculating Net Burn Rate, you are effectively identifying the financial runway. Even if the firm is spending $15,000 a month on operations, the actual amount flowing out of the company is $5,000. If the internet firm had $60,000 in their bank account, the zero-cash date (when the bank runs dry) would be in 12 months time ($60,000 / $5,000), not 4 months (as could be considered if only the gross burn rate was calculated)
Knowing your burn rate helps you to manage cash effectively. It dictates a road-map and time schedule before your firm burns out. If revenue figures fail to meet expectations burn rate can be adjusted, often by reducing staff, relocating to cheaper premises, or outsourcing part of the operational costs. Burn Rate may seem like it sets a deadline on you and your company to perform, however it also can be seen as the driver of innovation within your firm. It can help motivate you to optimize operations and invest intelligently in technology and staff. The more cash you burn, the further you could potentially go.