Early-stage startups often have yet to earn a profit. Their main focus is on building their product or service and growing their customer base, which typically comes at an operating loss.
As these companies dig into their cash reserves each month to cover overhead costs, they need to be aware of how quickly they’re spending cash to ensure they’ll have enough to continue supporting operations. Otherwise, they’ll need to seek out additional funding.
Burn rate is one helpful metric to help companies gauge the pace of spending and drive strategic planning decisions, which we’ll explore in further detail below.
What is burn rate?
A company’s burn rate describes how quickly it spends cash to cover operations, often expressed in monthly terms. It helps businesses that aren’t yet profitable understand how much longer they can support operations before running out of cash.
For instance, if a company has a burn rate of $40,000 per month, and they have $120,000 cash available, then it could operate for three more months before becoming insolvent.
Thus, burn rate is a measure of negative cash flow, representing how much cash the company shells out during a given period.
How to calculate burn rate
Burn rate formula
There are two types of burn rates, which have different formulas.
The first type is gross burn, which is a measure of the total amount the company spends each month on operating expenses. Thus, the formula is as follows:
Net burn rate is the other type companies can track. It shows how much the company loses each month, taking total revenues into account.
It will either be equal to or greater than the gross burn rate, but never less. The formula for net burn rate is:
Gross ad net burn rate example
A company has the following monthly expenses:
- Office rent: $5,000
- Wages/salaries: $65,000
- Utilities: $1,500
- Insurance premiums: $2,060
- Supplies: $850
- Marketing and advertising costs: $8,500
- Maintenance: $750
- Subscriptions: $1,375
- Other: $1,220
Adding all of these values together will provide the company’s gross burn rate of $86,255.
To find net burn rate, we’d need to know the company’s monthly revenue. If this value was $60,000 with COGS of $20,000 then the net burn rate would be:
Net Burn Rate = ($60,000 – $20,000) – $86,255
= $40,000 – $86,255
= – $26,255
In this scenario, even if the company is spending a “combined” total of $106,255 between COGS and operating expenses, the revenue the company earns helps to offset it.
Factors influencing burn rate
As illustrated by the formulas above, the main factors that dictate burn rate are the company’s spending activities.
Gross burn specifically is concerned with the company’s operating expenses, which are made up by:
- Office/facility rent
- Utilities
- Monthly wages/salaries
- Other monthly overhead costs
Any fluctuations in these expenses will have an impact on gross burn.
With net burn rate, the company’s revenues are also considered in the formula, adding another dimension to the equation. If spending levels remain constant, an increase in revenue will cause a decrease in the burn rate.
Interpreting burn rate
What exactly does the burn rate imply about a business? What types of insights does it offer?
As mentioned above, it helps startups running at a loss understand how quickly they consume available capital. In other words, it’s a relatively straightforward metric equal to how much a company spends on overhead each month.
A company’s burn rate is directly related to its runway, which is the length of time that it has until it completely runs out of cash. Thus, all things considered equal, a company with a higher burn rate will have a shorter runway, and vice versa.
So, if a company has a burn rate of $50,000, and $400,000 cash still available, the runway would be 8 months.
Runway = $400,000 / $50,000
= 8 months
Together, these metrics provide valuable insights for making strategic planning decisions, giving them a better idea of when they’ll need to secure additional funding, or risk going out of business.
What’s a good burn rate?
The lower the burn rate, the better, as it means companies have a slower pace of spending and will run out of capital less quickly.
What’s considered a “good” burn rate will vary by company and industry. However, the U.S. Chamber of Commerce shares a general rule of thumb that a company’s cash reserves should cover at least three to six months’ worth of operating expenses.
Thus, the ideal burn rate will depend on how much the company has in the bank. Let’s say the company has $90,000 in cash reserves. In that case, a good burn rate would be somewhere between $15,000 and $30,000, giving them a runway of three to six months.
Burn rate vs. run rate
Burn rate may be easily confused with another term — run rate. While the two terms may sound alike, they provide two very different measurements about a business’s finances.
Again, the burn rate describes how quickly the company spends its cash reserves. In contrast, the run rate is a forward-looking metric that estimates the company’s future revenues based on past performance.
Thus, run rate may not be as helpful or relevant for a startup company that has yet to earn a profit, or possibly even revenue.
Benefits of monitoring burn rate
Burn rate is a standard financial metric for all companies, particularly startups, and monitoring it regularly can provide the following benefits:
Drives informed decision-making
One of the key reasons companies should monitor burn rate is that it helps them determine their runway, thereby showing how much longer they can operate on current cash reserves.
With a clear idea of the company’s burn rate, business leaders can make important spending and strategy decisions to ensure the business can remain in operations while working towards profitability and becoming self-sufficient.
For example, if a startup founder determines the burn rate is $55,000, and the company has $350,000 left in capital, they know they have about six months left to secure additional funding or face insolvency. If they don’t expect to become profitable for at least ten more months, they may need to engage in cost-saving measures immediately to reduce the burn rate and buy a bit more time.
Supports investor confidence
Burn rate can help drive decision-making among internal stakeholders, though it can also be a valuable metric for external stakeholders, like investors, to gauge the financial health of a target company.
Investors lend capital to businesses they expect to grow and produce a certain rate of return. This means they’re interested in how much a certain company needs each month to support operations, and how well they manage the current capital they have access to.
Businesses can build confidence with current investors by demonstrating they’re putting the investors’ funds to good use, and are responsibly using the capital to pursue growth strategies. It can also help garner interest from new investors for the same reason.
Enhanced visibility into financial sustainability
Business leaders may also use burn rate as a sort of temperature check for the company’s spending, giving them an objective way to measure how monthly expenses have changed over time.
Even once the company becomes profitable and doesn’t have to pinch pennies to remain solvent, it can still be a helpful tool for assessing how much the company needs to generate each month to cover expenses as operations scale.
Managing and reducing burn rate
In a startup’s early stages, leaders must strike the right balance between growth and spending. They need to invest enough in the company’s offering to build a quality product and acquire customers. However, they must also stay aware of how quickly they’re spending cash, and ensure they’re using capital responsibly.
Any startup leaders looking to build self-sustaining, profitable operations will be concerned with the company’s burn rate and seek out strategies to improve it. The following are some of the ways to manage and reduce the burn rate to extend the startup’s cash runway:
Implement cost-saving strategies
Since gross burn is equal to the company’s monthly costs, a clear way to decrease it is to cut back on spending.
As mentioned above, companies need to spend some amount to keep operations up and running. However, there are likely areas where the company can right-size spending. This might include stopping investments in services that are not revenue-driving, like branding.
Another potential source of cost-savings is to evaluate the software subscriptions the company pays for. Maybe they can cancel unused programs altogether, or reduce the number of seats they pay for.
However the company chooses to reduce spending, the important thing is that they don’t make cuts and get rid of resources that will limit employees’ ability to be productive and complete their duties. This can only hamper the company’s growth prospects over the long term and make it take longer to achieve profitability.
Limit hiring
Aside from controlling current costs, it can also be beneficial to curb any future cash outflows as well. This might mean stopping or slowing down hiring activities.
Bringing on a new full-time employee doesn’t just cost the company the worker’s monthly wages. The company is also on the hook for any additional compensation, benefits, its portion of payroll taxes, and the supporting materials and resources the employee will need to complete work.
Outsourcing certain tasks or hiring contract workers may be a workaround solution if the company still needs additional support, as these options typically cost less than hiring a full-time staff member.
Use the right tools
As a company grows, it can become increasingly difficult to keep all spend data up-to-date and conveniently compiled in one location.
Without accurate, complete information about the company’s spending activities, business leaders may not have a good grasp of their monthly cash needs, and be unable to gauge the burn rate.
Adopting a digital solution that automatically tracks business spending and expenses from various sources makes it much easier to monitor costs and accurately determine the company’s burn rate.
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