Burn rate is a hot topic once again. As the tech market slows down, the media, investors and companies are focusing on it more and more.
But what is burn rate? Burn rate is used to describe the rate at which a company is losing money – in other words, it describes negative cash flow.
Typically, burn rate is expressed in terms of cash spent each month. For example, if your company has a burn rate of $650,000, your company would be spending $650,000 a month.
Burn rate is important because it helps startup companies and investors track the cash the organization is spending before it starts generating its own income. It also tells you roughly how long you have before you run out of money.
Understanding burn rates becomes even more important during market downturns. But smart entrepreneurs should understand burn rates whether the markets are up or down.
There isn’t much comprehensive or mathematical information on burn rates. We wanted to remedy that in two articles. This article is a basic primer. Our second article deals with advanced burn rate topics like burn rate optimization.In this article, we will:
- Distinguish gross burn rate vs net burn rate
- Show you how to calculate gross and net burn
- Define runway
- Discuss the relationship between burn, investment, and runway
- Explain why burn rates are expensive for companies
- Provide you with an Excel model to forecast your burn
If you are just wanting our burn rate modeling spreadsheet, click here.
Gross Burn Rate vs Net Burn Rate
Burn rate refers is how fast a company is losing money. CFOs typically think about burn rate in monthly terms. People often shorten the phrase from “burn rate” to just “burn.” E.g., “our burn is $20K a month.”
There are really two important burn rates, gross burn rate and net burn rate.
Gross burn rate refers to a company’s total costs. Net burn rate refers to total costs minus revenues. When you hear “burn rate,” you should assume it is net burn rate unless the person specifies otherwise.
How to Calculate Burn Rate: Net and Gross
So exactly how would you calculate your burn? Let’s look at an example from Capshare, now Shareworks Startup Edition. Here is a Quickbooks P&L from one of the company's earlier months:
The easiest way to find burn on the P&L is just to look at Net Income. Our Net Income in this month was -$38,164.65. So our burn rate for this month was about $38K.
What was the company's gross burn?
To find gross burn we need to find a sum of all our expenses. That line is called Total Expense. So our gross burn was $89,888.37. The difference between gross and net burn should be revenue. The revenue line item is called Total Income. It is $49,419.38.
If you subtract $89,888.37 from $49,419.38, you get $40,468.99. Why isn’t this number equal to the burn rate of $38,164.65?
The answer is that the P&L includes another source of income called Other Income of $2,304.34. If you add that Other Income to Revenue then subtract Total Expense, you get Net Burn.
Burn Rate and Runway
Burn rate is extremely important when a company has limited sources of funding to cover losses. If a company has a constant burn rate and a finite amount of cash, it will run out money.
Cash balance refers to the amount of money a company has at any point in time to fund burn.
In accounting terms, cash balance is a balance and burn rate is a flow. Burn decreases a company’s cash balance. This leads to a concept called “runway.”
Runway is the time a company has until it runs out of money.
Here’s the formula that relates burn and runway:
Runway = Cash Balance / Burn Rate
If a company has $500K in the bank and will burn $20K / month, it has a runway of 25 months ($500K / $20K = 25).
Some people will also use the term “zero cash date.” Zero cash date is the date when you will run out of money assuming your current burn rate. So the zero cash rate using the example above would be today’s date plus 25 months.
Burn rate often changes from month to month. So it is often difficult to know your runway with certainty. Because of this many CFOs simply estimate monthly burn. If they need more precision, they will build a more complex spreadsheet.
We have built a projections spreadsheet for you which you can download here.
Investors will often ask startup CFOs, “What is your runway?” Or they will say things like “this funding should give you at least a year or two of runway.”
Profitable companies don’t use the word “runway” because they don’t have burn rates. Technically, they have a negative burn rate which just means they are making profits. Not having burn also implies infinite runway.
Burn Rate and Investment
So what creates a runway for most private companies that are burning money? Investment!
Startups typically raise invested capital in a few ways:
- By selling equity (or debt that converts to equity)
- Through sweat equity (working for free gives you an almost infinite runway!)
- By using “free” money–grants, etc.
- By selling debt
Selling equity involves raising money from people who become shareholders in your company. The most common ways include raising equity from friends and family, seed investors, angel investors, or venture capital firms.
Investors’ desires to buy equity in an unprofitable company depends on a variety of factors. But it is common for investors to want to invest in high-growth companies with the promise of future profits.
In practice, most startups sell equity in rounds. Investors evaluate how well companies use their runway from previous rounds of funding. If they like it, they will often invest more money in a new round.
Many startups use “sweat equity.” Sweat equity represents free work donated to the startup. Many founders contribute sweat equity especially in the early days of a company.
This approach has a lot of benefits. Sweat equity allows early workers to secure their equity through work not cash. This means the founders don’t have to dilute their equity by selling some to outside investors.
Many startups fund their growth with sweat equity until they can either raise money from investors or get to profitability.
Getting a company to profitability without external investors is called bootstrapping. Bootstrapping means the founders keep all of the company’s equity.
Using free money is always a great option. It will increase your runway at no cost. Unfortunately, as economists frequently remind us, there is no such thing as a free lunch.
The most common sources of free money come from government grants or winning business plan contests, etc. Finding this kind of funding requires work. So these sources aren’t really free. A lot of scrappy startups use grants as a way to get going.
Selling debt involves raising money who buy debt in your company. This is often hard for early-stage startups. Debt investors want lower risk and early-stage startups are risky. Up to 75% fail. So most early-stage companies cannot raise traditional debt.
Why Burn Rate Is Expensive
Of the funding sources discussed above, the most common is selling equity to investors. Burning investors money may not psychologically feel “expensive” to you, and so you might think that burn isn’t expensive.
But it is! Every dollar you burn represents ownership in your company that you had to give up. Additionally, your reputation is at stake. If you waste investors money, don’t expect to raise a second round for your current company. And when you company folds, don’t expect to find too many investors lining up for your next venture either.
Here are some additional reasons why giving up equity in your company is expensive:
- When your company sells, IPOs, or becomes profitable, you will have to split those proceeds with other equity holders. These can be BIG checks that you will give to other equity holders. That money could have gone to you if you sold less equity.
- Equity holders often require significant legal protections that can limit what you can do in your business without their approval.
- Equity holders often require a legal say in how you run your business. If you end up selling more than 50% of your business, the new equity holders (as a group) will gain control of your business
- Structuring equity deals requires a lot of legal work and cost
Even if you fund burn in some other way, it will generally involve creating long-term obligations for you. So burning cash is expensive. This is one reason why companies think carefully before increasing their burn rate.
Can Burn Rate Be Good?
So after all of this, why would you want to burn cash? Even the very word “burn” sounds bad.
The short answer is that creating a successful startup is hard. Most entrepreneurs can’t create an immediately profitable startup.
There is often a relationship between the type of startup you start and time-to-profitability. Services companies often get to profitability quickly. Product companies often take longer.
Biotech companies, for example, often have years of R&D before they have a commercial product. It just isn’t possible for companies like this generate profits early on.
So these companies will need to burn some money before they can achieve profitability.
Additionally, some companies choose to have a burn rate even when they may not need to because burning more cash can help accelerate a company’s growth. Cash is an accelerant, just like rocket fuel!
Sometimes high growth is a more important goal than profitability. Growing revenue rapidly can establish your company as the market leader, lead to greater profits, , and higher valuations.
There are good reasons to burn money.
A recent comparison of bootstrapped and venture-funded Saas companies supported this conclusion. The comparison showed:
“…[burning] money doesn’t buy better core metrics but it buys growth speed.”
So the decision about burn rates can also relate to your desired growth speed.
Like the Rocket Formula shows, if you burn more fuel, you can go faster. Many companies that want to grow fast are willing to burn quite a bit of money to achieve their goal.
In our next article, we’ll talk about burn rate optimization and how to model out your path to profitability. If you want to get a jumpstart on that conversation, download our financial projections model.
You can download our financial projection model here. This model will help you model out your project revenue, gross burn, and net burn.