Burn rate is among the most basic yet important metrics that startups and investors are focusing on. It is the total amount of cash that is spent by the business each month, which shows both growth and the possible runway that the company must have to sustain itself. This article discusses the concept of burn rate and strategies that can be used to improve the idea.
Create $90,000 in revenues (in dollars) in the quarter
In the startup and investor communities, cash inflows are frequently described as “sales,” and cash outflows are often referred to as “expenses.” Strictly speaking, this is a good idea for businesses that create accounts on the basis of cash, which is typical for startups in the early stages. However, this technique loses importance once companies grow and create reports on the popular base of accrual. In an accrual setting, sales are often quite different when compared to sales made in cash, especially in companies that offer subscriptions.
In this case, for example, if you offer your customers a 12-month membership on your platform at $1200 in advance and give them access to your services during the period the cash sale is $1200 for the month you sell it, however, the sales you make on an accrual per month will equal $100 per month.
The same reasoning applies to expenses that are deferred for the future. To avoid confusion, we’ll refer to cash sales as well as cash expenses in the following article.
Is there a simple method to reconcile the accrual and cash bases? The net burn rate is linked with the statement of cash flows on the balance sheet. It is the total of the operating, investment, and financing cash flows.
The relationship between cash flows and burns, both net and gross, is illustrated below.
In practical terms, what does”net burn” really translate to? It is an approximate estimation of the length of time the company will last. Based on the previous example of an average net burn rate of $100,000 and a money balance of $700,000. What is the “life expectancy” of the company, referred to as ” runway,” is seven months.
It is not surprising that the main parties interested in issues relating to cash burn are shareholders in the company, specifically, the founders and external investors since they offer funding to the business. Investors typically derive their expectations from the projected burn that was made available to them in the funding round.
How Do You Set a Burn Rate?
The first step is to calculate the forecast using the internal financial forecast model that incorporates costs, cash sales, and capex. The drivers to the data in the model are based on the particular industry; however, in the case of technology-related startups, they are typically determined by the number of licenses or users as well as the price and cost of incremental costs per license or user, and mostly the cost of contractors, employees, and rent costs.
The next step is an assessment of the burn rate commonly used by businesses in various phases of growth. Within his essay, Fred Wilson provided an excellent guideline to determine what the burn rate for a gross basis is by multiplying the total number of employees on the team by 10,000 and $10,000 as what is considered to be the “fully burdened” cash expense for each employee which includes rent and other costs. He then outlines three phases of development:
Construction Product Stage The maximum is $50,000 of gross burn. The team is comprised of three or more engineers, as well as a product manager and a designer.
Building usability stage up to $100,000 in gross burn. This is with the same team as the building product stage. This includes some additional engineers as well as a community manager and some other costs.
The Business Stage is up to $250,000 With the same group, as well as an increased management team, a growing team, and a few finance personnel.
To provide some insight into this and other issues, in the 2013 article that was published in 2014, a variety of Seed or Series A startups discussed the amount of funding they had received as well as the burn rates they had:
The companies were in the product development or utilization stages and had disclosed burn rates as high as $50,000 and runways ranging from six to thirty-five years (20 years on average). This is compared to an average advised runway time of 15-18 months in the case of early companies that are raising funds, according to the experience of Investor Mark Suster.
How Can I Control My Burn Rate?
As we’ve discussed, the founders and investors are also interested in determining the actual rate of burn and comparison with forecasted figures that were provided during the previous investment round. This is because it gives an indicator of the company’s lifespan and the capacity to manage spending as it increases. Therefore, startups need to implement the appropriate devices that can monitor the burn rate and ensure it stays under control to avoid the premature demise of the business.
The first step in reducing your initial cash burn rate is to determine what level of development you’re in and to adhere to the elements that are essential to the stage prior to moving to the next step. That is, you should don’t put the cart ahead of the horse. It’s easy to be caught up in investing hugely in sales and marketing personnel and costly engineering, but this will not sound sensible until you’re certain that you’ve verified that your product does indeed have an existing client base from which it is able to grow.
