Starting a business inherently involves taking on a certain amount of risk. There’s always a chance that, despite your best efforts, your business will fail.
While no one starts a business just to see it fail, about 20 percent of businesses fail in their first year, and 70 percent will fail by their tenth year.
Those aren’t necessarily encouraging stats for the budding entrepreneur. But one way you can attempt to avoid failure is by analyzing the failures of those who came before you.
In the case of startups, it’s easy to pinpoint the major shortcoming you need to avoid: a whopping 82 percent of businesses that fail say cash flow issues are the main reason behind their downfall.82 percent of businesses that fail say cash flow issues are the main reason behind their downfall. Click To Tweet
To increase your startup’s chances of success, then, you should focus on your cash flow. And to keep your cash flow in check, the number you should zero in on is your burn rate.
What is burn rate?
Ultimately, burn rate measures the amount of cash your business spends each month. However, it’s a meaningful metric only for businesses that are not yet profitable.
Essentially, it’s a measurement of how much cash you’re throwing at your company. When you look at your burn rate compared to your business goals, it also measures how those cash expenditures contribute to the growth of your company.
When you’re looking to raise funds, your burn rate is one of the top factors that informs investors of your startup’s financial health.
There are two ways to calculate burn rate, both of which have different meanings.
Gross burn rate
Your gross burn rate is how much your business spends each month on operating costs. These costs can include office space, equipment, and employee salaries.
You can think of gross burn rate as the baseline cost of how much it costs to keep your business running every month.
Net burn rate
Net burn rate takes into consideration any cash your business manages to bring in each month. If you’re generating cash through sales, for example, your net burn rate will be lower than your gross burn rate.
Net Burn Rate = Gross Burn Rate + Cost of Goods Sold – Incoming Cash
Investors are typically more interested in your net burn rate, as it’s a better indicator of how your business generates cash without their funding. It’s also a better indicator of a startup’s runway.
However, smart investors will also have questions about your gross burn rate if
Runway is the amount of time your business has before it runs out of cash, based on your burn rate.
If you have at least six months of runway in the bank, your business is in a good place. Once you dip below that number, you should take steps to lower your burn rate.
What does your startup’s burn rate tell investors?
Ultimately, your burn rate is an indicator of the financial health of your business. But it also communicates a few other important pieces of information to investors.
Potential risk levels
Investors want to know that funding you will pay off in the long run.
If you have a very high burn rate you can’t justify, investors will likely consider you too high of a risk. However, as VC Mark Suster points out (in a very detailed blog post), a very low burn rate coupled with a high funding ask can also be a turnoff for investors. Understandably, they’ll want to know what you’re going to do with all that money when you haven’t spent much historically.
How much cash you’ll need
Investors will have a better idea of how much money you’ll really need from them when they know how much of it you spend in a month. Based on what you’re asking for, investors can use your burn rate to start negotiating how much funding they’ll actually give you.
How much leverage they have (or that you have)
If you have very little runway and desperately need cash injections, you as a startup owner have very little leverage. Investors might be able to negotiate more advantageous terms for themselves if you’re in an obvious rush to raise funds.
However, if you have a healthy burn rate, a responsible amount of cash in the bank, and a solid business plan, you’ll be more likely to raise funds on your own terms.
What’s the right burn rate for your startup?
Understanding your burn rate is critical if you want to understand the financial health of your business. However, each business is different, and there’s no “right” burn rate for any of them.
Instead, it’s more productive to ask yourself a couple important questions when deciding whether your burn rate is healthy.
How does your business compare to similar businesses?
If a concrete number to aim for will help put your mind at ease, it’s important to find the right points of comparison.
Brex has a really helpful breakdown that shows startups’ burn rates based on the type of funding they’re seeking and where they’re located. Unsurprisingly, as founders spend the money they earn from investors, burn rate increases as companies progress from one fundraising round to another. Also unsurprisingly, high-priced tech hub San Francisco was home to startups with the highest burn rates.
Ultimately, Brex found that regardless of funding round or location, startups that progressed from one round of funding to another tended to have higher than average burn rates. According to their report, 50 percent of companies that “graduated” to the next funding round had burn rates of at least $900,000 per month.
Industry type is also important to consider here. Brex’s report indicated that startups in internet services, transportation, and data and analytics have higher burn rates, on average. Conversely, startups in consumer electronics, design, operating systems, and apparel has lower than average monthly burn rates.
Finally, you need to take the maturity of your business into account. Toptal breaks down these stages as follows:
You have a small team. You’re largely focused on building and improving upon your product so it’s market-ready.
You have a slightly larger team. You’re now focused on growing your number of clients, subscribers, or buyers.
Building your business
Your team has grown and probably requires more specialized managers or teams. Instead of focusing on developing your product or finding customers, you’re now focused on growing your business, with both product improvements and market expansions.
As your business progresses through these phases, your gross burn rate will have to grow in order to accommodate your larger staff and other necessary expenses. Depending on the amount of cash you bring in over time, your net burn rate will also fluctuate.
Does your spending align with your overall business goals?
Since your burn rate is dependent on so many intersecting factors (industry, location, maturity, funding goals, even the length of your sales cycle), it’s nearly impossible to provide one figure that your particular startup should aim for. Factors like maturity and funding goals will also change over time, so you can’t just pick an ideal burn rate and stick with it indefinitely.
Instead, you should ask yourself what type of company you’re trying to build and whether your burn rate corresponds with your current goals. If you want to move aggressively and are aiming for an IPO, a higher burn rate might be acceptable since you’ll need to invest heavily in talent and branding. However, if your ultimate goal is to get acquired as quickly as possible, you won’t need to spend as much as quickly.
Ultimately, a higher than average burn rate isn’t necessarily a bad thing. As long as you know why it’s high—and as long as it’s sustainable based on your growth and goals—your burn rate can be whatever you need it to be.
What burn rate have you already discussed with investors?
The one caveat to keeping an open mind about your burn rate is considering what you’ve already promised investors. In order to maintain investors’ good will—and keep the money coming in if you need it—you’ll want to try to keep your burn rate close to the projections you included in your pitch.
Having a higher burn rate than you projected isn’t always a bad thing. If your high spending corresponds with high business growth, investors might not mind. But if you’ve already thrown lots of cash at your business without any results, investors won’t be likely to supply more funding.
Which expenses should you keep in mind to responsibly control your burn rate?
When considering your monthly expenses, there are a few cash flows you should keep an eye on.
The key to keeping your startup’s burn rate in check is making sure certain operating costs are as flexible as possible, especially in the very early stages. You should rent office space and equipment when possible. You should also avoid long-term leases and contracts if you can. Keeping these types of operating costs low from the start will help you maintain a reasonable burn rate. And if you need to lower your burn rate, you can more easily cancel a month-to-month lease than a three-year one, for example.
Some operating costs, like employee wages, are less flexible. Especially if you’re focused on hiring top talent, your staffing costs will likely be pretty high. If you need to drastically lower your burn rate, lowering these types of costs will also yield the biggest results. Unfortunately, that means laying off employees or reducing hours.
To lower your burn rate, you should first consider cutting down on unnecessary expenses. Only as a last resort should you let your talented employees go.
As a best practice, startups should avoid capital expenditures that would incur investment costs. However, if you’ve purchased office space or equipment outright, you might have mortgage expenses that impact your burn rate. To keep your burn rate where you want it, you should make sure this type of spending is completely necessary to the success of your business.
If you’ve taken out a loan, monthly interest accruals or payments coming due could affect your burn rate.
Spark confidence in investors with an informed, responsible burn rate
Ultimately, there’s no need to obsess over your burn rate. Your mental energy would be put to much better use tackling the “why” behind it. Knowing that why can help you ensure your burn rate aligns with your business’s overall growth goals.
However, when it comes to investors, whether you’ve already obtained funding or are seeking it, it’s important to monitor whether your burn rate is in line with your projections.
To stay on top of all your important numbers, your startup should consider investing in financial modeling software.
With RaiseIQ, you can create reports and projections that help you track the financial health of your business. You can also adjust your models as your business grows so you always have the most current financial predictions on hand.See how RaiseIQ can help you build financial models that will help you raise funding. Sign up for early access today.