Understanding the Burn Rate
The burn rate represents the speed at which an unprofitable company consumes its cash reserves. In the case of a startup, it is the rate at which a new company spends its venture capital to finance overhead before generating positive cash flow from operations. Essentially, it measures the company’s negative cash flow.
Burn rate is most often a consideration for young life sciences or technology companies that lack profitability or, in some cases, even revenue. It is usually quoted as cash spent per month. For example, if a company has a burn rate of $1 million, this means it’s spending $1 million per month.
Key Takeaways
- The burn rate indicates how quickly a new, unprofitable company is consuming its cash reserves.
- It’s typically calculated as the monthly cash expenditure of the company.
- Gross burn is the total monthly operating costs, while net burn is the total monthly money lost by the company.
- The burn rate affects the company’s financial runway—how long it can operate before exhausting capital. A higher burn rate means a shorter runway.
Calculating the Burn Rate
There are two types of burn rates: gross burn and net burn.
- Gross burn rate is the total monthly operating costs:
$$ \text{Total Monthly Operating Costs} = \text{Gross Burn Rate} $$
- Net burn rate is the total monthly money lost after accounting for revenue:
$$ (\text{Monthly Revenue} - \text{Cost of Goods Sold}) - \text{Gross Burn Rate} = \text{Net Burn Rate} $$
Example Calculation
If a technology startup spends $5,000 monthly on office space, $10,000 on server costs, and $15,000 on salaries, its gross burn rate would be $30,000. If the company generates $20,000 in monthly revenue and has $10,000 as the cost of goods sold, the net burn rate is:
$$ ($20,000 - $10,000) - $30,000 = -$20,000 $$
Even if the company spends $30,000 monthly, it’s effectively losing $20,000 per month. This impacts the financial runway. If the startup has $100,000 in the bank, its runway is five months, not three.
Managing Burn Rate
If the burn rate exceeds projections or revenue falls short, typically, the company needs to reevaluate its cost structures. This may involve reducing staff, lease costs, technology expenditures, and marketing budget.
What Is a Good Burn Rate?
A general rule is that a startup should maintain six to twelve months of expenses on hand. For instance, if a company has $100,000 in the bank, a good burn rate would range from $16,667 (six months) to $8,333 (twelve months).
Frequently Asked Questions
How do you calculate the burn rate?
- Gross Burn Rate: The total monthly expenditure.
- Net Burn Rate: Takes into account monthly revenue minus cost of goods sold. The formula is:
$$ (\text{Monthly Revenue} - \text{Cost of Goods Sold}) - \text{Gross Burn Rate} = \text{Net Burn Rate} $$
Is burn rate the same as expenses?
For gross burn rate, yes. However, the net burn rate factors in any revenue the company may generate.
Conclusion
The burn rate is a crucial metric for startups, especially those not yet generating revenue. It indicates how fast a company is depleting its capital and helps pinpoint when it might incur debt, termed as the company’s financial runway. When the burn rate is high, reducing structural costs—in ways such as cutting down on staff or marketing expenses—becomes inevitable to lengthen the runway and ensure sustainability.
Related Terms: runway, venture capital, operating costs, net burn, gross burn, revenue.
References
- Dictionary.com. “Burn Rate”.
- Management Study Guide. “Managing the Cash Burn Rate”.
