According to Fundera, the failure of 82% of small businesses can be linked to cash flow problems. This underlines the importance of finances and cash flow for a sustainable and successful business. However, many things go into managing the cash flow of a startup. One of these things is the burn rate.
This article will define burn rate, provide a detailed startup guide to burn rates, and its implication for the future of the business. More importantly, we will also explore the monthly burn rate formula and how to calculate burn rates in Excel using our financial model template.
What is the Burn Rate of a Startup?
Simply put, the burn rate is the rate at which a startup runs or burns through its finances. The term describes the rate at which a startup spends its cash reserves before reaching profitability. For all startups, burn rate is a major variable in determining the runway. The runway for a business describes how long it can operate before running out of cash.
A startup's burn rate is a monthly figure. For instance, if a business is said to have a $50,000 burn rate, the company spends $50,000 per month, which covers both variable and overhead expenses.
Types of Burn Rates
There are three types of burn rates that a business has, and we are going to cover them in this startup guide to burn rates. They include Gross Burn Rate, Net Burn Rate, and Average Burn Rate.
Gross Burn Rate
The gross burn rate refers to the total amount of money spent within a month. This burn rate does not consider other finances as it solely focuses on the expenses made during the month. Therefore, if a startup spends $50,000 monthly, the gross burn rate is $50,000.
The gross burn rate is a very important business metric. Apart from providing you with information on the amount of cash you spend monthly, it is useful in determining when a business has vulnerable revenue streamlines. It helps you identify your primary cost drivers and calculates the efficiency with which your company operates.
Net Burn Rate
For this burn rate, we consider other types of finances and aspects of the cash flow. It considers the money that comes into the business during the month and the money that goes out of the business. To get the net burn rate, you subtract the total expenses from the total revenue.
For example, if the business has a total expenditure of $50,000 in a month, but in the same month, it made $40,000 in revenue, the net burn rate for the month is $10,000. However, you should know that as much as the net burn rate considers the money that comes into the business, it does not consider injected funds such as equity investments or loans. It only considers the money that comes into the market through revenue.
The net burn rate is important to potential investors, banks, and lending institutions. It is a metric that helps them to accurately deduce how long your business can operate and survive with its current financial resources. Consequently, the net burn rate will help them make strategic decisions regarding the company's growth.
Average Burn Rate
This average burn rate is not as popular as the other two types of burn rates discussed earlier. Nonetheless, it is equally important. The average burn rate is calculated by dividing the total burn rate over a period by the number of months. Say the total burn rate of a business for a year is $120,000, then the average burn rate is $10,000.
It follows that the ability of a company to calculate its burn rate accurately depends on its bookkeeping and accounting practices. This is because you need the company's financial records, most especially the records of its expenditure and earnings over some time.
Importance of Burn Rates
We mentioned earlier that almost 82% of new businesses fail because of cash flow problems.
Investors are experts on this topic, so as a startup, you need to understand this startup guide to burn rates to convince them that you are worth investing in.
Moreover, understanding burn rates does not only help startups appear like an expert in their fields and convince investors; it aids in the planning and success of the company.
Important Startup Burn Rate Metrics
One of the things that startup founders ask or seem to struggle with is determining whether to increase or reduce the burn rate of their companies. There is no straightforward answer to this question, as the answer depends on many factors (which will be discussed later in the post).
However, there are certain metrics that founders will have to consider while working with burn rates, and these metrics help provide an acceptable answer to the question. These metrics are:
Unit economics refers to the revenue gained by the company over the unit sale of its products or service. This describes how much profit the company makes when the startup sells its product or renders its service. To get this variable, you need to subtract the cost of acquiring the customer (CAC) from the customer's lifetime value (CLV).
Cost of Growth
The cost of growth is the second metric, and it refers to the operational cost and expenses the startup has to work with. These expenses include workers' salaries, the cost of renting out office space, and other costs incurred in the operation of the business.
With these two metrics well covered, you will not only be able to determine whether to increase your burn rate or reduce it, but you will also be able to calculate the burn rate effectively.
Monthly Burn Rate Formula
To start with, the calculation of the burn rate is quite simple. Once you know this formula, it becomes easy to understand how to calculate burn rate in Excel.
From the definition of the different burn rate types, you can find the monthly burn rate formula for them. For instance, the gross burn rate is the total of expenses made in the month. Thus;
Gross Burn Rate = Outward cash flow
On the other hand, the formula for calculating the net burn rate is
Net Burn Rate = Total monthly revenue - Total monthly expense
Another formula you need to know is that of the implied runway. We have described runway as the number of months the business can operate before requiring additional funding. Thus the formula for calculating runway is
Runway = Cash balance/Burn rate(per month)
How to Calculate Burn Rate in Excel
In a world where most business operations and activities have been computerized, it is not a surprise to know that there are excel templates for calculating the burn rate of a business.
Before we delve into how to calculate burn rate in excel, you should know that the use of excel templates makes the calculation faster, more accurate, and even easier to update as time goes on.
Gross Burn Rate = Outward cash flow
In such case, on Excel, sum up your known and predicted expenses for any given month using =sum(). This number will be the burn rate for that month - a method you can replicate across all your months to understand the cash required to fund your business if your financial model is accurate.
Using Excel templates to calculate burn rates also makes it easier to share the calculations and values with investors and lending institutions wherever needed. Therefore, if you are looking to streamline your burn rate calculation and make it more presentable, you should consider using a Burn Rate Excel template.
BaseTemplates offers a financial model template to help startups calculate their burn rates with ease and in a visually appealing manner. We also have other templates to help businesses accentuate their pitches and other needs.
While you can easily download the template, there are certain parameters that you need to provide to use the template effectively. These parameters include the total cash balance. You need to calculate the total cash that your company has at hand.
Usually, this value is the addition of the raised funding and the existing cash in hand. As an example, if your business has $50,000 cash in hand and raised $500,000 in funding, the total cash balance is $550,000. Other parameters include the gross burn rate, net burn rate, and implied runway calculation.
What is the Perfect Burn Rate for Startups?
As mentioned earlier, this is one of the questions that many founders ask a lot in a bid to control their spending or get more funding from investors. While there is no definitive answer to this question, there is a framework that helps you answer the question.
This framework uses certain parameters or factors, and these factors will be discussed in this section.
Net Burn vs Gross Burn
You already understand the difference between the two types of burn rates. However, how do they help you determine the perfect burn rate for your startup? Here is how.
Outside of the definition you already know, the implications of these two metrics on the business are different. Gross burn shows the total amount of money the business spends, while net burn shows the amount the business loses in a month. Thus, if you have an expense of $150,000 in a month and generate a revenue of $50,000 monthly, you are running at a $100,000 loss per month.
In this case, you would need $1,000,000 in the bank to have a runway of 10 months. If you're in this position, you will need to raise capital fast or reach profitability. To raise capital faster, check out our pitch deck templates which have helped hundreds of founders raise capital for their startup.
Growth and Profitability
In as much as the growth and profitability metrics seem to have the same meaning, their implications for the business are quite different. To understand the difference, there is a need to touch on the concept of gross margin.
Gross margin refers to the amount of profit generated from the sale of your product or service while bearing the total cost of selling the product in mind. As a rule, if you have a low gross margin, say between 10% and 30%, building a scalable business will be very hard as you would need to make a lot of sales just to cover the operational cost.
This is particularly true in markets where there is a monopoly. If one business has market dominance, its scale means their margins can be much smaller due to economies of scale. For companies trying to break into this market, it is much harder as they won't be able to compete on price with the market leader without requiring unrealistic amounts of funding to fuel their growth.
Companies that have succeeded in the startup world are usually software companies. This is because they easily record over 80% gross margin, and this is why they are more successful than traditional businesses selling consumer products. Notwithstanding, SaaS companies take a longer time to scale up their revenue than the short time required by many product companies.
Gross margin is important in determining the perfect burn rate for a startup because it is advisable for companies with high gross margins and scaling ability to spend more capital on their growth. This means that they need a high burn rate.
The need for a high burn rate stems from the fact that it enables a company to capture market share as fast as possible once it has established the perfect product, before competition sets in.
Startup businesses, especially SaaS startups, would need to make more investments in their engineering department to maintain the advantage of the product and possibly build on it. You may also need to invest in infrastructure (such as server space) to capture more market and spend more on marketing to capture more consumer attention before your competition.
All these investments mean you will have to burn through a lot of cash, increasing your burn rate.
Cash or Capital Availability
The amount of money you have at your disposal also determines if you can afford a high burn rate as a startup. If you have strong venture capital backing and enough money in the bank, a high burn rate is not out of place.
This is not the same for a business that relies on angel investments and less money in the bank. For example, a startup that has raised $40 million in investments can confidently burn $1 million a month. At this rate, the startup will have a 40-month runway, which translates to over three years before needing to raise another investment.
However, with companies that are scaling fast and spending that much, there is a need to justify the high burn rate. If you were spending $12 million a year, you would need to manage at least 3X the burn rate in value creation.
To accommodate a high burn rate successfully, you will need to;
- Be on good terms with your investors
- Have a strong balance sheet
- Have a strong business performance
- Establish a strong pattern of growth
- Have a large target market you're trying to capture
With all these in place, you can manage a high burn rate and also find it easy to raise funds after the high burn rate. However, you also need to factor in the investor's trust. If you go through a high burn rate and run out of cash, the investor has more leverage on you at that point.
Valuation is the last aspect of the framework that helps you determine the amount of burn you should manage as a business.
Your current valuation also determines the right amount of burn you can manage. If, for instance, you have raised a $50 million post-money valuation with $2 million in the bank and the market conditions change, you should know that the valuation warrants that you raise at least $50 million to avoid a down-round, even with the challenging market condition. And with the market condition going south, you must be careful of a high burn rate.
With the framework components complete, you can use the following suggestions to determine the perfect burn rate for your business.
Why is Understanding your Runway Important?
As a rule, you should be careful and ensure that your framework does not put you in a situation where you cannot operate for less than six months with the cash in the bank.
You need to calculate your net cash by adding the cash balance with the net payables and receivables. You can then divide the net cash with your burn rate. Remove the last month from the answer, giving you the accurate amount of money you can operate with the cash in the bank.
The reason for removing the last month is to plan for emergencies and ensure you have a reserve to fall back on in a crisis. Failure to do this may put you in the "trading while insolvent" category, which has legal implications for your business.
In addition, it typically takes 12.5 to 40 weeks to raise a seed round, so having at least 6-9 months of cash in the bank will give you the time needed to raise funds required to grow.
If you have gotten to this point in our startup guide to burn rates, you know there is no need to re-emphasize the fact that cash flow is an important aspect of any startup.
One thing that affects the cash flow of a business, especially a startup, is the burn rate. You want to ensure that you understand how it works, its implication for your cash flow, and how to calculate it.
While you can calculate the burn rate manually, using a well-detailed template, such as the Financial model template, is advisable. This template makes your burn rate, cash sales, and expenses calculation easier and allows for a more organized presentation of your business.
Frequently Asked Questions about Burn Rates for Startups
Is it difficult to raise and manage funds that will sustain your burn rates as a startup?
Like most business endeavours, managing funds is not a walk in the park. In any case, you should be careful about a high burn rate if your fundraises have only been through seed funds, accelerators, and angel investors.
While these fund raises are not exactly bad sources of capital for startups, you may find it difficult to get a larger amount of money from them, especially in tough market conditions.
Unlike VCs that concentrate on few investments, these sources of financing have many investments and find it difficult to cover their bets on startups with more cash.
To learn more about other funding sources, check out our compiled list of how to raise money for business startups.
Should startups always have open communication with the venture capitalists?
If you have raised funds through a VC and are getting uncomfortably close to the end of your runway, it is time to have a conversation with your venture capital regarding the runway and funding.
You need to ask the hard questions at this point. You should know if the VC is willing to provide a bridge loan when your funds run low or if you need to cut back on some excess expenditures.
If you share the same VC with some companies, talk to them and understand how the VC reacted when they got in a similar situation. Of course, this does not mean that the VC would react the same way, but it helps you get an idea and prepare ahead.
Can venture debt affect you?
If your startup uses venture debt, you have less runway than the average startup. This is because some venture debt does not allow you to go below a certain amount of money in the bank.
In this case, your calculation of the runway does not work with the end of the cash in the bank. Instead, it works with the limit on the cash in the bank.