What Is Burn Rate?
The burn rate is typically used to describe the rate at which a new company is spending its venture capital to finance overhead before generating positive cash flow from operations. It is a measure of negative cash flow.
The burn rate is usually quoted in terms of cash spent per month. For example, if a company is said to have a burn rate of $1 million, it would mean that the company is spending $1 million per month.
Understanding the Burn Rate
The burn rate is used by startup companies and investors to track the amount of monthly cash that a company spends before it starts generating its own income. A company's burn rate is also used as a measuring stick for its runway, the amount of time the company has before it runs out of money.
So, if a company has $1 million in the bank, and it spends $100,000 a month, its burn rate would be $100,000 and its runway would be 10 months, derived as:
- ($1,000,000) / ($100,000) = 10
A company can reduce its gross burn rate or the total amount of operating costs it has each month by producing revenue or by cutting costs, such as reducing staff or seeking cheaper means of production.
Burn Rate Example
There are two types of burn rates: net burn and gross burn. A company's gross burn is the total amount of operating costs it incurs in expenses each month. A company's net burn is the total amount of money a company loses each month.
So, if a technology startup spends $5,000 monthly on office space, $10,000 on monthly server costs and $15,000 on salaries and wages for its engineers, its gross burn rate would be $30,000. However, if the company was already producing revenue, its net burn would be different. Even if the company operates at a loss, with revenues of $20,000 a month and costs of goods sold (COGS) of $10,000, it would still work to reduce its overall burn.
In this scenario, the company's net burn would be $20,000, derived as:
- $20,000 - $10,000 - $30,000 = $20,000
This is a very important distinction because it affects the amount of money a company has in the bank and therefore its financial runway. Even if it's spending $30,000 gross, the actual amount it is losing per month is $20,000. This means, for example, that if it had $100,000 in the bank, its runway would be five months rather than around three months. This dictates the way in which the managers outline the company's strategy and the amount that an investor would want to invest in the company.
However, when the burn rate begins to exceed burn forecasts, or revenue fails to meet expectations, the usual recourse is to reduce the burn rate, regardless of money in the bank. This requires that the entrepreneurs rethink about the startup's cost structure. This usually means reducing staff and other major cost drivers such as office lease, technology, or marketing
- The burn rate is the pace at which a new company is running through its startup capital ahead of it generating any positive cash flow.
- The burn rate is typically calculated in terms of the amount of cash the company is spending per month.
- Gross burn is the total amount of operating costs it racks up each month, while net burn is the total amount of money a company loses monthly.