There are many metrics and key performance indicators (KPIs) that indicate the health of a startup. One of the most important metrics is the startup burn rate.
While its name does sound negative, the startup or business burn rate is usually a positive indicator. It’s also a KPI that investors are keen to see when considering investing in a startup.
In this article, we’ll be covering:
- What a startup burn rate is
- How to calculate it
- When a burn rate is a good metric and when it can be bad for a business
- How some startups’ high burn rate has led to their demise.
What is a startup burn rate?
In their early stages, startups are often unable to generate positive net income, or a profit. Instead, they are focused on expanding the number of customers and enhancing their product.
Often referred to as cash burn or negative cash flow, the startup burn rate is usually calculated on a monthly basis. However, in some cases it may be calculated on a weekly basis.
The startup burn rate is a cash flow planning metric that helps investors (and startups) see how much a business is spending per month before running out of money and seeking new funding.
Further reading: 9 Reasons Your Business Needs a Cash Flow Plan
It’s worth mentioning that an associated term with burn rate is ‘runway.’ The runway is the amount of time a startup has left before running out of money.
Let’s take an example of what a burn rate looks like for a startup:
If startup XYZ has a burn rate of $100,000 a month, this means it’s spending $100,000 a month. This $100,000 can include anything from salaries, marketing expenses, equipment, production costs, to rent, among other expenses.
How to calculate your startup’s burn rate
As an indicator of your company’s cash position, the burn rate accounts for the following:
- Investment activities (carried out by your company)
- Cash flow from your operations (incoming and outgoing)
- Financial activities
To calculate your startup’s burn rate, you need to be aware that there are two sub-metrics:
- Gross burn
- Net burn
Gross burn
The gross burn measures the total amount of operating costs a startup incurs every month in the absence of revenues, profits, or positive cash flow.
The Corporate Finance Institute (CFI) describes gross burn rate as a “company’s operating expenses.”
To calculate gross burn, you’ll need to add all your monthly operating expenses including rent or least, salaries, and overhead and administrative expenses.
A company’s gross burn offers “insight into [its] cost drivers and efficiency, regardless of revenue,” the CFI adds.
Net burn
The net burn, on the other hand, measures the total money spent – or lost – each month after deducting any positive cash flow during the period.
An alternative formula for the net burn is subtracting your generated revenues from the gross burn.
Let’s take an example to differentiate between gross burn and net burn.
If Startup XYZ’s gross burn rate is $100,000 a month, it means its monthly operating expenses amount to $100,000.
On the other hand, if Startup XYZ spends $100,000 a month but also generates $10,000 in revenue, then its net burn is $90,000 per month.
Further reading: Do You Know These 41+ Startup Terms and Metrics?
Why investors care about your startup’s burn rate
Investors, including venture capital funds (VCs), invest in startups and expect them to spend that money on growing the business, its revenues, and eventually turning a profit.
As a startup founder, investors don’t want to give you money and watch you keep it aside. Rather, they want to see you spending that money to scale your business and increase the return on their investment.
In this case, the startup burn rate becomes an indicator of your pace in growing your startup and their investment.
On the other hand, when investors see that a startup isn’t spending its funds, they view a falling burn rate as an indicator of stalled business growth.
And although VCs and investors look at cash burn as an indicator of growth, they also recommend having a cash runway covering at least 12 months. So if your burn rate is $10,000 a month, then you should have at least $120,000 in available cash to sustain your business.
Having 12 months’ worth of cash runway helps you as a business weather unforeseen events like a sudden increase in raw materials, a market downturn, a sudden rise in expenses, among other events.
By analyzing a startup’s rate of spending cash, investors can see when the startup will need new funding and how or if this cash consumption is translating into future money.
Another reason cash burn and runway are important for investors is because no one wants to fund a high-risk company. High-risk startups are those that will swiftly spend through their funding only to ask for more without generating satisfactory results with all that cash spend.
By having a clear view of a company’s available cash and their spending needs, founders can better grasp their financing needs, improve decision-making, and offer better forecasts and results to investors.
What is a good burn rate for a startup?
One of the questions startup owners often ask is ‘what is a good burn rate for a startup?’ and they never find a definitive answer.
The truth is, there’s no definitive answer. Every startup is a different use case. Even startups competing in the same industry over the same customers have different burn rates.
A startup’s cash burn depends on:
– The size of the startup
– The funding the startup has received (if any)
– The revenue it generates
– The market in which the startup is operating (which impacts its costs and revenues)
– The currency in which the startup spends its money
And you’re likely to see other factors that impact a startup’s burn rate compared to its peers and competitors.
However, investors and financial advisors can agree on this: When calculating your startup’s cash burn, it’s best to include all expenses incurred.
Otherwise, the “metric will be misleading if seemingly ‘one-off’ expenses, like furnishing a new office, are omitted. It’s best to compare your bank balance at the beginning of the month versus the end of the month to ensure all expenses are included,” stresses KPI dashboard maker GeckoBoard.
When is a high burn rate a bad thing?
Although burn rate is an important metric for investors, not all high burn rates are good for a startup.
For example, if a company has a high burn rate, investors will need to see:
- How much is this company generating in revenue in return?
- How long before this company begins to realize its revenue from the high cash burn?
- Is it just spending money with no clear forecast of revenue and growth?
Cash burn is important. But even more important is how your startup is spending that money.
Many startups, both globally and in the MENA region, have had to shut down because their burn rates were too high.
The problem with cash burn is that if you don’t watch it closely you can go out of business!
Keep reading to discover use cases of global and regional startups which went out of business because of their high burn rate.
How to reduce your startup’s burn rate
There are many reasons why your business may be struggling with a high burn rate. Whether it’s sizable expenses, low or slow incoming cash, or expenses you’re unaware of, you need to keep an eye on your burn rate so you don’t go out of business.
Your burn rate should include fixed costs like salaries, office space, equipment, along with variable costs like marketing expenses and contractor or vendor costs.
If you’ve noticed an uptick in cash burn, then you need to uncover the culprits behind this increase, determine their necessity, and see how you can maintain a healthy burn rate.
You’ll also need to see if these extra expenses are one-offs or new regular expenses you need to include in your calculations.
If these expenses aren’t one-offs, it’s best to review your cash flow forecasts to see if your original estimate for runway has been affected and if you need to raise funding earlier than expected or cut expenses instead.
Here are 4 ways to reduce your startup’s high burn rate
1. Reduce or cut unnecessary overheads
A common cash flow planning mistake is jumping head first and renting a luxurious office under the pretext of meeting clients.
This is quite common among new business owners and tends to shave off a lot of early-invested money.
2. Reduce your churn rate
If you’re a software-as-a-service (SaaS) business, then you know what churn is and how important a metric it is.
By reducing your churn rate and increasing retention, you can get more value from your current customers, maintain a healthy relationship with them, and increase your customer lifetime value (CLV).
Generally, a higher churn rate means more money spent on acquisition, which results in a higher burn rate.
3. Narrow down your target audience
Many startups – especially B2C ones – often believe that their target audience is ‘everyone.’ And trying to target everyone at the same time is not only a marketing fail, but also a costly financial endeavor.
By narrowing down your target audience or at least dividing them into groups that share the same qualities, you can enhance your marketing efforts and reduce spending, thereby lowering your burn rate.
4. Skip expenses that don’t directly impact revenue
As a startup, there are many kinds of expenses that you need to keep track of. It’s therefore important that you reduce any expenses that don’t directly translate into revenue.
Does renting an office and paying a hefty lease translate into higher revenues for you? Does sponsoring events every month raise your revenues?
Startup burn rate: The case of FAST
On 5 April 2022, e-commerce checkout startup FAST announced that it was shutting down without truly clarifying the ‘why.’ FAST had raised $102 million in a Series B round led by payment firm Stripe in January 2021.
Fast’s burn rate amounted to nearly $10 million a month! This means it easily went through its $102 million in funding in 10 months. And that’s a super high burn rate.
In addition, Fast had reported only $600,000 in total revenue for 2021, which was viewed as a feeble result compared to its massive spending spree.
Fast’s “future has been in doubt for days now, after reporting indicated that its 2021 revenue growth was modest, its cash burn high and its fundraising options limited,” TechCrunch reported.
Since its establishment in 2019, Fast has raised $124.5 million in funding, of which nearly $120 million came from Stripe.
Other startup failures due to burn rates
Fast is not the first company to have closed its doors because it burnt through its cash way too fast.
It’s only one in a series of startup fails over the years. Here are a few other failures due to high burn rates.
Global startup fails
– Primary Data
Despite getting $103 million in total funding, it had two main problems. Its tech wasn’t “as compelling as it needed to be” and its former CEO Lance Smith discovered that the startup had a super high burn rate and no revenue. (CB Insights)
– Next Step Living
At one point this energy company had over 800 employees and generated over $100 million in annual revenue. However in a bid to expand its services, it ended up being in a low-margin business with a high cash burn rate. By the time Next Step Living returned to its main revenue-generating business, VCs no longer wished to invest in the company. (GreenTech Media)
MENA region startup fails
The MENA region is no stranger to startup failures. But few admit that their startup burn rate was the cause of their crash.
– Cirqy
In 2015, Egyptian designer-products e-commerce platform Cirqy shut its doors after 18 months of operation. Its co-founder Kareem El Shaffei told Startup Scene that Cirqy “had all it takes” including a solid financial model, a creative marketing plan, and even “seamless business operations.” Their biggest problem? “Our decision-making on spending sucked.”
“Between a funky office we didn’t need, paying 25% of our capital on an overqualified developer and skipping entirely the concept of an MVP [Minimum Viable Product], our cash burn rate was shooting through the roof. This was when our inexperience shone,” El-Shaffei wrote via Medium.
Wrapping it up
As a startup founder, there are a few things you need to keep track of. Chief among those are your expenses or your overall cash flow. The money coming in versus the money going out.
You have to keep track of how much funding you need to raise, how you’ll use the funding, and how this funding will help you scale your business.
As Price Intelligently puts it: “You can’t go bankrupt if you make more money than you spend.”
As a startup founder, you want to raise funding to build and grow your startup and move from merely financing your startup to generating revenues and profits. You want to reach the point of positive cash flow and that’s before you run out of money.
Maintaining a healthy runway and keeping an eye on your startup burn rate are key to a healthy startup with healthy cash flow.
You’ve seen how fast ‘FAST’ burnt through its funding only to end up laying off dozens of employees and closing its doors at a time when e-commerce as a market is booming.
What this means is that a startup burn rate is important for your business and investors. It helps you manage your cash and your reserves.
It tells you where you need to cut expenses and how much revenue you need to generate.
Need help creating a cash flow plan and estimating your startup’s burn rate?
Get in touch with Stride and we’ll help you set up a cash flow plan that matches your business plan, forecasts, and takes into account unforeseen events that may affect you and your investors.
