One of the most common reasons why startups fail is because they run out of cash (Ehrenberg, 2014). Therefore, it is essential to control the burn rate, especially in the initial stages of a startup. It's also an important metric that investors pay a lot of attention to.
In today's article, we analyze the most important questions about the burn rate concept: what is it? , how to calculate it? , what values can it take? The burn rate, or in Spanish the effective consumption rate, refers to the speed at which a company burns or uses its cash reserves. The term implies that more cash is being used monthly or periodically than what comes into the company, to finance operations and cover general expenses: paying employees, suppliers, invoices, etc. In the startup world, the burn rate is a widely used term. Although it is very common for a company to have negative cash flows during the early stages (expenses exceed revenues and, therefore, external financing needs to be used to cover the difference), it is important to analyze the value of the burn rate to correctly forecast the consumption of funds and improve operational efficiency. Although not strictly necessary and the decision will vary depending on the company's particular context, in many cases, the burn rate is calculated based on monthly periods. Calculating the monthly burn rate allows companies to have a more detailed view of their cash flows and to effectively plan for the short term. However, in some situations, companies may choose to use quarterly or annual periods to calculate their burn rate. This may be appropriate when expenses and revenues fluctuate significantly over shorter periods and a broader perspective is required to obtain a more accurate picture of the company's financial health.
How to calculate the burn rate?
There are two main ways to calculate a company's burn rate. We can calculate our gross consumption rate Or ours net consumption rate. While the first concept refers to the total sum of operating costs, the net burn rate takes into account revenues and, therefore, reflects the amount of money that a company “loses” during the calculated period of time. It is important to remember that when calculating the current burn rate, whether gross or net, it is something specific and its value will vary from one month to the next, depending on both the level of turnover and the company's expenses.
Gross burn rate formula
The “gross burn rate” refers to the rate at which a company is spending or consuming its capital regardless of revenue. The basic formula for calculating the gross burn rate is as follows:
- For example, if a company has spent 100,000€ in the last 6 months, the gross burn rate would be: Gross Burn Rate = 100,000€/6 months = 16,667€ per month. This indicates that the company is spending approximately 16,667€ per month without taking into account the income generated in that period.
It is important to note that the gross burn rate does not consider the company's revenues. To obtain a more complete picture of the financial situation, it is common to calculate the “net burn rate”, which takes into account both expenses and income.
Net burn rate formula
The “net burn rate” formula takes into account both a company's expenses and revenues over a specific period of time. The basic formula for calculating the net burn rate is as follows:
- For example, if a company spent 100,000€ and generated 50,000€ in revenue over a period of 6 months, the net burn rate would be: Net Burn Rate = (100,000€ - 50,000€)/6 months = 8,333€ per month. This indicates that, on average, the company is spending 8,333€ more than it is generating in revenue each month.
The net burn rate is an important metric for evaluating a company's financial health, as it shows if the revenues generated are sufficient to cover expenses or if the company is consuming its capital at an unsustainable rate.
The burn rate in the search for Private Funding
A company's burn rate is a key indicator of its financial health and long-term sustainability. Therefore, a low and controlled burn rate can generate trust among investors, while a high burn rate, without adequate justification, can generate concern and increase perceived risk. Although there is no specific burn rate threshold that leads an investor to decide not to invest in a company (the decision will be influenced by additional factors such as: the type of investor, industry, other key metrics, etc.) and the burn rate must be evaluated in the broader context of the financial situation and the growth prospects of the company, there are some key points to consider:
- The burn rate is a key indicator of financial viability of the company: It provides investors with an idea of how long a company can operate before running out of money to maintain its business. If the burn rate is high and the company is spending money at a fast pace without generating enough revenue, there is a risk that the company will run out of capital and may face serious financial problems.
- A low burn rate indicates that a company is efficiently managing your financial resources and he's controlling his expenses. This can be a positive indicator for investors, as it shows that the company is being prudent and responsible with its money.
- The burn rate can also provide information about the strategic planning of a company. If a company has a high burn rate but is aggressively investing in growth and expansion, investors can see it as a long-term strategy to capture greater market share. However, if the high burn rate is not justified by positive results or a clear strategy, it can cause concern among investors.
- The burn rate is one of the factors that investors consider when assess a company's level of risk. A sustained burn rate without a clear revenue projection may raise doubts about the company's ability to generate returns. And, in turn, a high burn rate may indicate greater risk, since there is a possibility that the company will run out of funds before achieving profitability or securing new sources of financing.
- Even if the current burn rate is low, if the company has a history of poor financial management or has shown difficulties controlling its expenses in the past, investors may be more cautious about investing in it. La confidence in the company's ability to manage efficiently your resources are an important factor for investors.
The burn rate in the search for Public Funding
The burn rate of a company not only plays a critical role in seeking funding through private investors. In most cases, public entities take into account the value of the burn rate during the financial analysis of companies, before granting the requested funding. Enisa, for example, pays close attention to cash levels and their evolution, so from the moment a loan is requested until the application is analyzed, it is important not to have a “Burn rate” very high. If at the time of the analysis the company finds itself with a cash flow close to zero, the request will usually be rejected. “For this reason, we recommend asking Enisa for a loan as soon as possible after closing a round of capital, even before formalizing it or counting on the total amount you want to raise. A request can begin to be made in parallel with the development of the round, but it must be clear that if they accept the request before closing the round, they will condition it to the effective formalization of the round and will give a maximum period of 2 months for its execution.”
How to reduce the burn rate?
At this point, the big question arises: how can a startup reduce its burn rate? Although, as we have already mentioned before, the consumption rate can be seen as a choice and there is no burn rate that is more efficient than another, it is important to know the speed at which a company is consuming its funds in order to plan the search for funding if necessary (either through external investors, venture capital, or alternative sources of income) in order to avoid closing the company. In cases where a company, for whatever reason, needs to reduce its burn rate, there are several alternatives that it can resort to, such as:
- Reduce personnel costs: In some companies, and even more so when we talk about companies with SAAS business models, it is very common for this to be the expense item with the highest value. To reduce its value, the company can choose to slow down hires, stop them or, in more extreme situations, reduce the number of employees on the workforce. In this regard, another option for companies may be to opt for flexible hiring, outsourcing certain functions or automating tasks to reduce costs associated with the workforce.
- Reduce uncollected accounts: Either by reducing customer payment periods, establishing effective billing processes, offering customers the possibility of making payment through different methods, etc.
- Increase unpaid accounts: Renegotiating the payment deadline with suppliers, choosing suppliers for factors other than price, etc.
- Carry out a strategy focused on customer acquisition and retention: Increasing marketing and sales efforts to attract new customers and increase the retention of existing ones can lead to faster revenue growth.
- Adjust the growth strategy: Evaluating the growth strategy and considering options such as a more gradual or phased expansion, rather than accelerated growth, can help reduce the burn rate. This allows for a more controlled and sustainable approach to growth.
In short, reducing the burn rate involves taking steps to control and reduce expenses, improve operational efficiency and increase revenues. It requires a strategic approach and a careful evaluation of the different areas of the company to identify opportunities for optimization and financial efficiency.
