What is Burn Rate?
Burn Rate refers to the rate at which a company depletes its cash pool in a loss-generating scenario. It is a common metric of performance and valuation for companies, including start-ups. A start-up is often unable to generate a positive net income in its early stages as it is focused on growing its customer base and improving its product. As such, seed stage investors or venture capitalists often provide funding based on a company’s burn rate.
How to Calculate Burn Rate?
1. Gross Burn Rate
Gross Burn Rate is a company’s operating expenses. It is calculated by summing all its operating expenses such as rent, salaries, and other overhead, and is often measured on a monthly basis. It also provides insight into a company’s cost drivers and efficiency regardless of revenue.
2. Net Burn Rate
Net Burn Rate is the rate at which a company is losing money. It is calculated by subtracting its operating expenses from its revenue. It is also usually stated on a monthly basis. It shows how much cash a company needs to continue operating for a period of time. However, one factor that needs to be controlled is the variability in revenue. A fall in revenue with no change in costs can lead to a higher burn rate.
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What are the Implications of a High Burn Rate?
A high burn rate suggests that a company is depleting its cash supply at a faster rate. It indicates that is it at a higher likelihood of entering a state of financial distress. This may suggest that investors will need to more aggressively set deadlines to realize revenue given a set amount of funding. Alternatively, it would mean that investors would be required to inject more cash into a company for it to realize revenue.
How to Reduce Burn Rate?
1. Layoffs and Pay Cuts
Typically, an investor may negotiate a clause in a financing deal to reduce staff or compensation if a company is experiencing a high burn rate. Layoffs often occur in larger start-ups that are pursuing a leaner strategy or have just agreed to a new financing deal.
A company can project an increase in growth that improves its economies of scale. This allows it to cover its fixed expenses such as overheads and R&D to improve its financial situation. For example, many food delivery start-ups are in a loss-generating scenario. However, forecasts in growth and economies of scale encourage investors to further fund these companies in hopes of achieving future profitability.
Often, companies spend on marketing in order achieve growth in its user base or product use. However, start-ups are often constrained in the sense that they lack the resources to use paid advertising. As such, growth ‘hacking’ is a term often used in start-ups to refer to a growth strategy that does not rely on costly advertising. One example is Airbnb engineers reconfiguring Craigslist in order to redirect traffic from Craigslist onto its own site.
Applications in Financial Modeling & Valuation
When building a financial model for a startup or early-stage business, it’s important to highlight the monthly burn rate and the runway until the next financing is required.
Early stage businesses will often raise money in phases to fund different stages, so it’s important to highlight how long the company will last until it needs more money.
The above image is an e-Commerce financial model showing the company’s cash balance over time.