What is the Burn Rate?
Burn rate is a term that startups use to describe their cash burn or cash spending. If your company has $1 million in the bank and spends $50,000 per month, you have a burn rate of $50,000/month. Burn rate can also be used as a measure to predict when your company will run out of money based on current revenue projections.
If you're growing faster than expected, you should adjust your burn rate accordingly — either by increasing it if you plan on raising money again (and being able to justify why you're burning more) or decreasing it if you need to cut back. Conversely, if growth isn't fast enough and money is running low, companies may decide to reduce their burn rates. By reducing their headcount and spending less on marketing and other expenses companies can preserve their remaining capital for as long as possible.
"Spend More. Burn less. At first, we had no sales and marketing, just engineers — and they sold the solution. But even with that jolt of confidence, getting to that first million is difficult because nobody knows you and you likely don’t have a solid sales and marketing function."
- Eric Yuan (Founder, Zoom)
Want to learn more about the origin story of Eric Yuan? Read more about Eric Yuan’s origin story here.
How to Calculate Burn Rate?
Burn rate is a core metric for startups as it is an indicator of how long the company can stay in business. The formula to calculate burn rate is:
(Operating Expenses - Operating Profit) / Time Duration
A positive burn rate means that the business spends more than it earns, and a negative burn rate means that the business spends less than it earns. A negative burn rate could be achieved for instance if the business were to receive external funding.
How does Burn Rate work?
Burn rate is the rate at which a new company is spending its venture capital to finance overhead before generating positive cash flow from operations. For example, if a company has $1 million in the bank and spends $250,000 per month, it has a burn rate of $250,000 per month. Investors want to know a startup's burn rate because they want to know how much cash the startup will need before it can start selling its product or service and begin making money.
Burn Rate Examples
Let's say you're the CEO of a startup that develops software for large companies. You have 200 employees, mostly developers. The average salary of your developers is $80,000 and benefits cost an extra $20,000 per employee. So each developer costs $100,000 per year. As you are the CEO and founder, let's say your salary is $250,000 with an extra $50,000 for benefits.
You also spend about $200,000 on office rent each month and another $50,000 on miscellaneous expenses like internet service or food in the office kitchen. To fund all this spending every month, you take out a loan with monthly payments of $1 million to cover salaries and other expenses until your seed funding comes through later in the year.
In this example case:
- Total Monthly Expenses = (200 * 100K) + 50K + 1M + 200K + 50K = 4.35M
- Burn Rate = 4.35M / Month
How to Reduce Burn Rate?
A great way to reduce the burn rate is to increase revenue without increasing expenses. For example, you can raise prices or offer more services and products, which allows you to generate more cash. If your business is seasonal, consider your cash flow throughout the year and how you can find ways of generating income in those months when things are slow without increasing overall costs.
Another option is to reduce your expenses by cutting back on frivolous spendings, such as travel or entertainment for employees. This can be difficult because people often resist change; however, it may be less painful and will improve morale if employees feel like they're included in this process so that everyone feels ownership of the decisions being made.
You might also consider refinancing debt if you have an expensive loan balance with a high interest rate. When you refinance at a lower interest rate, your monthly payments decrease while maintaining the same payment schedule until the loan is paid off in full. You could also pay down credit card balances with lower interest rates before paying off other debts first since that'll help save money on interest charges over time.
Finally, use a cash management system to plan for positive cash flow proactively so that there are no surprises when it comes time for payroll or other bills due each month (or week). By utilizing these strategies during challenging financial times--and even after things get better--you'll set yourself up for success with less stress!
Conclusion
The takeaway here is that burn rate is the amount of cash a company spends each month. A company's burn rate should be examined and compared to its current cash balance in order to get an idea of how long it can survive. The lower the burn rate, the longer a company has to grow before it needs more capital.
For entrepreneurs and managers, this may be one of the most important financial metrics they calculate. It is also one of the simplest metrics that investors look at when deciding whether or not to invest in a company. So don't forget – when you're looking at your company's monthly finances, keep an eye on your burn rate!
Entrepreneurship
