© 2020 by FounderCEO.io          

Burn Rate: What, Why & How

 

 

All right! You just pitched your venture successfully and raised the capital you needed to start. For all you first time founders this is unchartered territory. It is easy to get lost in the excitement of kickstarting your business by starting to hire and  building/developing prototypes, but it is very crucial to start acting like a business. You need to begin developing metrics to measure the health of your firm. It is time to track your sales , consumer and financial metrics to help strategically plan for the future.

Your sales metrics help create a growth engine, your customer metrics help build traction but at the beginning stages of your startup before you start seeing any return of investment the most important metrics are financial metrics - most importantly ‘Burn Rate’.

 

An interesting theory about the origin of the term ‘burn rate’ was proposed by Jeron Paul connecting it to rocketry, Russian Scientist Konstantin Tsiolkovskiy coined an equation to study jet propulsion in the late 1800s which is popularly referred to as Rocket Formula now. Which essentially translates to a rocket’s predicted change in velocity(success) is equal to the product of effective exhaust velocity or how effectively it ‘burns’ its fuel and how small it’s mass ratio or dead-weight is.

 

Burn-rate was used in the financial circles in the 90s during the dot com evolution. It was used to describe how startups spent their funds before they started making revenue very much like the Rocket Formula.

 

‘Negative cash flow’ or burn rate is a critical metric you need to pay most attention to, this can set the tone for your spending norms for your business.

 

Why Is Burn Rate Important

 

In the initial stages for any startup the most important thing is to keep your burn rate in check. It helps understand the time by when you will run out of funds based on your monthly spending. Burn rate will help you be prepared to keep the lights on when the need arises. By being ready you can do what it takes, in this case either raising more funds, speeding up the rate at which you can hit the market to get positive cash flow or to lower spending to slow down the burn rate.

 

Developing burn rate lets you produce an accurate forecast of how much you will spend in the near future. If it exceeds your forecasts you need to lower your expenditure accordingly. This is a great indicator to set spending limits. You can also set benchmarks internally for your burn. If you are missing your targets more than you are comfortable with, it’s time to analyse your spending to see how much of it is justified. For example- you can’t go and get a swanky office in Financial District on the 43rd Floor, there is no room for fanciness, try and operate minimally as you cannot afford to let investors think of you as inefficient.

 

It is an important metric to show your investors too. They use it to see how effectively you’re “burn”ing their investment. It can affect your reputation in the investor circles. If it's too high it’ll only be harder to raise more money when needed, so it’s best to keep it optimal.

 

There can be an array of factors that can impact your burn rate like a sudden change in the economical landscape or a product cycle transition. By keeping tabs on your burn rate you can monitor the financial situation of your firm closely and be prepared for any surprises that spring up on you. The key is to be lean, costs can accumulate very quickly otherwise.

You can identify patterns from your burn rate. When your revenue is higher your burn rate reduces and if your burn rate is going higher it means your revenue is not catching up the way you anticipated it to.

 

Obviously, while tracking your burn, it is important to understand which part of it is fixed cost and which part of it is variable. By observing these patterns you can predict how you are spending so you can scale these metrics accordingly over a course of time.

 

It can be tempting to think the obvious thing to do is spend less and have a lower burn rate and preserve your funds, however this is not the answer. Following are a few important considerations for founders to understand their burn rates better.

 

Gross Rate Vs Net Burn

 

Gross Burn is the total amount of capital you spend in a month. This is inclusive of all the outgoing cash flow towards any operational expenditure. Net burn is the monthly loss you incur.  

 

Net Burn= Opening cash balance - Cash balance at the end of the month

 

If you are spending $10,000 a month towards operational costs like paying your bills, paying your employees etc, and making $5000 in revenue, your monthly gross burn is $10,000 because you are spending that much. Your net burn would only be $5000 because you are bringing in $5000.

 

VCs will be looking at your net burn, but it is equally important to keep your overhead as low as possible. You want to be prepared in case there is a dip in profits, there might be sudden increase in your burn rate as you might run out of funds, or you might have to get your gross burn rate back in control to compensate for loss in revenue to keep your net burn rate steady.

Understanding and balancing the difference between these two is what keeps your venture healthy.

 

Burn Rate, Runway & Investment

 

‘Burn’ is a decrement of funds. Runway is a concept based on burn. It is defined as the amount of time an enterprise has till it runs out of cash. It is also referred to as ‘zero cash date’.

 

Runway = Cash Balance / Burn Rate

 

Runway can be calculated by dividing the cash balance by the burn rate. For e.g. if you  have $50,000 in funds and burning $5,000 per month, you have a runway of 10 months.

 

Burn rate is not constant and it fluctuates month to month. This implies that your runway is not absolutely fixed either, these metrics are evaluated on a monthly basis. VCs track funds in terms of runway too.

 

It is advisable to plot your runway on a graph. Lines don't lie like numbers can.  Runway line accelerating towards zero is an awful thing to stare at and is very likely to induce change before it's too late.

 

Burn Vs Opportunity

 

As mentioned earlier, it can be easy to assume that lesser spending will help save your capital, but it is not about cutting costs but directing them effectively. You do not want missing out on great opportunities.

 

When invested right your capital can multiply in the scheme of things. You need to spend smart to scale your growth, it’s all about the bigger picture. You need to be objective enough to not let these opportunities slip away. Agreed that you need to be prudent with your money but at the same time you cannot go overboard with hiring huge teams or expensive marketing campaigns to acquire consumers who add zero value.

 

You need to be aggressive in spending to push for growth. Higher burn rates at the early stages almost always translate into a better future for your firm. You need to spend on your necessary evils but cut down hard on your unnecessary outlays.

 

How to reduce your burn rate

 

If your burn rate is higher than you want, you need to make corrections. Let’s see how:

  • Increase your revenue: Well, this is the obvious one. Increase your pipeline and conversion rate. Or raise your prices. More sales should mean more cash.

  • Reduce your direct costs: Take a hard look on your payroll cost. Generally for SaaS business, this is the area that can have highest impact. Delay new hires and lay off non-essential employees. Device a plan to reduce your other direct costs, like material cost, as well.

  • Reduce indirect expenses: Find out ways to reduce your indirect costs. Lower your employee entertainment cost, economize your travel cost. Cut out anything that is not contributing directly to your success.

  • Manage your working capital: Reduce collection period and increase your payment period. You can offer discounts to encourage faster collections. May add late payment charges as well. Don’t pay your bills any faster than you have to.

  • Defer huge capital expenses that need cash outflow: Do the cost-benefit analysis and delay the capital expenses if you can.

This brings us to our most important question- What is the right burn rate for You?

 

There is no fixed pi here to be universally right but here’s a framework to arrive in the vicinity of your custom fitted answer.

 

Time it takes to raise Capital from the current stage your firm is at

Now this is going to sound super obvious but raising money works better if done sooner than later. Raising more money in later stages needs so much more analysis than initially because initial investment is just idea, founders and maybe the product, later a lot of things come into play like churn analysis, customer feedback, financial metrics, cohort analysis etc.

 

That being said, know your investors ahead of raising capital and keep doing research on who else would be a good fit. Fund raising is not a one time event. It is part of your job description, you signed up for it. You need to tap all potential capital markets to see substantial growth.

 

Existing Investors

Always have an open line with your investors, you need to get them involved and discuss how comfortable they are with your decisions and direction.

 

If you have multiple investors, say more than four, things might get trickier because no one owns responsibility to help solve your problems especially money related and with only so little of their skin in their game there is no incentive either. Another problem with multiple investors is that if half of them are willing to give you more capital and the other half are not you might end up not getting anything at all because investors are not willing to let the other half take them for a free ride, they expect them to pay to protect their own investments.

 

Your Appetite for Risk

Things to ask yourself to understand your risk appetite -

  • Your Time invested in the venture

  • Money you have personally invested

  • How cautious are you ? (This one is obvious but much needed)

Taking risky calls can work wonders for some firms but you need to make informed decisions. Sometimes playing it safe will help you but you have to act in the interests of the firm you cannot take risky calls just because you have an appetite for it.

 

Your Access to capital

Your existing investors is your ‘access to capital’. You just need to make sure that they will ensure smooth sailing if needed or if you need to find new VCs to come on board.

 

Apart from these you also need to analyse how your last valuation went, how reasonable it was and how complicated your cap table is. These will help you understand how to optimally pace your burn rate based on which you can set a goal and plan all your spending to fall under those lines.

 

Here’s how a couple of VCs advice on burn rate-

 

A piece of advice from a VC Danielle Morrill like she mentioned here:

  • Don’t aggressively increase your burn rate until you are confident you have found product/market fit.

  • Try not to spend more than 5% of your budget on things outside of payroll, benefits and rent.

  • Try to avoid unnecessary scaling (hiring) early on.

Sam Altman in a Business Insider Interview said :

'It’s OK if you want to spend money to be aggressive for growth or speed. The thing that is not OK is if the plans change or environment changes, you should be able to reach profitability on the money you have. What is OK is to spend money for productivity. What is not OK is just to light money on fire'.

 

For better or worse, managing your burn rate will need critical thinking and real effort. Roll up your sleeves and get to work.


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