“Revenue is vanity, Profit is sanity, and Cash is king”
As a founder or CEO, there are numerous metrics to monitor, ranging from customer acquisition costs to revenue growth. However, one metric that entrepreneurs frequently overlook is their cash burn rate. Simply put, as a start-up founder, cash should and will always be a top priority.
Explanation of Cash Burn Rate
The cash burn rate represents the monthly amount of money spent by your company to cover operating expenses such as salaries, rent, and marketing. This metric is critical for startups because it shows you how much cash you're spending each month, and it will help you determine how much runway you have before you run out of money.
Your cash burn rate can be calculated on a monthly basis, as it will likely change due to new expenditures. Your cash burn rate of one month is a point-in-time number. For example, in January, your burn might be $10,000, and in February, $20,000.
You can calculate an average cash burn rate over a period of time. In the example above, your average cash burn rate in those two months would be $15,000.
You can also project your cash burn rate based on your upcoming expected spending.
Gross Burn rate VS Net burn rate
There are two ways to calculate the burn rate: gross burn rate or net burn rate.
- The gross burn rate is simply the amount of money spent each month. This is, for the most part, your total operating expenses for a given month. This is a number you can get straight from your P&L.
- The net burn rate is the money you spend in addition to your revenue (cash received).
Of course, this suggests that you have a negative cash flow as you are spending more than you are receiving.
Another way to calculate your net cash burn rate is to deduct the cash balance at the end of the month from your cash balance at the beginning of the month. Make sure you do not take into account any investments that came through the bank.
Importance of Cash Burn Rate for Startups
One of the primary reasons that cash burn rate is such an important metric for startups is that it can assist you in projecting your runway. Your runway is the amount of time your company can operate before it runs out of money. Monitoring and understanding your cash burn rate will give you an idea of how long your company can operate at its current burn rate before running out of funds. This KPI can help you plan for fundraising rounds, adjust your spending, and, if necessary, pivot your business strategy.
It goes without saying you need to have the plan to maintain your cash burn at a certain level that will give you and your investors peace of mind. A common strategy for businesses is to have at least 6 months of runway. For start-ups in their seed stage, consider 12 months of the runway as it could take a long time to raise a round or to start generating enough revenue to cover your expenses.
Aside from runway projections, your cash burn rate can have an impact on your ability to raise capital. During the due diligence process, investors will frequently inquire about your cash burn rate, as it is a key metric that can indicate the health and sustainability of your business. If your cash burn rate is too high, investors may conclude that your company is not efficient or sustainable in the long run.
Defining Your Cash Burn Runway
- How to Calculate Your Cash Burn Runway
You will need to know your gross or net cash burn, as explained above, as well as your cash balance to calculate your cash burn runway.
Once you have these two numbers, divide your cash balance by your cash burn rate.
Example of a gross cash runway: you have $100,000 in the bank and $25,000 in monthly expenses. Your gross cash burn runway is 4 months ($100,000 / $25,000 = 4). This means you have enough cash to cover your expenses for the next four months.
Example of a net cash runway: you have $100,000 in the bank, $45,000 in revenue, and $25,000 in monthly expenses. Your net cash burn rate is 5 months ($100,000 / $20,000 = 5). This means you have enough cash to cover your expenses for the next five months.
- Common Misconceptions About Cash Burn Rate
A few common misconceptions about cash burn rate can cause confusion or incorrect assumptions. One common misunderstanding is that a low cash burn rate is always a good thing. A low cash burn rate may indicate that your company is efficient and sustainable, but it may also indicate that you are taking a safe route and not investing enough in growth.
You may also believe that a high cash burn rate indicates impending failure. While a high cash burn rate can be a red flag if it is sustained over time, it is not always a death sentence for a startup. Some businesses may need to spend more money in the short term in order to invest in growth and long-term success. This is especially true if you have investors backing you up.
Reducing Your Cash Burn
- Rate Strategies for Cutting Costs
One of the most effective ways to reduce your cash burn rate is to reduce your expenses. However, it is critical to be strategic about cost-cutting so that you do not compromise the quality of your product or service or harm the morale of your team.
Renegotiating contracts with vendors or service providers, downsizing your office or workspace, using open-source software instead of paid versions, and outsourcing non-core functions to freelancers or contractors are some cost-cutting strategies.
- Increasing Revenue to Decrease Cash Burn Rate
Increasing your revenue is another way to reduce your cash burn rate. This can be accomplished by increasing sales, broadening your customer base, reviewing pricing strategies, or introducing new revenue streams.
You may need to invest in marketing and sales efforts, offer promotions or discounts, or focus on upselling and cross-selling to increase sales. Expanding your customer base may need broadening your geographic reach, introducing new products or services, or focusing on new customer segments. Creating new revenue streams may also entail creating new products or services, collaborating with other businesses, or licensing your technology or intellectual property.
That said, talk to your advisors and finance experts if you feel your burn rate is getting too high, and you should get the help you need.
Conclusion
We've discussed what the cash burn rate is, how to calculate it, and why it's important. By regularly monitoring your cash burn rate, you can extend your runway and improve your chances of raising capital.
If you feel overwhelmed with a high cash burn rate and you need strategies to find the right balance between cutting costs and investing in growth, reach out to us here.
