“The rate at which a new company uses up its venture capital to finance overhead before generating positive cash flow from operations.”
In other words, it’s a measure of negative cash flow.
In between funding events, burn rate becomes an important management measure, since together with the available funds, it provides a time measure to when the next funding event needs to take place.
Investopedia explains “Burn Rate”:
Burn rate is usually quoted in terms of cash spent per month. For example, a burn rate of 1 million would mean the company is spending 1 million per month. When the burn rate begins to exceed forecasts, or revenue fails to meet expectations, the usual recourse is to reduce the burn rate (which, in most companies, means reducing staff).
The term came into common use during the dot-com era, when many start-up companies went through several stages of funding before emerging into profitability and positive cash flows and thus becoming self-sustainable (or, as for the majority, failing to find additional funding and sustainable business models and thus going bankrupt). In between funding events, burn rate becomes an important management measure, since together with the available funds, it provides a time measure to when the next funding event needs to take place.
Calculation of “Burn Rate” and “Cash Zero Date”
In the early stages of your company, you will be spending dollars, running at a loss, before hopefully emerging into profitability and positive cash flows. Because of this, the two most common questions for early stage companies are:
- What is your burn rate?
- What is your cash zero date?
The metrics burn rate and cash zero date, both venture capital terms, are believed to have come out of the dot-com era when tech start-up companies went through several stages of funding to finance overheads before reaching positive cash flows.
Burn rate is really your average monthly costs. It gives people a feeling for how much you spend in a given month. So, for instance, if you were six months into the year and you had spent $600,000, year to date, on operating expenses, regardless of revenues coming in, your burn rate would be approx. $100,000 ($600,000 divided by six months). Because start-ups experience extreme volatility, you usually take an average of the previous six or twelve months expenses to smooth the metric out.
The next metric is the cash zero date. This date tells your audience when you run out of cash (e.g. cash is equal to zero). A very rough calculation is to take your cash position on a particular day and divide it by the average monthly burn rate and adjust for number of days. So, it would look like this:
Let’s say that you currently have $250,000 in the bank and your burn rate as calculated previously is $100,000 per month. This means that you will have (250k/100k) 2.5 months until your cash zero date. This assumes that no other cash is coming in i.e. revenues or additional funding.
Carefully Monitor your “Burn Rate”
When it comes to the cash consumed by your start-up business, the slower your “burn rate,” the better. The key to understanding your company’s health is to monitor its burn rate.
Knowing the burn rate in your new business and managing it well will tell you, and indicate to your investors, when you’ll need more investment or a loan, or when you will break even and begin to make a profit.
If you forget to check this compass within your new business, you could run out of cash before you reach those milestones and find yourself “burnt-out” of business.
Controlling Your Start-up Business “Burn Rate”
Be ruthless in controlling your expenses especially in the early going. It’s helpful to:
- Monitor expenses every day
- Keep major outlays and new financial commitments to a minimum
- Spend your precious cash on what’s critical to producing revenue for your start-up business.
- Become more operationally efficient
Why It Matters
Investors look at the burn rate versus expected future revenues of a company to decide if it’s worthwhile to invest in the firm. If the company’s burn rate exceeds forecasts or if its revenues are not growing at a reasonable pace, it may be too risky to invest in the company.