Burn rate: what it is and how it influences fundraising
Why does your accounting show different figures from your actual cash flow? How long can your startup survive on the cash at hand? How much capital should you raise?
In this article, we’ll answer all these questions. But first, some definitions:
Burn Rate: Term used by venture/angel funded companies to refer to their monthly negative cash flows. It’s always per month, divided into:
GROSS Burn Rate: Total amount of monthly negative cash flows. It refers to the sum of all cash flows of the company on a monthly basis.
NET Burn Rate: Gross burn rate minus positive cash flows on a monthly basis..
Example: The company has cash outfolows of $100.000 and inflows of $80.000 The Gross Burn Rate is $100.000 and the Net Burn Rate is $20.000.
Generally speaking, when people talk loosely about burn rate, they mean the Net Burn Rate.
Burn Rate and Cash Flows VS Revenues and Costs
Why are we talking about burn rate and cash flows instead of revenues, costs, or profits? The main reason is:
Profit is always an opinion and cash is always king
Revenues and costs are not often “cashed” immediately. Customers may pay late, or have a 60 days term. Suppliers may give the company a break and accept delayed payment. Revenues and costs are accounted for the moment the contract is closed, while the change in cash usually happens later.
This creates the main difference between revenues and cash flows.
Example: The company issues an invoice in September payable in 30 days. According to the books, the company registered revenues in September. However, the entry is going to convert to a positive cash flow in October.
So why is this important?
You issue an invoice in September for $100.000 and you have costs for $120.000.
However, only $70.000 are paid to you within the month and the other $30.000 will be received the following one. Let’s assume all costs are paid out the same month they are booked.
From an accounting perspective you are making a negative operating margin of $20.000 (120.000 – 100.000). But, in terms of cash, you have an negative cash flow of $50.000 (120.000 – 70.000). So you are out -or have a burn rate of – $50.000!
Runway: how long can you survive on the cash you have?
Runway: The amount of cash you have in the bank divided by the burn rate. In other words, the number of months that the company will take to burn all its cash (assuming constant negative burn rate).
This is a paramount metric for founders of companies that have negative burn rates. You should be very aware of it for your own planning but also to clearly communicate it to investors. Later we will explain how you should tailor your fundraising according to it.
Example: Let’s continue with the example above, when the negative operating margin is of $20.000 and the negative operative cash flow of $50.000 and let’s assume you have $500.000 in the bank.
If you consider the book value of $20.000 your runway is 25 months ($500.000 / $20.000). Truth is, the real runway is less. $500.000 / $50.000 (your cash burn rate), estimates a runway of only 10 months!
Why would you even have burn rate? Optional profits
The most basic condition for businesses to exist is that the output should have a greater market value than the input. Basically, business is for profit. Intrinsically, you are not supposed to have a negative burn rate, you are supposed to be for profit.
Startups are no exception to the basic condition. However, what sets them apart is that short term profit is sacrificed for the mid-long term one. That is why startups raise risk capital from investors instead of banks. Their purpose is to maximise their profits in 5 to 10 years time, not today.
For startups, the opportunity costs of being profitable today are higher than the profit you could make today.
Why making a short-term profit of 10 when you can spend more than what you earn to generate a profit of 10.000 in a few years time?
How does burn rate affect fundraising?
When investors ask you about your burn rate, indicate an average of the last months (2 to 3 months usually, longer than that and you risk giving an unrealistic picture).
Your burn rate is also very important to determine your capital need.
It is common for companies that raise angel or venture funding to seek a runway of 12 to 18 months.
Calculating your capital need is then just a matter of multiplying your burn rate by 18.
Investors are assuming you raise capital with the purpose of burning it in 1 year and a half time. For this reason, if they see that your burn rate is too low compared to the capital you want to raise, they’ll probably raise more questions on your forecasted expenditures.
Example: If you burn $10.000 a month and you ask for a $1 million investment, VCs will not take you seriously because that means that you will probably burn the cash in approximately 100 months and they will ask themselves: why is he raising so much capital? Does he want to cash in? It will probably be a deal breaker.
Thanks to the capital abundance of the past few years, entrepreneurs got used to burning as much cash as possible to achieve their goals. The climate seems however to be shifting and investors and becoming more conservative and attentive to unit economics and burn rates.
Benchmarks: are you burning too much, too little or just enough?
No benchmark is available for burn rate. Indeed, how much money companies “burn” is closely correlated with how much they can (or think they can) raise from investors.
2016 has marked a capital crunch, especially for what concerns series A investments. Today, the general trend is much more focused on fundamentals. You still see burn rates but they are usually highly justifiable, as opposed to some cases over the past years where startup expenditures were out of control, as mentioned above.
There’s no one-size-fits-all-rule, but if you are talking to your investors you’ll probably soon develop a feeling of what’s the right burn rate.