Why Burn Rate Matters for Startups
Having cash in the bank is one thing; knowing how to manage it and spend it wisely is another thing entirely. This is where the burn rate comes into play, and it’s a vital component for startups to pay attention to.
It’s the rate at which your company is depleting its balance sheet to pay for operating expenses before it begins to generate positive cash flow. Your startup's success or failure may hinge on its ability to predict and manage the many factors that affect burn rate. 82% of new companies fail due to insufficient cash flow, which illustrates how often startups overlook the importance of their burn rate.
Controlling your burn rate is a juggling act between profit and growth. A too-high cash burn rate may indicate that a company isn't on track to become profitable. In contrast, a too-low burn rate could indicate that a business isn't using its resources efficiently, leaving it vulnerable to competition from more innovative companies. This is where balance is needed.
Here is a guide to help you lower your burn rate and expand your purchasing power.
How Is Burn Rate Calculated?
Burn rate is broken down into two subcategories: gross and net, with each subcategory having its own metric to track.
Although expressed per month, it is best to determine your burn rate over a quarterly, semi-annual, or annual time frame. If your income and expenses fluctuate monthly, your burn rate calculation within a shorter time frame may give you inaccurate results.
Gross Burn Rate
The total amount of money spent each month is known as the "gross burn rate" for your business. Revenue is not factored into it. You can use the following method to calculate your average monthly gross burn rate for a certain time frame:
Total Expenses / Number of Months = Gross Burn Rate
Net Burn Rate
Net burn is the amount of money your business loses each month after factoring in profits. Therefore, if your business is spending heavily but producing sales, your income will reduce your net burn rate.
You can calculate the net burn rate for a given period by subtracting the starting cash amount from the ending cash balance, then dividing that result by the total number of months in the given period. Here is the equation:
(Starting Balance - Ending Balance) / Number of Months = Burn Rate
A Practical Example of Calculating Burn Rate
Company Z spends a total of $100,000 every month, of which $30,000 goes for rent, $20,000 for servers, and $50,000 for payroll and other expenses. The gross burn rate would then be $100,000. However, the burn rate would be different if the business were profitable.
For instance, if the company makes $50,000 in profit per month despite losing $100,000, the net burn rate is $50,000, indicating a smaller loss than the $100,000 in monthly expenses would suggest.
This variation can significantly affect the company's future success. By way of illustration, if a business has $500,000 in the bank but incurs monthly losses of $50,000, it has enough money to stay in business for about ten months, as opposed to the five months it would have with $100,000 in monthly losses. This five-month period, in which the company has enough capital to fund its operations is its ‘runway’.
Creative Ways to Reduce Burn Rate
Many startups have to accept a high burn rate as a part of life. And perhaps you have already built a high burn rate into your budget estimates. However, larger burn rates make it harder for you to eventually break even.
When your business evolves and capital expenditure increases, there are a number of ways to reduce your burn rate:
Leverage a Financing Tool
Leveraging the right financial tools helps extend runway by providing quick access to the capital needed for your operations. Compared with raising funds from investors, you won’t have to worry about a longer turnaround or equity tradeoffs. Financing can help you access the funding you need, when you need it, without having to further dilute your equity.
With financing solutions like Gynger, you can finance your entire software spend, breaking down annual payments into monthly ones, which enables you to improve your cash flow and slow your burn rate. Although you’ll still pay the full amount over time, financing these expenses frees up cash in the short term to invest in the things that will increase your ARR in the long term.
By leveraging the right financing tools, you can invest in growing your business instead of burning your cash on paying for SaaS.
Test Out New Ways to Increase Sales
Explore other methods of sales acceleration without considerably increasing marketing expenses. You can upsell and cross-sell to existing clients, test various pricing methods, charge for additional products, or expand to a new market.
When your business is just starting to grow, it's a great time to be creative and test new things. Consider cross-promotion and collaborations to share and grow your customer base with similar companies, as well as solutions to optimize your Acquisition Cost (CAC) payback period, which can further free up cash to invest in growth.
Variability in workload is expected. In situations where you can't meet demand, help from independent contractors or freelancers can be a lifesaver and very cost-effective.
Independent contractors and freelancers are only compensated for their work, appear at your discretion, and do not require the same benefits as full-time and part-time employees.
Understanding Your Cash Runway
It takes time for a startup to become successful, so a large net burn is not necessarily cause for concern. You should be concerned with your cash runway, which indicates how many months of operations you have until your business runs out of money. You can determine the length of your cash runway by dividing the cash on your balance sheet by your net burn rate.
The formula is:
Cash Balance / Net Burn Rate = Cash Runway
Company X, for instance, has a current balance of $800,000. Their monthly net burn rate is $100,000. They use the following formula to calculate their cash runway:
800,000 / 100,000 = 8
Company X will run out of cash in eight months if they do not generate more free cash flow, generate additional revenue, secure new investments, or reduce spending.
Most investors advise maintaining a runway of at least six months, but in the current economic climate, you should focus on maintaining 12-18 months minimum. Thus, if your monthly cash outflow is $50,000, you must have at least $600,000 - $900,000 available. An extensive runway assures that even if there is a temporary market slump like the one we’re experiencing now, an issue with one of your product releases, or an unforeseen expense, you will be able to address it without jeopardizing the health and success of your startup.
Reduce Your Burn Rate and Improve Cash Flow With Gynger
In the early phases of a venture-backed startup, the burn rate can be a nerve-wracking metric. Monitoring your company's burn rates regularly is beneficial for your bottom line and also great for drawing your attention to areas that need rethinking, such as rising churn rates, large expenses, or lack of product market fit. Keeping the burn rate low ensures that all costs are covered and growth is consistent.
At Gynger, we understand how critical it is to keep your burn rate in check and keep your bank account healthy. Instead of dipping into your venture capital funds, use Gynger to access non-dilutive capital to pay all your software and infrastructure expenses.
Contact us today to see how we can help you today,