What is burn rate and how does it affect your startup?

Knowing the nuances of your burn rate, can make or break your next round. When it comes to startups, the saying is that “cash is king” only goes so far. Layer in other common industry catchphrases such as “growth at all costs” and “always raise more than you need” and it’s enough to make an early stage founder’s head spin. Having cash is critical, of course, but more so is knowing how to manage it and when to spend it. However, learning to be strategic about your burn rate—and understanding why you should spend what you’re spending—isn’t always easy to figure out. We talked to founders, CFOs and industry experts about how startups should think about their burn rate. Here’s their advice.

When Efrat Kasznik asks first-time founders about their startups’ burn rates, they often tell her how much they’re spending each month and how long the cash will last. Why the burn rate is what it is or how spending will change over time, rarely comes up in conversation.

“If you haven’t tried to figure these things out, you might as well go back to the drawing board,” says Kasznik, a former CFO who created consultancy Foresight Valuation Group in 2010. “In my mind, you don’t have the right to ask someone for money until you do.”

Ensuring you have a clear understanding of your burn rate and how it can vary with the growth of your company is very important in order not to run out of money.

Don’t get ahead of yourself. Larry Augustin, who has been a founder, a CEO and a board member of many startups since the mid-1990s comments, “People get into trouble because they plan for what they’ll do with the next funding round rather than plan based on the funding they already have. That next funding round may not happen. Managing burn rate is a way to give yourself options.”

But burn rate—defined as the negative cash flow of companies that have more expenses than revenue—is not necessarily a measure of danger. It is actually pivotal for successful startups. Companies with great growth opportunities rarely capitalise on them unless they’re willing to burn through a lot of cash along the way.

So, the goal is to figure out the balance between sufficient and excessive burn rate, but how do you do that?

What’s burn rate all about?

For the founder who has little more than an idea and some free hours to pursue it, burn rate is unknowable, says Tim Lipton, who has provided CFO services for more than 100 start-ups. With no financial assets, the only burn rate that matters is the founder’s rough estimate of how long and how much it will cost to develop a product.

“Of course, you can’t know, but you’ve got to get out there and start making mistakes until you have a better feel for what it will take to hit key product milestones,” he says.

However, it’s never too early to be thinking about a key question that will inform your ultimate cash burn analysis: What kind of company do you hope to build?

If, for example you are targeting a massive consumer market and won’t be happy with anything other than an IPO, you’ll need to make big investments to attract top talent from other successful companies and establish a widely recognised brand.

On the other hand, building a gaming app or a cloud service serving a niche business market, with a goal of acquisition, means your need for capital will be lower.

The formula is simple. The more you need to spend, the higher your burn rate will be and the more cash you’ll need to raise.

Once you get started in earnest, managing your burn rate is all about containing monthly expenses. Luckily there is free stuff out there. DoNotPay, a five-person company who run a chatbot to help consumers challenge parking tickets, file lawsuits and accomplish other tasks, work out of free space in San Francisco provided by Amazon for startups that use AWS.

Like almost every startup, DoNotPay leans heavily on cloud services to support everything from email to HR and payroll services rather than setting up its own in-house processes.

Which burn rate metrics really matter?

As your business grows and you look to raise further capital, frugality isn’t enough. At this stage Kasznik advises, you need to get serious about the two main variables that will determine your burn rate: unit economics and the cost of growth.

Unit economics is the amount your company earns on every item your company sells, whether it’s a hardware product, an app or a cloud service. You calculate unit economics by subtracting the cost to acquire each new customer from the lifetime value of that customer.

When considering cost of growth, the main expense for most companies will be employees. In London, the average salary for tech jobs is around £74,000 in 2019, according to research. Even in lower-cost locations, payroll frequently exceeds 60 percent of a startup’s outgoings. Many first-time founders don’t properly factor salaries and benefits into their calculations of future cash burn, or they underestimate how many people they will need says Kaznik.

By understanding your unit economics and cost of growth, you can make a more informed decision on how much you need to raise to cover the burn rate for long enough to achieve your goals. Typically, companies should raise enough to last 12-to-18 months.

Burn rate goes up, but rarely comes down

Many founders are tempted to increase their burn rate as sales increase, and this is justified if the company is beating its financial goals. “If every £1 of investment is generating £3 in profits, you’re obligated to pour on more jet fuel and spend more to capture market share”, says Lipton.

While increasing the burn rate will delay profitability, it’s usually seen as worth it for fast-growing companies, typically they’ll end up with a stronger market position. This, in turn, will lead to higher profits and more customers than they would have had with a lower burn rate. Read more about the trade off in this post by Venture capitalist Mark Suster.

In contrast, lowering your burn rate should be seen as a last resort. Most early stage startups have a very hard time recovering from major cuts in spending, especially if it involves dismissals. “I tell founders to consider this a one-way street,” says Brett Galloway, a former Cisco Systems executive and serial entrepreneur. “These are real people you’d be hurting, and it’s not okay. Avoid lowering the burn rate at all costs.”

It’s not just employees that don’t appreciate a falling burn rate, your investors won’t like it either. Venture capital firms are usually focused on the future return they can make and less concerned about losing their initial investment.

“Venture capitalists will usually push you to move faster,” says Kasznik. “They didn’t give you money not to spend it.” Even if a company’s sales grow twice as fast as expected, investors would rather see additional spending to maintain or even increase the burn rate instead of keeping expenses flat to cut it.

In some cases, reality forces a cut in spending. If your unit economics are eroding and there are less than 12 months of runway, it’s time to act, says Augustin. Since it typically takes five months or more to raise funds, you’ll want to bring down the burn rate quickly before drastic, last-minute surgery is required.

That’s what Augustin had to do three years ago, when he cut spending on a big sales and marketing campaign at SugarCRM, where he was CEO. The move required layoffs, but eventually the $24 million in monthly burn rate turned into a positive cash flow of $7 million. The shift not only kept the company from going out of business, but gave Augustin the breathing room to sell it later down the line.

Craft your internal “spend culture”

As a general rule, startups should keep expenses as low as possible. Strategic burn to gain market share and win customers is different from everyday spending on operational expenses that undoubtedly add up. Founders need to craft a “spend culture” that’s appropriate for their business.

A company on track to becoming a unicorn may want to offer free food and massages to retain high-priced talent during what is likely to be a protracted drive to profitability.

However, for most companies, offering fewer perks makes sense. Founders may even want to locate to a lower-cost home base or find premises you can access for free like DoNotPay. Don’t forget to factor in the state of the overall economy. Your investors will certainly be thriftier if there are storm clouds on the horizon or overhead.

Takeaway: don’t obsess over burn rate

While managing your burn rate is important, it shouldn’t take up all of your time. Review your financial statements monthly, get a sense of how much runway you have left, and—unless the company is approaching bankruptcy and every penny counts—only spend more time on this if a key line item is out of the norm.

“Don’t be cavalier, but if there’s no smoke, there’s definitely no fire” says Lipton.

And while common sense suggests burning through cash is a sure-fire path to bankruptcy, remember that startups are governed by different rules: a healthy burn rate may be just what you need to win.

Running a startup is no easy feat. Visit our Startup Insights to learn more about each stage of a startup’s early life and what you need to know.