As many business owners know, the only way to make money is to spend money. However, in the startup world, it can be easy to find yourself draining your funds quicker than expected. Learning how to manage your startup’s burn rate is essential in ensuring that your startup has longevity and has the ability to really take off.
What is burn rate?
Burn rate is the speed at which an unprofitable company consumes its cash reserves. For a startup, burn rate refers to the rate at which venture capital is being spent to finance overhead before generating positive cash flow. Therefore, burn rate can be viewed as negative cash flow.
Startups and investors can use burn rate to track the amount of cash that a company uses monthly before it starts to generate its own income. Burn rate can be used as a measurement for a startup’s “runway,” or the amount of time that the company has before it runs out of money. Having an idea of your startup’s runway can help guide your business strategy and can also be a determining factor in the amount of money you’re able to get from investors.
How to calculate burn rate
There are two forms of burn rate. The first, gross burn rate, refers to the total amount of operating costs that a startup incurs in expenses each month. Gross burn rate is simply expressed as:
Total Monthly Operating Costs = Gross Burn Rate.
For example, if a company spends $5,000 on office space, $10,000 on software, and $15,000 on salaries and wages each month, then their monthly operating cost would be $30,000. Therefore, their gross burn rate would be $30,000.
The second form of burn rate is net burn rate. Net burn rate is the total amount of money that the startup loses each month. When calculating net burn rate, expenses and revenue are both taken into account. Net burn rate can be calculated by using:
(Monthly Revenue – Cost of Goods Sold) – Gross Burn Rate = Net Burn Rate
Let’s say that same company from before is generating a revenue of $20,000 a month with a cost of goods at $10,000 per month. Taking into account our gross burn rate of $30,000, we could generate their net burn rate by doing the following calculation:
($20,000 – $10,000) – $30,000 = -$20,000
Though the company is spending $30,000 a month, they’re only losing $20,000 a month thanks to their revenue. This can be an important distinction to make when calculating a startup’s runway. If this company had an investment of $100,000, and they were losing $20,000 a month, we can then say they have a runway of five months.
Generally, it’s recommended for startups to have 6-12 months of expenses on hand. Therefore, if your company has $100,000 in the bank, then a good burn rate would be between $16,667 (6 months runway) and $8,333 (12 months runway).
Tips for managing your burn rate
Managing burn rate can be difficult, especially in the early stages of launching a startup. Here are some ways to keep your spending down and create a healthy burn rate for your business.
- Stay focused: Know what stage of development you are in and stick to only the essential elements to that stage. It’s easy to get lured into investing heavily in marketing, sales personnel, or extra engineering, but these kinds of investments don’t make sense in the early stages of launching a startup when you don’t have an established client base. Trying to do everything all at once will only increase your burn rate and result in a reduced financial runway.
- Know your market: Taking the time to research your market and understand its dynamics and sales cycles can help you to have a better projection of your cash flows and minimize your burn rate.
- Keep your team small: Don’t rush into bringing in a large team for your startup. Bringing in additional hires can be expensive. Especially in the early stages, your team members should each be ready to put multiple hats on and carry out more than one function of the company. This way none of your hires are being underutilized and you can save yourself from needing to increase spending.
- Consider contract hiring: In the beginning of your startup, it’s recommended that you opt for contract staff rather than hiring directly. While it may be more expensive in the short term, you’re provided with more flexibility to increase or decrease the work force in case of exponential growth or sudden downtimes, which can help to optimize your costs.
- Avoid unnecessary expenditures: When starting out, try to rent or lease as many items as you can rather than purchasing. It’s often cheaper to do so, which helps with minimizing your overall expenses.
The bottom line
Burn rate is an important metric for any company, but is particularly important for early startups that haven’t started generating revenue yet. Your burn rate can tell managers and investors how fast your company is spending its capital, which can have an impact on your business strategy and your potential to gain future investments.
Knowing how to properly manage your money is essential for keeping your startup alive. And it all starts with having the right startup bank account to back you up. Grasshopper’s Accelerator Startup Checking Account is equipped with tools that can help you to better manage your finances and better your financial runway.
By Michaela Lenahan in Startups
