The burn rate is a term typically used to describe the speed at which a startup company is spending the funding it has raised.
This implies that the business is in negative cash flow and is making a loss from operations.
The loss is covered by the capital that it has raise from investors and venture capitalists.
The burn rate is typically expressed as a dollar amount on a monthly basis.
So if the burn rate of a tech startup is $100,000. Then it means that the company is losing $100,000 per month. And if it still $500,000 of investors funds left in the bank, the company would be left with 5 months worth of runway before needing to raise more funding through fund-raising activities to maintain operations.
This is assuming that the company does not hit critical mass during the 5 months, make a profit, and becomes self-sustainable.
What burn rate tells about a company
Investors in startups, especially tech companies, pay particular attention to burn rate.
This is because it indicates how much money the company is spending on overheads before finding it’s way into positive cash flow.
With a high burn rate, it can imply that a company is not practicing prudence with how they spend investors funds.
On the other hand, aggressively opportunistic investors might see a high burn rate as a sign that a company is spending a lot of money on acquiring a lot of customers to grow the user base.
Private equity firms might categorize burn rate into two categories.
- Gross burn rate
- Net burn rate
The gross burn rate would be the sum of all operating costs including:
- Rental
- Salaries
- Marketing expenses
- etc
This provides a good overview of the monthly expenditure of the company to maintain operations at it’s current level.
The net burn rate would be applicable to companies that are generating a revenue but still making a loss.
Thus, the net burn rate would be the total expenses minus the gross profit derived from revenue.
The overall burn rate can play a critical role in the decision of a potential investor whether to invest in a company.
For example, if a startup with a $50,000 burn rate is seeking to raise a $500,000 investment from an investor, the investor would be able to estimate that his capital that is pumped into the company would at least help it to sustain operations for the next 10 months.
And if he cannot see that the company would make major progress in the market, then it would still need to raise more money in 10 months.
This might be fine if the business is progressing forward as that might attract other investors into the fold.
But if the business is going backwards, the company can fail to raise more funding from other investors or experience a down round.
Burn rates can be understandably high for startups experiencing high growth in the acquisition of customers.
But if it is not due to an exponentially increasing customer base, then the company might need to make internal changes to reduce the expenditure or risk going bankrupt.
