A Startup’s Guide to Burn Rates: Definitions, Formulas, and Management Tips
Running a business can be tough, and the data reveals that nearly 70% of startups run out of money before their third year in business. Would they have done things differently if they had known in advance?
We can’t know for sure, but one thing is certain: Understanding your company's burn rate, or the pace at which it spends its available cash, is crucial for financial stability. It’s even more important for startups navigating the early stages of growth. Knowing how to calculate and manage this metric can help you boost your chance of survival and even help you thrive during uncertain times.
Here’s what you should know about burn rate, its importance in planning for your future, and how you can more easily access the data it represents.
What is a burn rate?
Burn rate is a finance term that describes how quickly a business uses up its available cash. It is typically expressed as a per-month rate, such as “ABC Paper Company has a $25,000 per month burn rate.”
The burn rate is just one financial trait that helps company leaders assess a business's health. While it is not the only concern, it signals the amount of time a company can continue operating without seeking additional funds or generating more income.
Take our ABC Paper Company example. If it had just $200,000 in cash reserves, it could only keep operating for eight more months before running out of cash (if all other things remained the same). Looking at the burn rate helps companies set realistic expectations for the future and prioritize cash flow. Burn rate also tells investors about the risk of buying or investing in a company.
Why tracking your burn rate is so important
Financial experts consider burn rate an essential marker for assessing financial health. Depending on the situation, companies that use up cash reserves more quickly may be seen as less healthy than those that burn through cash less quickly. A high burn rate can be seen as a sign that the company doesn’t have its finances under control.
The Bureau of Labor Statistics reports that nearly 20-25% of companies fail by their 2nd year. While there may be many reasons for this, cash flow issues top all startups' concerns.
Other reasons to track the burn rate include the following.
It helps companies plan
Imagine not knowing how long your money will last before making major business decisions.
That’s the predicament a business leader would be placed in without knowing their burn rate. By simply guessing how long funds will last (instead of tracking and estimating), it’s impossible to responsibly plan for the next few months or even a year.
A company set to run out of cash in two months may take very different actions than one that won’t run out of cash for two years.
It communicates to investors
New companies are especially concerned with burn rate because investors focus on it when deciding whether to invest. Burn rate is often referred to as part of the “startup runway,” or the time a new venture has after it begins and before it runs out of cash.
Investors know they are taking a risk when joining any new startup, but the burn rate may hint at how much of a risk they are taking. It’s a key indicator telling them how long they have to make things profitable and turn a fledgling brand into a long-haul business.
How to calculate your burn rates
Two widely accepted burn rate calculations, net and gross, help companies understand more about their business and what’s possible for the future. Each works uniquely and has its own formula.
Net burn rate
The net burn rate works using the concept of “net,” which means expenses minus revenue. Like any other net calculation, such as a net paycheck (take-home pay), the net burn rate only considers what’s left after the bills are paid.
Here’s the formula:
Net Burn Rate = (Total Monthly Expenses) - (Total Monthly Revenue)
To calculate it, simply:
- Add up your total monthly expenses, including all cash outflows. Include payroll, rent, supplies, inventory, taxes, insurance, debt payments, etc.
- Add up your total monthly revenue. This typically includes sales income, rentals, royalties, interest, and all other types of income.
- Take your total monthly expenses and subtract your total monthly revenue from it. The result is your monthly net burn rate.
In the case of ABC Paper Company, with $80,000 in monthly expenses and $60,000 in monthly revenue, the net burn rate would be $20,000 a month.
A positive burn rate means the company loses $20,000 a month and has to access savings, credit, or liquid assets to make up the difference.
A positive net burn rate puts a company in the negative.
If the company in our example has a negative burn rate, it would mean it makes more money than it spends and doesn’t lose money each month.
Gross burn rate
A gross burn rate looks only at expenses and doesn’t factor revenue into the equation at all. The calculator is simple and looks like this:
Gross Burn Rate = (Total Monthly Operating Expenses)
You only need to add up all of the business's monthly expenses, including payroll, inventory, supplies, insurance, rent, and other costs of doing business.
ABC Paper Company had $80,000 in monthly expenses, so its gross burn rate would be $80,000.
Unlike a net burn rate, the number will always be positive, as businesses will always have monthly expenses. Income or revenue isn’t considered in the formula.
What is a good burn rate?
Determining whether a company's burn rate is “good” or “bad” depends on many factors. The same rate for one business could be devastating for another. To get an accurate view, you would need to put the rate into context and also be sure you don’t look at a gross burn rate compared to a net burn rate, as they mean very different things.
A good burn rate allows the company to expand and meet important goals while avoiding the risk of going bankrupt. No company wants to run out of cash completely. The ideal burn rate balances growth opportunities with long-term stability.
While there’s no hard and fast rule about good burn rates, you can look at these factors to help you decide and apply them to your unique business goals:
The stage of the business
New startups, especially those in the very early stages, will naturally spend more money initially to set up the business, purchase real estate, and hire talent. After a point, however, a lower burn rate should be achieved to help the company outlast a 12-18-month runway and move into the next stage of financing and revenue.
Growth-stage companies have gotten to a point where they need to scale quickly. This could happen if they sell out of product and need to ramp up production or expand into a new global market. Expect to see a higher burn rate for a time as the company manages this new growth spurt.
Older companies that have found their footing can be considered mature companies. They should be profitable and make more money than they spend. The burn rate would be very low or (ideally) negative. A shift toward a positive burn rate may signal it’s time to evaluate financial behaviors or reexamine new incoming investments.
Industry norms
It’s difficult to compare the burn rates of companies from different industries, and that’s why it’s not generally done.
A tech startup, for example, may have higher burn rates due to its large initial investments and the time it takes to become profitable. Compare that to a smaller, service-based company with very little research and development or overhead costs. Since they spend cash differently, they won’t have similar standards for burn rate.
Economy and funding environment
A company’s profitability may dip during economic uncertainty and bounce back when markets have steadied. In the same way, the burn rate can swing back and forth depending on external factors such as interest rates, a bull vs. bear market, and how investors feel about spending their money.
For example, if investors have better access to capital, they may be more likely to invest, boosting liquidity in their chosen companies and bringing burn rates down. But if they’re nervous about what’s ahead, they can pull back their cash and leave companies to handle the higher expenses on their own (raising burn rates).
Tips for managing your burn rate
Reducing the burn rate is essential for extending your company’s runway and ensuring long-term sustainability. Here are some effective strategies.
Invest in sales and customer retention
Spending money for more marketing or sales campaigns may seem counterintuitive when trying to cut costs. However, investing in the right strategies can help you get ahead, even in difficult times. Look for ways to use what you have, whether it’s sales software or a new data tool.
To invest in people, consider upskilling your current team to help them succeed without hiring additional help. This will reduce interviewing and onboarding costs while keeping your best team members to grow with the company.
Also, talk to your customers about how to do better. You can often find trends in service or satisfaction that will clue you into your next move. By delighting your existing customer base, you can boost sales with the audience you already have.
To understand why strategic spending can be beneficial even during cost-cutting, check out our guide to the Rule of 40 for a more nuanced take on investing in growth.
Keep your data up-to-date
Since a burn rate can only be calculated with the best data, you should always know your expenses and revenue numbers. Previously, this required an open line with your bookkeeper or accountant. Now, with solutions like Digits, it’s as simple as opening a dashboard and seeing all of your most important financial metrics laid out before you.
Because Digits syncs with your credit cards and bank accounts, you won’t have to manually update transactions. View your real numbers right away — no waiting six weeks for your bookkeeper to get you the latest data — so you’re always prepared with an accurate burn rate.
Reexamine your monthly spends
In addition to having the most recent data about your spending and income, set aside time to review all the line item details. With the transactions imported into Digits, you can see expenses for a particular category or vendor or even search for specific payments to examine further.
Going over everything helps you plan for cost reductions and alerts you to fraud or billing errors. If you see something that doesn’t appear correct, you can follow up and prevent additional spending for things you didn’t authorize or plan for.
This is also the best time to set strict budget limits on things that can be capped. While some expenses, like property taxes, are out of your hands, you might still shop around for insurance or vendor services. (And some vendors would rather cut you a discount than lose your business to a competitor. Don’t be afraid to negotiate the price.)
Temporarily freeze hiring
Downsizing is a serious decision with consequences for your employees. If possible, consider how a hiring freeze might accomplish a similar goal.
Instead of releasing workers, just hold off on expanding teams and focus on placing internal candidates for valuable roles. You can also be creative with how you staff for highly-skilled positions, using consultants or freelancers when you don’t need a full-time employee.
If your employees are willing, move to more performance bonuses and incentives based on results to get the best ROI for your wage structure.
Financial data only helps if it’s accurate and current
Data is more valuable than ever in today's business climate. By collecting it often and ensuring it’s of the highest quality, you can gain more meaningful insights about your business (and its burn rate).
Digits automates your bookkeeping by gathering and categorizing your spending and earnings information all in one AI-powered platform. Digits can then run your numbers, answer your questions, and create robust dashboards and reports that offer incredible insights into your spending, revenue, and the time you have before you should start looking for additional sources of cash.
While just one aspect of a healthy business, a lower burn rate may be the key to surviving and thriving, no matter your industry. See how Digits’ automated accounting can help you not just keep on top of your finances but also learn from them — book a demo today to learn more.
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