If you’re getting into startup investing, it’s important to understand the terminology. You should know a few vital metrics when looking at a startup because they can be strong indicators of long-term success.
What is Burn Rate?
Burn rate is the rate at which a company spends its available cash in excess of what it earns on a monthly basis. This might change month to month but is most easily calculated by dividing the previous year's financials by 12 or the previous quarter's loss by 3. It’s often used to evaluate the financial health of a company.
Why Burn Rate is Important in Startup Investing
Investors pay close attention to the burn rate because it helps them understand how long a company's funds will last before it needs to raise additional capital. This is important because startups often rely on external funding to keep their operations going and to fund growth. If a startup has a high burn rate, it may be a red flag for investors as it indicates a lack of financial discipline and the potential for the company to run out of money quickly. Once a startup runs out of money, if it fails to raise more, it will likely be forced into bankruptcy.
A high burn rate can be a cause for concern, as it indicates that a company is spending significantly more money than it is generating. This can put the company in a precarious financial position as it may not have enough cash on hand to cover its expenses. In many cases, a high burn rate will lead to bankruptcy if the company is unable to generate sufficient revenue to support its spending or continually raise more funds.
A low burn rate can be a sign of financial strength as it indicates a more sustainable business model and a better chance for long-term success. A low burn rate can also provide the company with flexibility as it can use its available cash to invest in new opportunities or weather any potential downturns in the market. A low burn rate means the company can operate efficiently and effectively, making the most of its resources and not wasting money on unnecessary expenses. It also means the company is likely generating some level of revenue, either through sales or investment, which can help sustain its operations and fund future growth.
How To Calculate a Startup’s Burn Rate
To calculate the burn rate, you will need to determine the amount of cash a company has on hand and the amount of time over which it plans to spend — or has spent — that cash. Then, divide the amount of cash the company has by the amount of time it plans to spend — or has spent it. This will give you the burn rate, typically expressed in terms of the amount of cash that the company is burning through per month.
For example, say a startup has $120,000 in cash and plans to spend that cash over the next 12 months. The burn rate for this startup would be $10,000 per month ($120,000 / 12 months). This means that the startup is burning through $10,000 of its cash every month.
The easiest way to determine and get a good actual estimate of a startup's burn rate is to look at its historical performance. In the context of equity crowdfunding, all startups have to report their two previous years' financials, so simply taking their net loss for those years and diving by 12 will give you a good idea of where they are sitting. You can also calculate it by each year to see whether it is improving and moving in a good direction.
To calculate burn rate, it's important to use accurate and up-to-date information about the amount of cash a company has on hand and the amount of time over which it plans to spend that cash. This will ensure that the burn rate calculation is accurate and provides a true picture of the company's financial health. This information can typically be provided by the founder or found in the financials released on the Securities and Exchange Commission website.
Overall, calculating the burn rate is a simple process that can provide valuable information about a company's financial health and its ability to generate revenue and achieve profitability. By understanding a company's burn rate, businesses and investors can make more informed decisions about the company's future prospects.
Using Burn Rate To Calculate a Startup’s Runway
Once you have determined a startup's burn rate, determining a startup's runway is an easy calculation but also very important. A startup's runway is how long the startup has until its cash is depleted, and it either needs to raise more funds or go bankrupt. To calculate a startup's runway, take its burn rate and divide that by its cash on hand. If a startup is profitable, its runway is technically forever because it has a negative burn rate and can endlessly sustain the business and roll forward its profits.
Using the previous example, if a startup has a burn rate of $10,000 per month and only $100,000 cash on hand, it has approximately 10 months of runway.