Fernway DiarySM

Apr 11, 2022

For startups, understanding and effectively managing their burn rate is essential for making a sustained, successful push for growth and development over the long term. The optimal burn rate for an individual startup will depend on their market niche, the stage the company is in, the product or service they’re developing, and their ultimate business goal (i.e., IPO or acquisition). Knowing their burn rate, the factors that influence it, and how it can vary with the growth of the company will help startups determine the difference between sufficient and excessive expenditures and avoid running out of money.

Understanding Burn Rate

Burn rate, simply put, is negative cash flow—the amount by which expenses exceed revenue. This situation is normal for startups, which sustain operations with investments of venture capital while the business capitalizes on opportunities for innovation and accelerated growth. A company’s gross burn rate is the total amount it spends on overhead and variable expenses, which is usually calculated by month. Should the company also be generating revenue, subtracting the amount of revenue generated from the gross burn rate yields the net burn rate.

The length of time a startup’s cash reserves can sustain the business at their current burn rate is referred to as their runway. For example, a startup with a monthly burn rate of $30,000 and $180,000 in reserves has six months of runway left. In general, it is recommended that startups have at least 12–18 months of runway available to ensure the business can weather short-term market problems, unexpected expenses, or other issues without going under.

While startups are advised not to take on unnecessary expenses in order to keep their burn rate as low as possible, especially in the early stages of their growth, it is not the case that lower is always better. Burn rate tends to increase as a startup grows. Optimizing burn rate is a matter of knowing which expenditures are strategically necessary and using capital appropriately to achieve business objectives. To determine that, certain important metrics should be considered.

Key Burn Rate Metrics

Two of the most important variables that determine burn rate are unit economics and cost of growth. Unit economics is the amount a startup earns on each sale of its product or service, which is calculated by subtracting each customer’s acquisition cost (CAC) from their customer lifetime value (CLC). Cost of growth is operational expenses such as payroll and benefits (usually the largest expense for a startup), renting office space, etc.

While these are not the only factors taken into consideration, having a solid grasp of these metrics will assist startup founders in accurately calculating their burn rate. It will also give leadership a direction for investigation if either metric seems out of line. For example, excess churn or low return on ad spend may negatively affect unit economics, pointing to a need to focus on customer retention or a more strategic deployment of ad dollars. Conversely, low cost of growth may not be an advantage if it means that staffing does not meet operational needs and leaves the business under-prepared to capitalize on market opportunities.

Strategically Focused Spending

Venture capitalists expect the startups they back to spend the money they invest, but they want to know those funds will be spent to accelerate a company’s growth. A high burn rate isn’t necessarily bad, if it is demonstrably due to a startup taking necessary, well-informed risks in pursuit of larger returns. What investors are more likely to hesitate at is a declining burn rate, if cutting expenses threatens to stall growth. Thus, having a solid understanding of burn rate is fundamental to a startup’s ability to spend wisely, forecast effectively, and decide when to seek funding.

Providing Essential Insight

Startups lean on professional advice to ensure their business is structured effectively for growth, scale, and shareholder liquidity at every stage in the business lifecycle. Fernway Solutions offers a full range of advisory, corporate structuring, tax planning, compliance, and accounting services to ensure your startup has what it needs at each stage of its growth.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:

The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.