In the startup space, investors want to know how much of a financial runway you have until your business generates profit. Knowing your burn rate allows you to tell a compelling narrative to investors about how you're methodically extending your runway.
Knowing how quickly your company spends money is a smart way to drive sustainable growth. Particularly in today's turbulent economy, running a good business is about fostering a low burn rate (not just obsessing about growth at all costs).
Want to learn more about burn rate, why it matters, and how to reduce it? Stick around as we explore five effective ways to reduce your burn rate.
What is burn rate?
Let’s start with the basics.
Your burn rate refers to how fast your company spends your cash pool in a loss-generating scenario. It's a financial metric used among startups to measure a business's performance and allow investors to land on a valuation.
In the early stages, startups often cannot generate positive net income, so investors and venture capitalists provide funding based on the company's burn rate. Basically, the burn rate is used to track the amount of monthly cash a company spends before it starts generating profit.
Generally, the lower your burn rate, the closer your business is to getting in the green and unlocking financial stability.
How do I calculate burn rate?
Calculating your burn rate helps your business understand how long you can operate before running out of money - a.k.a your cash runway.
There are two ways to calculate burn rate: gross burn rate and net burn rate.
Gross burn rate
Gross burn rate measures your monthly operating expenses without accounting for revenue. Operating expenses include costs like rent and salaries, which can be helpful to track and measure if you're looking to cut down on spending.
To calculate your gross burn rate, you need to know your monthly expenses and total cash or starting capital - the cash balance first invested into the business from outside investors or yourself.
- Gross Burn Rate = Monthly Operating Expenses / Starting Capital
- To get a percentage, simply multiply this number by 100.
Net burn rate
On the flip side, your net burn rate takes revenue into account, and it's a measure of how fast a company is burning through its available capital relative to its revenue.
You’ll need to know your monthly revenue (if there is any), monthly operating expenses, and starting capital:
- Net Burn Rate = (Revenue - Operating Expenses) / Starting Capital
- To get a percentage, multiply this number by 100.
What affects burn rate?
Understanding your burn rate comes back to the unit economics of your business. Unit economics refers to the amount of money your business earns on every product or service you sell. This is based on your customer acquisition cost (CAC) and Customer Lifetime Value (CLTV).
Your CAC refers to the cost and time spent converting a potential lead into a new customer, and your CLTV refers to the total revenue your business can expect from a single customer during their lifetime.
To calculate your unit economics, you need to subtract each customer's acquisition cost (CAC) from their customer lifetime value (CLTV).
Understanding unit economics from the get-go is an important measure in predicting financial conditions. It is critical for future growth, particularly for investors looking for businesses that are low-risk and will offer sustainable financial growth.
What is a low burn rate?
As we mentioned, the lower your business's burn rate, the closer you are to achieving profitability.
Lowering the amount of cash you're spending (and how fast you're spending it) can give your business a longer financial runway. This is especially important when heading into uncertain economic times or even low-revenue periods.
As a general rule, you should have around 12 months of cash runway, which means your burn rate needs to be one-twelfth of your available cash pool. If you have $1,200,000 in the bank, your burn rate should be close to $100,000 per month.
How do I reduce my business’s burn rate?
If you’re ready to get your business closer to profitability, it’s important to take practical steps to reduce your burn rate. Here are some strategies you can use to do just that.
1. Understand your numbers and run an audit
Understanding your financials is critical for all businesses. When making decisions, you need to regularly review your numbers to know trends, patterns, and changes.
What expenses are rising? How long does it take you to get paid? Do you have enough cash available to pay your bills?
By jumping into your accounting software and regularly auditing your spending, you can identify opportunities to cut down on spending to lower your burn rate.
2. Set smart spend controls
With the help of tech, you can use expense management platforms to set merchant categorisation controls and spending limits to reduce wastage in your business.
This is especially important if you use corporate cards and increase your employee headcount. With smart spend controls in place, you can proactively curb out-of-scope spending and ensure every dollar spent is going to good use.
3. Look for lots of small wins
There are stacks of ways to focus on small expense improvements, such as reducing duplicate subscriptions, signing up for annual subscriptions, and saving on foreign transaction (FX) fees.
By switching to a fee-free corporate card and moving to a lower-cost annual subscription, you can make small changes to your spending that can impact your bottom line.
4. Hold off on major purchases
Although there is nothing wrong with setting big goals and scaling your business, it's essential to time your big expenses wisely. If lowering your burn rate is a priority, it's worth delaying major costs until your company has a healthy cash reserve to support it.
If you need to cut spending when cash is tight, major repurchases or big capital expenses might need to take a back seat. That way, you can prioritise reaching profitability and refocus on growth once you’re in the green.
5. Be fundraising ready
Investors are looking for businesses with a healthy cash runway and a good handle on their cash flow. So, getting your expenses and spending into shape will improve your burn rate and put you in good stead when fundraising.
Be proactive and prepare all your due diligence materials, such as financial statements, company valuations, financial projections, and more.
Get a handle on your burn rate for sustainable success
Understanding your burn rate and how to calculate it can help set your business up for long-term, sustainable success. When running your business, tracking and calculating your burn rate can set you apart from companies that tend to fail within the early years due to poor financial management and cash flow issues.
The equation is simple: review your expenses, look for ways to lower your spending, and prioritise a cash buffer over growth to reach profitability sooner.
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