Donny Tyra, Director at Graphite
Only a small portion of startups eventually become successful. It’s estimated that 90% of total startups fail, with 38% of startups failing because they’ve run out of money. Your cash burn rate is one of the main indicators of whether your organization will avoid this fate and achieve growth.
It’s difficult for startups to gauge success in their early stages, especially with VC funding flowing in and out of the organization.
If you spend too much too fast, you’ll eventually run out of money and your organization might go under. However, you need to spend enough to invest in technology, talent, marketing, and other resources that your organization needs to grow.
Not every startup is going to be the next Amazon or Google, but you want to do everything in your power to boost your organization to its full potential. Calculating and managing your cash burn helps you better understand your runway, giving you insight into how quickly you’ll need to support yourself with revenue or another capital raise.
What is Cash Burn?
Cash burn is the rate at which your organization consumes cash. This rate is different from net income because it includes all outflows of cash, such as purchases of equipment and payments of loans. It also includes inflows of cash from sales but does not include inflows from financing sources.
Your runway, one of the main calculations associated with cash burn, is the length of time it will take to use all of the cash you currently have at the current rate of cash burn.
Your runout date is the date your runway ends. In other words, it’s the day when you’re projected to run out of cash based on your current spending patterns.
Mature organizations ideally never hit a runout date, but startups often use projected runout dates to plan for future funding rounds.
Why is Cash Burn Important for Startups to Track?
Startups have a lot less wiggle room to make financial mistakes compared to more established organizations. While a legacy organization has a sound foundation that can support temporary setbacks, startups are on shakier ground.
Keeping your cash burn under control is crucial when growing your startup. If you don’t know what your cash burn rate is, you could be in for some unwelcome surprises as you’re trying to get your organization off the ground.
Investors always look at cash burn rates when evaluating startups to judge their feasibility for growth. If you’re burning cash quickly without the growth in value to show for it, this will be a cause for concern.
While spending is necessary early on to get your business off the ground, investors need to see a leadership team that is savvy enough to translate spending into tangible business outcomes. If these outcomes don’t happen, investors are at high risk of losing money on their investments.
Additionally, tracking your cash burn will help you decide when to launch future funding rounds. If you mistime your funding rounds, you won’t have the resources you need for your organization to grow.
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How to Calculate Cash Burn Rate
For small startups, calculating burn rate is very simple and can be done with just your bank statements. Your gross burn rate is equal to the amount of cash you spend in a defined period of time—usually a month or a quarter.
When most investors and analysts use the term cash burn, they are actually referring to net burn rate.
Your net burn rate is more complex and represents your total cash loss in a given period. To calculate net burn, you subtract operating expenditures from your revenue receipts. This is typically a more valuable number to calculate as it contextualizes your spending relative to your earnings.
While two startups may both have a gross burn rate of $30,000 per month, if the monthly revenue of one organization is $10,000 and the other is $50,000, net burn rates have varying degrees of concern attached.
What’s the Ideal Cash Burn Rate?
There’s no hard-and-fast rule about the ideal cash burn rate for startups. The right cash burn rate for you will depend on factors like:
- Your industry
- The age of your organization
- The general state of the marketing
- Where you are in the funding process
You’ll want to find a cash burn rate that keeps you afloat between funding rounds without limiting your organization’s ability to grow and develop.
Ultimately, your ideal cash burn rate is any amount where you’re burning less cash than the total value you produce.
For mature organizations, this is easy to define, as you want to consistently spend less cash than you’re making. For early startups, value is harder to calculate. Investors typically look at your organization’s potential to generate returns in the future.
Bringing on a financial expert can also provide valuable insight into a healthy cash burn rate for your organization.
The Dangers of a High Burn Rate
A consistently high burn rate often spells danger for growing startups. You could potentially run out of money before you’re able to line up your next round of funding. This could cause your startup to close or result in a forced sale.
Even if you don’t run out of funds, a high burn rate will be a cause for concern with investors. It will be difficult to keep your investors’ trust if they are worried about their returns.
Additionally, there’s a risk of dilution for both your founders and early investors if you need to continually fundraise to manage your cash flow. With each funding round, you lose ownership of your organization, so even if you ultimately sell, you won’t receive much of the proceeds.
How to Reduce Cash Burn Rate
A certain amount of cash burn is normal for any startup, as you’ll need to spend money to make money. However, there are many steps you can take to cut back on your cash burn and prevent it from getting out of control.
Payroll is a huge expense for any startup and is often the cause of a high burn rate.
On average, it costs $300,500 to hire a team of just five people. Because of this, you’ll want to hold off on hiring until there’s a need for the role and the employee has the opportunity to provide real value.
For example, avoid hiring an entire sales team until your product is ready to hit the market. Contractors are a good way to fill in the gaps in the meantime. Just be discerning when hiring contractors, as they cost more per hour than a full-time employee.
Startups are very fluid and frequently change their plans, structures, and business dynamics. You should be very cautious about committing to long-term contracts that will limit your flexibility in adjusting spending to correspond with these changes.
In the past few years, we have seen many startups struggle with commitments on office leases. They signed leases for five or even ten years for the office space needed to operate their businesses. When COVID hit, and their workforce became remote, many startups had to spend huge amounts of money to break these leases.
If you need to work in an office, opt for a short lease or take advantage of the flexibility of coworking spaces.
Another spending area to keep an eye on is your software subscriptions.
Those $100 per month subscriptions add up quickly, and you’re often locked in for a year or more once you make a purchase. Before committing to a new software subscription, think about the future of the technology—is it something you’ll still need in a few years?
If you decide that a new addition to your tech stack is necessary, it’s always worth negotiating contract values to try to get the price down.
Also, be sure to cancel subscriptions you are no longer using. Many organizations wind up spending thousands of dollars on subscriptions that are auto-paid with credit cards that no one is using simply because they neglected to cancel.
Many startups set a fixed budget for digital marketing and don’t re-evaluate it, resulting in unnecessary cash burn.
If you’re not seeing results from your digital marketing, consider cutting back or reallocating those funds to keep cash burn in check.
Manage Your Cash Burn With Support From Graphite
As a growing startup, you’ll need to get your finances ready for venture capital funding, but managing your cash burn is tricky when you’re busy running other aspects of the business.
Graphite is an accounting firm that works exclusively with startups, so we know the ins and outs of early-stage finances. We provide the expertise and guidance you need to get ahead in the competitive startup landscape.
Check out our startup financial model template as a first step towards managing the tricky aspects of startup finances like budgeting for hiring, identifying a revenue model, and creating accurate and reliable financial statements.
Need CFO or Accounting Help?
Born out of a VC fund, Graphite fully understands the strategic and financial needs of high growth companies. If you need accounting support or simply have a question about accounting at your company, feel free to connect with us!