When entrepreneurs pitch their startups on the TV program Shark Tank, investors (the “sharks”) hear them out, then hammer them with tough questions. One they always ask is: What’s your burn rate?
Burn rate is shorthand for how fast a business is using up its cash. The sharks ask because they know a company’s burn rate is an important metric for understanding the strength of a new venture’s business plan.
Here’s what burn rate measures, how to calculate burn rate, and why it’s critical to understanding the health and viability of your business.
What is burn rate?
Although a burn rate can refer simply to spending (gross burn rate), it typically refers to how quickly a company’s cash is being used up (net burn rate). The latter figure is more meaningful because it considers the money that the company is earning: If you’re bringing in more than you’re spending, you don’t have a net burn rate.
You can measure burn rates for any time period, including quarterly or annually, but usually it’s calculated on a monthly basis.
Determining your cash runway shows you how long your company’s current capital reserves will last. Burn rate is particularly useful when assessed along other line items like monthly revenue and profit. Taken together, these metrics can help you understand if your spending is sustainable, influencing decisions about your business’s operations and growth plans.
How to calculate burn rate
Burn rate is measured in two ways: gross and net. Typically, the term “burn rate” refers to the net burn rate, because it takes revenue into account, while gross does not. You need to calculate your gross burn rate, however, to figure out your net burn rate.
Calculate the gross burn rate
The gross burn rate formula is simple, and it only considers monthly operating expenses. You first determine the time period, then total up the company’s expenses during that period.
With that information, you can use the following formula:
Total expenses / # of months in time period = average monthly gross burn rate
For a simple example, consider an ecommerce company that spends $30,000 in three months. The gross burn rate formula is:
$30,000 / 3 months = $10,000 average monthly gross burn rate
Calculate the net burn rate
Typically, when people say “burn rate” they’re referring to the net burn rate calculation. It’s a more critical figure with an important distinction because it considers not only the business’s cash spend rate but also how much revenue the business generates.
The net burn rate formula is:
(Revenue – gross burn) / # of months in the time period = average net burn rate
Let’s use the previous example, with the company that had $30,000 in expenses over a period of three months. Say the business brought in $24,000 in revenue during that period. The formula is:
($24,000 – $30,000) / 3 months = $2,000 per month average net burn rate
In other words, the company is spending about $2,000 per month above what it earns in revenue.
How long will your money last?
Burn rate is most helpful when considered in the context of how much cash your company has on hand to burn. That tells you how long you can keep the business running at this rate.
To figure out how long cash reserves will last, use this simple equation:
Cash reserves / monthly net burn rate = X months of cash runway
In the example above, the ecommerce company’s net burn rate is an average of $2,000 per month. With $24,000 in cash on hand and $2,000 in monthly spending, the business can keep running at this rate for 12 months until the cash runs out—or something changes.
This context helps you evaluate net burn rate to answer important questions. Can your company afford to spend at current rates, or do you need to reduce expenses?
Do you need more money to continue operating? If the answer is yes, you might consider raising prices, cutting costs, or launching new products to start generating revenue. You might also need to consider seeking additional funding from investors or tapping credit lines.
The answers to these questions should also take into account variable expenses like changes in raw materials pricing. And though it’s impossible to predict the future, some monetary cushion should be stockpiled for unexpected expenses.
What is a good burn rate?
Because monthly burn rate is such an important metric, business owners might wonder what qualifies as “good.”
Broadly speaking, a low burn rate is better than a high burn rate—but the fact is, there’s no comprehensive guide or even a general rule that applies to all companies. Some industries or product types may have higher burn rates than others. Still, factors like your company’s age and funding status can influence the burn rate as follows:
- New companies. In the early stages, startups tend to have higher burn rates as they invest in product development and marketing campaigns, while also hiring staff. Investors who back new companies expect them to spend money at a faster pace, though a startup still must estimate its cash runway—meaning how long can it stay in business at the current burn rate.
- Established companies. When a company becomes established, the goal is sustainable operations and positive cash flow, showing that expenses are managed efficiently and the business is sustainable. If the business is still losing money after a number of years and has negative cash flow, the company’s cash reserves will dwindle and threaten the company’s viability. Management may need to examine spending line items to find ways to reduce fixed expenses and boost income.
- Investor-funded businesses. Privately held companies may extend their cash runway with more funding in the form of venture capital or an angel investment. Most backers receive an ownership stake and will want to see your financial statements and balance sheets; other investors may request changes to the company’s structure or set specific growth targets as a condition of their funding. Companies that seek capital on public markets undergo equally intense scrutiny based on the extensive public financial statements they must file with federal securities regulators.
5 tips for reducing burn rate
- Optimize and reduce expenses
- Renegotiate vendor contracts
- Analyze pricing and revenue streams
- Increase efficiency
- Consult with experts
If your company is depleting its cash too quickly, there are several actions you can take to reduce your burn rate:
1. Optimize and reduce expenses
Expenses are directly related to burn rate, and there’s no substitute for carefully scrutinizing spending to see where you can optimize or cut. Some expenses, say for raw materials, often are beyond your control. But do you have any nonessential expenses that can be cut or reduced without harming the business? This category could include underutilized office space, professional services that aren’t adding enough value, or software the business no longer uses much.
2. Renegotiate vendor contracts
Open a dialogue with your suppliers to discuss better terms. For example, you could try to negotiate discounts for volume purchasing. Or you might find an alternative supplier with lower prices.
3. Analyze pricing and revenue streams
Revenue is what lowers your burn rate. Consider where you may be able to raise prices, increase average order value, or explore products that could be enhanced with new features to bring in more revenue.
4. Increase efficiency
Any bottlenecks or other inefficiencies in your operations can cost you time and money. Look for ways to optimize your supply chain, automate tasks where possible, and eliminate any redundancies.
5. Consult with experts
Sometimes, it’s easier for an outsider to take a dispassionate view of your business. You may be able to glean recommendations from people you already deal with, like business mentors and investors. A paid financial adviser can also develop strategies for planning and business organization.
Burn rate FAQ
What is a good burn rate?
Broadly speaking, a low burn rate is better than a high one. But what qualifies as “good” can vary based on factors like the industry and the age of the company. Startups often have a higher burn rate as they focus on product development and growth, while more established companies have lower burn rates—or no net burn rate if they produce surplus cash.
Is burn rate the same as expenses?
The two concepts are closely related, but they’re not the same. Expenses are the costs of doing business—anything that ensures a company’s ongoing operations and delivery of products or services. Burn rate is the pace at which a company is drawing down its cash reserves, offset by any revenue in the case of net burn rate.
How is burn rate used in project management?
Burn rate is sometimes used to track the financial progress of work projects. The metric can help with managing resources, forecasting costs, and monitoring whether spending is within the budget, among other benefits.