Burn Rate

Definition, how to calculate, formula, 4 ways to reduce

Table of Contents

What is Burn Rate?

How to Calculate Burn Rate

4 Ways to Reduce Burn Rate in 2022

Default Alive vs. Default Dead?

Burn Rate Example

What is Burn Rate?

Burn rate is a KPI used to describe how fast a company is spending it's cash to fund the entire operation. Typically burn rate is measured in cash spent per month. Burn rate essentially measures how many months a company can stay in business before running out of cash. Let's take a quick example: If your company has $100,000 USD in cash on hand with a burn rate of $25,000 USD per month, your company will run out of cash in four months.

82% of startups fail because of cash flow...

Yep that's right, running out of cash is the leading cause of death for startups across the world. You can't take your cashflow for granted or ignore your burn rate because well, it's the life blood of your company. Being aware of your burn rate, what you're spending the money on, and what levers you could potentially pull in order to reduce it are all essential to being a successful startup or small business founder.

A high burn rate is often times an indicator of over spending...did you really need to buy all those bean bags and that neon company logo sign for the office? Probably not. The three most common areas startups and small businesses over spend in are branding, vendor relations, and office space.

How to Calculate Burn Rate

There are actually two core burn rate formulas: Gross burn rate and Net burn rate. Let's look at how to calculate both of them below.

Gross burn rate calculation

Gross burn rate is all about measuring efficiencies of businesses and excludes new revenues (that are hopefully) flowing in to the business.

Gross burn rate = cash on hand / monthly operating expenses

Net burn rate calculation

Net burn rate is the rate at which a company is losing money. It essentially shows how much cash a company needs to continue operating over a period of time. A fall in revenue with no change in costs can lead to a higher burn rate.

Net burn rate = cash on hand / monthly operating losses

OK so you can compute both gross burn rate and net burn rate for your business, but which is better or more frequently used? In short, both are important to the longevity of your business. If you're talking to a peer, investor, or mentor and they ask simply, "what is your burn rate?", you can assume they're referring to your gross burn rate.

Burn rates aren't just for startups!

Often times you will only hear about burn rates in the startup world but burn rate is equally important to mature growth stage companies as well. Burn rate is an extremely useful KPI as a means of measuring cash reserve, building and targeting later investments.

4 Ways to Reduce Burn Rate in 2022

  1. Reduce churn rate → If your company is dealing with crazy churn rates (north of 7%), your revenue is going to take a big hit and your burn rate will go up. Churn rate can be fatal to businesses.
  1. Cut costs & reduce expenses → This is probably the most common and most obvious way to reduce your burn rate. Try to think about what expenses aren't directly leading your company to higher revenues. My guess is that the bean bag chairs, catered lunches, and $2,000 espresso machines aren't critical to driving revenues. If your burn rate is high, fold-up chairs and instant espresso may be a better bet!
  1. Focus on your company's core competencies → These next to strategies are somewhat related. It's a classic mistake to try to be the solution to everyone's problems. You have to remember that every new idea you chase is going to cost your company money in the form of time and labor. At the early stages, double down on what you're good at and keep your scope tight.
  1. Ditch products and services that don't sell → An easy example of this is to think of eCommerce though it applies to SaaS and other businesses as well. Let's take an eCommerce example. Let's say your company makes T-shirts. You want to be inclusive and offer 6 sizes (XS, S, M, L, 2XL, and 3XL) but after further analysis of your sales and inventory, 85% of your sales are S, M, and L. It might be tough to turn down customers but if you have a burn issue, it's time to say goodbye to XS, 2XL, and 3XL.

Default Alive vs. Default Dead?

The idea for Default Alive or Default Alive comes from the wonderful mind of Paul Graham, the legendary entrepreneur, investor, and founder of Y Combinator.

In Paul's essay he says that one of the first questions he asks a startup founder is, "are you Default Alive or Default Dead?". What Paul is trying to ask in layman's terms is - based on current expenses, growth rate, and cash on hand - is the business on the right trajectory to reach profitability before running out of money. If yes, then that business is Default Alive. If no, they are Default Dead.

Paul asks this question because for starters, most founders don't know their finances - Do you know whether you're Default Alive or Default Dead as of reading this? Founders that know the answer to this question have a clear understanding of their finances and are signaling to Paul and other early investors that they're serious about monitoring the performance of their business. The second reason Paul asks this question is to understand where to take the conversation next. If they're Default Alive, Paul likes to talk about new ideas and growth strategies, with the later, the conversation turns to how the business can avoid an almost certain death. Here's the link to the original essay from 2015, it's a good one!

Burn Rate Example 

To make it easier to understand the concept of burn rate, here is an example. For illustration, let’s say you own a startup named “Divine Furniture”, and you are reviewing your burn rate for early April, which is the year’s 1st quarter. 

You start with $180,000 on January 1st and end with $60,000 in cash on March 31st, which is the last day of the quarter. Firstly, you need to deduct the ending cash balance from your beginning cash balance. Taking the figures mentioned above, you’ll need to subtract $60,000 from $180,000, so you end up with $120,000.

Next, you need to divide the difference by the number of months you are assessing. In this scenario, it’s three months, so you’ll end up with $40,000. Thus, your company’s burn rate is $40,000 per month for the year’s 1st quarter. 

An alternative gross burn rate or net burn rate computation that ignores capital expenditures may be preferred by potential investors. The above estimate, however, will offer you the data you need to manage your startup’s cash flow. This includes not only regular business costs but also things like loan payments and owner's withdrawals. 

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