There is a great amount of enthusiasm when you start your own business. It is truly amazing to see what started as just an idea become a real thing. However, motivation is not a guarantee of success. Unfortunately, less than 50% of businesses make it to their 5th year, and only 33% make it to 10 years. A massive 82% of businesses fail because of cash flow problems. For this reason, your burn rate is an essential figure that you have to be aware of.
What Is Burn Rate?
A company’s burn rate is the speed at which it will burn through the cash reserves in order to pay for expenses. Some will refer to the burn rate as a net-negative cash flow. The figure is so important because it tells you how long you can remain in business with the money you currently have, the expenses you have, and no sales being made.
Burn rate can be measured in two ways. You can calculate the gross burn rate, which is when you take all of your expenses regardless of the income that you make, if any. Or you can calculate the net burn rate, which is your gross burn rate minus your income. What you are left with is your runway. This is the amount of cash you have in the bank divided by the monthly net burn rate or the number of months you can stay in business.
How Do You Calculate Burn Rate?
Bear in mind that our numbers are only an example. You might be a unicorn company, or you might be just starting out with a small amount of capital, either way, you need to know how to calculate your burn rate.
Calculating your gross burn rate:
You should already have this but create a list of all of your monthly expenses without missing any, even if they don’t add up to much. Your list needs to include salaries, office space, rented equipment, utilities, taxes, insurance, production costs, etc.
Now take all of your sales and income from the same period of time as well as the amount of money you have in the bank right now.
For example, you have $100,000 in the bank; you have $20,000 in expenses, and this month you have generated $15,000 in sales.
Your gross burn rate is $20,000-$15,000 = $5,000
By taking your $100,000 and dividing it by $5,000, you will have a runway of 20 months.
Calculating your net burn rate
In this case, if you have no income, your net burn rate is your monthly expenses ($20,000). Your runway now will be five months. It’s easy to look at your gross burn rate and say that your company finances are healthy. But we live in highly unpredictable times, which is why it is essential to monitor both.
The Advantages of Knowing Your Burn Rate
In the first place, if you are looking for investors, one of the figures they will be interested in is your burn rate, so they know how fast you will spend potential capital and how long you are able to stay in business.
Your burn rate will also indicate where are possibly overspending, at this is frequent for startups. Here are some expenses that can be reduced and therefore improve your burn rate:
Office Space- “I started in my garage” might sound like a cliché, but there is a good reason why many startups choose to avoid renting the office space of their dreams. It is better to start small and be a little crapped than to have a huge overhead that isn’t being used to the full potential.
Salaries- This is probably the largest overhead any company will incur. It is true that you can’t be everything by yourself, but make sure you are taking advantage of modern software solutions and automation rather than hiring people to do repetitive tasks unnecessarily.
Vendor Relationships- loyalty to vendors, is great but be careful; this doesn’t make you miss out on better offers or negotiating more agreeable terms.
Branding and Marketing- Needless to say, you do have to spend on getting your brand seen and heard; just be sure not to fall for unnecessary marketing strategies that don’t allow for a return on investment.
Imagine a startup, or for that matter, any company that isn’t aware of its high burn rate. Business owners wouldn’t be aware of the overheads or consider ways to reduce them. For this reason, some would say spotting a high burn rate is a blessing in disguise.
Your burn rate will also indicate how much revenue is needed. You need to know how much revenue is needed so that you can at least stay afloat and hopefully grow. In an ideal world, you should have a minimum of 12 months runway. This peace of mind will allow for unexpected expenses, production issues, or fluctuations in the market. It is also a reasonable time for startups to start generating more income.
How Do You Set the Right Burn Rate?
This is a difficult question to answer, as there are numerous variables to consider. The general rule of thumb to have a gross burn rate of $10,000 per employee. From here, you can calculate a burn rate for various stages of the startup:
- Product Building- A smaller team of engineers and designers, a gross burn rate of up to $50,000.
- Usage Stage- You might need more developers and even a manager, and there might be some other expenses. A possible gross burn rate of up to $100,000
- Business Stage- The product will be in full swing, and it’s time for the business to start expanding. Management will be expanding, but you might also need to set up departments like HR and finance. A gross burn rate of up to $250,000.
Bear in mind that there will be times when your burn rate is higher, and this isn’t necessarily a cause for concern. You may need to invest more heavily at certain stages, particularly in periods of growth and expansion, but the burn rate will level off again once the income from this period starts to come in.
How to Manage Your Burn Rate
Though we have briefly mentioned ways to reduce your overheads, there are other techniques that will help you manage your burn rate at various business stages.
Only hire when completely necessary. Also, consider whether you are better off employing staff or hiring contractors. Outsourcing can greatly reduce your overheads as you have access to greater talent and reduced rates. Plus, you don’t have to pay social security fees, which, depending on your country, can be as much as 30%. Another advantage of outsourcing is that you have more flexibility and don’t get caught in lengthy employment contracts. During the summer months, you can hire interns to keep your costs lower.
Reduce your churn rate
Your churn rate is the number of customers who end their relationship with you. It is particularly important when it comes to monthly subscriptions, and this is your regular income. For example, if you have 500 customers and lost 25 in one quarter, your churn rate would be 5%. Engage with your customers and take care of them. A good churn rate for a SaaS is between 5% and 7%. Even with good control of your overheads, a high churn rate will impact your revenue and, in turn, your gross burn rate.
Take advantage of free trials.
Businesses need software solutions to maximize efficiency and productivity. There are so many software solutions out there and with a range of different pricing packages. You may think you need a solution; the demos really do convince you that you need it, but make the most of the free trials available to find the right tools to enhance your business and get the greatest ROI.
Don’t be the CEO who is afraid to get their hands dirty.
Each employee will have a role based on their skills and expertise. That being said, you need to have to ability to wear different hats. Your skill set needs to include everything from meeting investors to product design. Being able to dip into each department and process will enable you to see just how well resources are being used and where improvements can be made.
Let go of products that don’t sell
Variety is the spice of life, and it seems like a great thing to be able to offer your clients different products. But, if they aren’t selling, they only cost you money, so it is better to cut the product and turn your attention to those that are selling well.
Get comfortable with your numbers.
Being the accountant might not be what you had in mind when you were planning your startup, and even when you grow enough to have a finance department, you still need to be comfortable with the calculations and understand all of your numbers, not just the burn rate and runway, so that you know the exact financial situation of your business at any given time.