What is Burn Rate?

March 25, 20237 min read
What is Burn Rate?
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Key Takeaways

  • Burn rate is how fast an enterprise “burns through” their venture capital, a key metric for potential investors to know.
  • A startup business that has a low burn rate is more apt to ultimately become profitable, and thus generate investor returns.
  • Venture capital is no longer exclusively for hedge funds or the ultra wealthy.

It is vitally important for those in venture capital to know the burn rate of the startup in which they are interested. Such knowledge can keep investors from making potentially bad decisions, as well as help them uncover margin opportunities. What is burn rate? Here is that and more.

What is Burn Rate?

It is a crucial metric that business owners should know, but many do not. Part of that could be because the rate requires calculation, although the primary formula is straightforward,

In essence, burn rate is the dollar amount a business requires to pay all expenses in a certain period – typically a month. Another way to say it is, burn rate is how fast an enterprise “burns through” their venture capital. That is key information for potential investors to know.

While the metric can help any business owner, their stage in the business lifecycle notwithstanding, it is typically calculated to see how swiftly a startup will exhaust its capital before turning a profit.

As for established businesses, a low burn rate indicates how likely it is they will get through quarters in which revenue is low.

What is the Burn Rate Formula?

There are a few ways to calculate burn rate, but the most straightforward formula is (Starting Cash – Ending Cash) / Number of Months = Monthly Burn Rate

How Do You Calculate the Burn Rate?

First off, get a calculator and the balance sheet for the period you are evaluating. Subsequent steps include:

  • Specifying the recent period that will be assessed.
  • Finding the cash balance on the balance sheet for the period’s start and finish.
  • Subtract the ending cash balance from the beginning cash balance.
  • Dividing the difference by the number of months being assessed.

Note that, to get a more accurate calculation, it is wise to review more than the previous month’s financial info.

Here is a burn rate example:

Say Business A is going over the burn rate for April, the last month of the first quarter. On Jan. 1 – the first day of the quarter – the business’s cash balance is $160,000. On the last day of the quarter, March 31, its cash balance was $100,000.

First, the ending cash balance is subtracted from the beginning cash balance: $160,000 – $100,000 = $60,000.

Next, the $60,000 difference is divided by the number of months – three – being assessed: $60,000/3=$20,000.

Thus, Business A’s burn rate for the year’s first quarter is $20,000.

What is Gross Burn Rate vs. Net Burn Rate?

The two types of burn rates are gross burn and net burn. A business’s gross burn rate is operating costs that are incurred monthly. The net burn rate is the amount of capital a company loses each month, or the rate at which a business is losing money. Note that the total cannot be more than the gross burn rate, but it can be less.

Burn Rate vs. Cash Runway

The difference here is that the cash runway gauges how long, at the company’s current cash burn rate, the company’s cash will last. It is important to know how long one’s business can survive with the cash they have on hand.

What is Cash Runway Formula?

The formula for cash runway is Current Cash/Monthly Burn Rate = Cash Runway.

How Do You Calculate Cash Runway?

In keeping with the above burn rate illustration with Business A: $100,000 (ending cash over three-month period) /$20,000 (burn rate) = 5 (runway). If there’s a sales decline or increase in outlays, Business A has sufficient cash for five months.

What is Considered a Good Burn Rate?

It is generally recommended that a startup have at least six months of expenses available, preferably a year.

What Costs are Considered in Burn Rate?

Operating costs run the gamut but usually include salaries, administration costs, and property leasing or rent.

How to Reduce the Burn Rate

There are measures a company can take to lower their burn rate:

  • Improve the gross profit margin to increase revenue without raising expenses.
  • Review subscriptions, dues, and marketing efficiencies to decrease expenses.
  • If debt payments are high, consider refinancing the debt.
  • To plan for positive cash flow, use a cash management system.
  • A leaner strategy might call for layoffs or pay cuts.

What Does Burn Rate Reveal About a Company?

When a business seeks startup capital, investors check to see whether they have a low burn rate. Why low? Because their investment capital can work harder. A new business that has a low burn rate is more apt to ultimately become profitable, and thus generate returns on investments.

How to Know a Company’s Burn Rate

Investors can compare a company’s burn rate to their business plan to assess whether a company has a good chance of becoming profitable.

What are Ways to Invest in Venture Capital?

Generally, venture capitalists finance startups and small businesses that have long-term growth prospects. Overall, ways to get involved in the venture capital space include through venture capital debt, funds, stocks, and direct investments.

While all investments carry risk, investing part of one’s holdings in high-reward assets such as venture capital presents opportunities that can have great reward/ In fact, in 2020, returns on venture capital exceeded 50%. Over the last 25 years, returns have averaged 32%, according to the U.S. Venture Capital Index.

How to Invest Outside the Stock Market

Increasingly, investors are putting capital in what are called alternative investments, which generally have low correlation to volatile public markets. These investments include asset classes such as real estate, art, private credit – and venture capital.

Historically, only institutional investors and the extremely wealthy had opportunities in venture capital. Eight years ago, though, legislation paved the way for ordinary investors to engage in equity crowdfunding, which spawned venture capital platforms for ordinary investors.

For example, the alternative investment platform Yieldstreet added a venture capital program to its offerings, and with low minimums. Such investments provide curated exposure to private companies during what typically are periods of fast growth.

Like all alternative investments, venture capital also serves to diversify portfolios, which is key to successful investing.

Rise above Volatility

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Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments. This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

A low burn rate is a sign of a strong cash position, which is a key indicator of a startup’s financial health. Investors should know what a company’s metric is before taking a position in it. Putting capital in startups can be a rewarding investment option, particularly if investors go through a platform such as Yieldstreet, which vets its venture capital offerings. It also is a good way to diversify investment holdings.

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