If you’ve founded a startup or are seeking investment for your startup, you’ve probably been asked the question: “What is your burn rate?”
In the world of startups, your Burn Rate is your company’s rate of spending every month. Typically, this will be an average of your historical spending (or projected). See the image below:
In the example above, we take the total spend and divide it by the number of periods. Assuming a startup has $900,000 in the bank, this would give them approximately 10 months of Runway, or 10 months to continue operating until the business is forced to close.
In this article, let’s dive into why understanding your burn rate is so important for startup founders and investors.
Why Burn Rate Is Important
As a basic guideline, it is advised that start-ups have enough cash to cover at least 12 - 18 months of expenses without having to depend on revenue. The key word here is “depend”. Revenue projections can paint a rosy picture but they likely won’t happen in reality. And while the goal of any business should be to make a profit, most businesses will not reach profitability within a year.
Therefore, having 12 - 18 months of runway will allow you to hit key milestones in your business, pivot in the face of any difficulties, and secure additional investment to scale and reach profitability.
BTW, the amount of runway required for your startup will vary depending on the industry, company size, business model, market conditions, and founder/investor preference.
How Investors Think About Burn Rate
A common problem we see here at 8cast is that startups “budget” using projected revenue.
Recently, one of our clients in the Media and Entertainment space was seeking to raise a $3.5 million seed extension. The financial model was assuming that the company would secure an investment, earn revenue, and be able to sustain itself until the next round of funding.
This may seem fine on paper but there were a couple of issues with the model.
The first issue was that if you removed revenue from the projection, the startup would run out of money in less than 10 months. The venture capitalists were concerned that their investment would be lost before the company could even make it to a Series A.
The founders were banking upon being able to raise 3 months from the end of the 12-month forecast period, but the VCs smartly pointed out that capital raising can take a looong time. In fact, it may take up to 2 years for the average startup to raise a round, per Carta.
The key here for you is to come up with a realistic budget for 12 - 18 months that assumes the worst-case scenario: no revenue.
The second issue was that investor appetite can change dramatically. The VC pointed out that even if the startup hit all of its milestones, it still could take time to close given market conditions.
The fundraising market is drastically different as of March 2023 than it was a year ago. The easy money that fueled startup investment is gone due to the Fed raising interest rates; SVB has gone kaput; and investors are sitting on the sidelines with lots of cash.
Startup founders should expect that investment will take longer to secure and budget accordingly. The best startup founders may be able to raise in just a few months, but most others should assume that it will be closer to the average.
Creating better business plans, financial models, and budgets
Poor business planning is a key reason why many start-ups fail. Budgeting for 12 - 18 months and understanding how investors think of burn rate will allow you to increase the likelihood of startup success.
Here's the point where connecting with a financial model consultant or start-up fundraising consultant can be extremely helpful, and 8cast offers financial consulting that can help you achieve your goals.
Some benefits of working with a financial consultant include:
1. A clear financial blueprint: Create a distinct financial outline for the business to follow. Detail how much money the company requires to get started, what it will be used for, and how the funds will be obtained.
2. Support operations: Even after a business has launched, it may take some time to become profitable. Cash management is needed to ensure there are funds for ongoing operations, such as paying rent, utilities, salaries, and other expenses.
3. Boost investor confidence: When pitching to investors, having a financial consultant at your side demonstrates a solid plan, a capable team, and that you are committed to the success of your business.
4. Encourage flexibility and manage risks: Starting a business is inherently risky, however, a consultant can help you adapt to changing circumstances and manage risks. If unexpected expenses arise, a sudden drop in revenue, or the business needs to pivot, a financial consultant can help you make smart investment decisions with your limited funds.
5. Maintain accountability: A financial consultant can help hold you accountable for achieving your financial objectives. You can periodically compare your results to your budget and adjust as necessary — this can help you stay on track and avoid overspending.
6. Speed up growth: By having an effective framework for budgeting and investing, businesses can invest in new products, services, or markets, which can help to increase revenue and profitability.
A final note
The process of coming up with great ideas and innovations is already challenging; bringing those products and services to potential customers, securing a niche for yourself, and attracting real investors shouldn't be.
Working with experienced consultants to create an excellent roadmap for your start-up business can give you an edge and make the journey much easier.