Definition of a Burn Rate
The term “burn rate” is usually used to refer to the speed at which a company is spending its venture capital investments. It’s almost always applied when a new company is spending the initial venture capital funding that it raised before starting to generate income.
Because of this, tracking burn rate helps companies to see how much longer they can continue to operate and provides a metric for the race against time as companies try to become profitable before running out. Burn rate is generally calculated in terms of how much money is being spent per month, and it’s often worked out as an average.f cash.
For example, if a company spends $500,000, $1 million and $1.5 million across three consecutive months, that gives them an average burn rate of $1 million over that three-month period.
As well as being a useful metric for the start-ups, burn rates are also useful for potential investors. They’ll want to know how quickly their potential investment is getting through money so that they can figure out whether it’s a good investment or not. Start-ups may need to provide evidence of their plan to become profitable before the money runs out for an investor to give them the green light.
Let’s go back to that previous example. If the company that we looked at began with $10 million in the bank, after that initial three-month period, they have $7 million left and a burn rate of $1 million, which means that they can continue operating for another seven months.
It’s important to note that there are two different types of burn rate, and so if you’re discussing burn rate with a third-party, you should ensure that your definitions are the same. The two main types of burn rate are:
- Net burn: The total amount of money a company loses each month.
- Gross burn: The total amount of operating costs a company incurs each month.
Similar to net profit and gross profit, the two metrics are related but subtly different. Net burn is calculated by taking the gross burn and subtracting any income that’s coming in to offset the losses. So if a company spends $200,000 a month and brings in $30,000 of revenue, they have a gross burn of $200,000 and a net burn of $170,000.
How can companies reduce their burn rate?
There are two main ways for companies to reduce their burn rate. They can either cut costs or they can increase revenue.
What does a high burn rate mean?
A high burn rate doesn’t necessarily mean anything in and of itself. However, it shows that a company is spending money at a rapid rate and can be a cause for concern if the company isn’t showing signs of generating income. Some investors will set more aggressive deadlines when providing funding to a company with a high burn rate.