The “burn rate” is a term used to describe how quickly a company spends its cash reserves before it starts generating positive cash flow from operations. It’s typically calculated on a monthly basis and is a key metric for understanding the financial health and runway of a company, especially in the start-up and scale-up phases.
The burn rate is relevant to scale-ups for several reasons:
- Runway Estimation: Knowing the burn rate allows a scale-up to calculate its “runway,” or how long it can operate before it needs to become cash-flow positive or raise additional capital. This is critical as it provides a time frame for when the company must achieve certain financial milestones.
- Investor Communication: Investors are very interested in a company’s burn rate. It gives them insight into how wisely a company is spending its investment and how much time they have to either start generating a profit or secure additional funding.
- Financial Health Monitoring: A company that’s scaling up is likely growing its operations, which can mean increased costs. Monitoring the burn rate helps ensure that spending is aligned with growth and that the company does not run out of cash.
- Resource Allocation: Understanding burn rate helps a company to make strategic decisions about resource allocation. It helps determine whether the company can afford to invest in new hires, marketing campaigns, research and development, and other growth activities.
- Cost Control: Keeping an eye on the burn rate helps in identifying unsustainable spending patterns and encourages the implementation of cost-control measures if the company is spending too much too quickly.
- Risk Management: A high burn rate can indicate high risk. If a scale-up is burning through cash too quickly without showing adequate progress towards revenue generation, it can signal the need to reassess the business model or growth strategy.
- Valuation Justification: For scale-ups looking for further investment, a manageable burn rate can be a point of negotiation, justifying the company’s valuation and the use of funds from a new investment round.
There are two types of burn rates commonly referred to:
- Gross Burn Rate: This is the total amount of cash a company spends per month.
- Net Burn Rate: This is the amount of cash a company loses per month, which is gross burn minus any incoming cash flow from operations.
A scale-up, which is a growing business that has moved beyond the startup phase, has to particularly watch its burn rate. The costs can escalate quickly as it invests in new markets, products, and team members, and mismanaging the burn rate can lead to a financial crisis if not properly managed.