This is a complimentary blog to our Cash Runway guide for 2023. We will go over the Cash Burn Rate specifically, how to manage it, and how to prevent it from being an excuse for your lenders to use use it against you. Finally, as concluding matters, we will talk about when the best time is to fund your scale-up.
What is A Cash Burn Rate?
Cash burn is a term used to describe the rate at which a company is using up its cash reserves. It is typically calculated by taking the company's current cash balance and dividing it by the amount of money the company spends each month, known as the burn rate.
Cash burn can include a wide range of expenses, including salaries and wages, rent, utilities, marketing and advertising, research and development, and other operational costs.
It is important for a company to carefully monitor its cash burn to ensure that it has enough cash to continue operating and meet its financial obligations. A balanced cash burn rate is a great signal for potential investors:
Not like that, Heath...
The burn rate is often expressed as a monthly or quarterly percentage. There are two main types of burn rate: gross burn rate and net burn rate.
The gross burn rate...
...Is the total amount of money that a company spends in a given period, including both its operating expenses and any capital expenditures. For example, if a company spends $100,000 in a month on operating expenses and $50,000 on capital expenditures, its gross burn rate for that month would be $150,000.
Your accountants will know how to calculate your operating expenses, but here for you an extensive list of everything that potentially goes into the calculations:
Cost of sales, Acquisition and Retention Expenses, Payroll Taxes and Benefits, Payment Processing, Advertising, Insurance, Legal and Professional Services, Licenses, Rent, Utilities, Repairs and Maintenance, Supplies, Travel Meals and Entertainment, Miscellaneous, Subscriptions, Office Equipment.
You will remark that while some of it is related to production, the rests are intangibles or indirect costs of running a business. The term often employed is overhead costs: salaries and wages for administrative staff, rent for office space, utilities, insurance, and other operational expenses.
Overhead costs are not directly tied to the production of a specific product or service but are necessary for the business to function and generate revenue. It is important for a company to carefully manage its overhead costs in order to control its expenses and maintain a healthy profit margin.
Overhead costs are typically recorded as expenses on a company's income statement and are subtracted from its revenues to calculate its net income.
If you’re not an accountant all of this is probably pretty boring:
The net burn rate...
...On the other hand, is the difference between a company's gross burn rate and any non-operating income it receives, such as interest income or investment income.
In the example above, if the company received $25,000 in non-operating income (property or asset sales, currency exchange, gains from investments, and other atypical gains or losses) during the month, its net burn rate would be $125,000 ($150,000 - $25,000).
In general, the net burn rate is a more accurate measure of a company's cash burn rate, as it takes into account any non-operating income that can offset its operating expenses.
However, both gross burn rate and net burn rate are useful metrics for investors and analysts to track, as they provide insight into a company's financial health and its ability to fund its operations.
Why is cash burn important to lenders?
Now for the interesting part!
Cash burn provides an indication of a company's relative financial health and ability to repay its debts. It indicates whether investments are effective and give an idea of how long the company can sustain their operations without new cash influxes.
If a company has a high cash burn rate, it may be more likely to run out of cash and be unable to make its required loan payments. It’s not rocket science.
A high cash burn rate IS a red flag for lenders and makes them less likely to lend money to the company.
On the other hand, if a company has a low cash burn rate, it may be viewed as more financially stable and a better candidate for lending.
In general, lenders will want to see that a company has a sustainable cash burn rate and is taking steps to manage its cash flow effectively in order to minimise the risk of default.
How can VCs use your cash burn against you?
VCs (venture capitalists) may use their partner’s cash burn rate in a number of ways. It’s understandable: a company with a high cash burn rate is a risky investment, as it may be more likely to run out of cash before it can generate a return for the VCs.
A high cash burn rate will be looked at with scrutiny by your VC partner. A high cash burn rate is not bad per se. Uber and Tesla always had an incredibly high one, even at their beginning and they turned out to be extremely successful.
What your lender will look at is rather how you spent your/their money. Was hiring a new developer really that useful, considering its price? Can you justify the burst in credit card spending on business lunches? Things like that.
While some funders might think that because more resources are available, there will be less scrutiny involved, it is generally the contrary that happens. It’s like Uncle Ben said:
VCs may also be more likely to negotiate for a higher equity stake in the company in order to compensate for the added risk of investing in the business.
If as a founder, you’ve not made the wisest decisions after getting your funding, this might inevitable.
When is the best time to fund?
The best time to raise capital can vary depending on a number of factors, including the stage of the company, the industry it operates in, and the current economic environment.
In general, it is often advisable for a company to raise capital when it is in a strong financial position and has a clear plan for how it will use the additional funds to grow and succeed.
This can help to attract investors who are confident in the company's ability to generate a return on their investment. Additionally, market conditions may also play a role in determining the best time to raise capital.
For example, if the economy is strong and investor confidence is high, it may be a good time to raise capital, as investors may be more willing to invest in new opportunities.
On the other hand, if the economy is weak or there is uncertainty in the market, it may be more challenging to raise capital and investors may be more cautious about committing their funds.
Ultimately, the best time to raise capital will depend on the specific circumstances of the company and the state of the market.