What Does Burn Rate Mean?
Burn rate is the speed at which a startup company uses its existing finances for overhead expenses before it can generate a positive cash flow. In general, it is measured as the amount of cash spent every month. If the company is unable to generate revenue beyond a certain time, then it must reduce its burn rate, which could mean cutting down its monthly operating expenses.
Divestopedia Explains Burn Rate
Burn rate is also the amount of money that a company is losing every month towards its operating expenses. There are two types of burn rates: gross burn rate and net burn rate. Gross burn rate is the total amount of money that a company spends every month, while the net burn rate is the difference between the amount of money spent and the amount of money earned by the company during a month. For example, if a company spends $1,000 and its income is $600, then its gross burn rate is $1,000 while its net burn rate is $400.
Many investors look closely at the net burn rate before putting their money into a company. For example, if a company has a burn rate of $100,000 and they have a cash reserve of $2,000,000, then they have enough cash to sustain operations for the next 20 months, provided the burn rate does not increase. On the other hand, if a company has a burn rate of $500,000, then they have money left for only four months. Depending on the number of months for which a company has a sustainable burn rate, the existing investors should make plans to bring in more investments.
Sometimes, this burn rate also helps to determine how much money should be raised in every round of funding. For example, if a company is spending only $50,000 a month, then there is no need to raise $10,000,000 during the first round of funding. In this sense, the burn rate helps to determine the amount of money that a company needs at any given point in time.
In the event of an M&A, the acquirer should look closely into the burn rate in order to get an idea of how much liability there is and how much funding they need. Usually, a company seeking venture capital financing will raise enough cash to cover an 18 month burn rate.