So what is the right burn rate for your startup?
On the surface, a startup’s burn rate is easy to calculate, intuitive, and easy to understand. Below the surface, though, we see that burn rates hide a level of complexity that early-stage entrepreneurs routinely overlook due to a lack of understanding. This knowledge gap is caused by a weak industry dialogue and a dearth of academic research on the subject.
We believe that founders deserve to benefit from a more robust understanding of burn rates and we want to help them achieve just that.
For a review of the concept’s fundamentals and to learn how to calculate gross burn, net burn, and runway, we recommend the following articles:
- “Burn Rate” by Fred Wilson
- “Is My Startup Burn Rate Normal?” by Danielle Morrill
- “What is the Right Burn Rate at a Startup Company?” by Mark Suster
“My Burn Rate is Better Than Yours”
In a recent study, running out of cash was the primary reason why 30% of the businesses under review failed. So, is there a “correct burn rate”? Several high-profile entrepreneurs have shared their thoughts on this topic (see the above list), and many have offered concrete burn rates that other entrepreneurs can follow.
Unfortunately, these entrepreneurs attach several caveats to their numbers and, subsequently, make the exercise of sharing burn rates as fruitful as running after a rainbow.
A proper burn rate assessment involves carefully analyzing what your company is spending its cash on, and will be unique to your company’s specific geographic location, industry, relative position vs. competitors, and strategy. Although each company has an optimal burn rate, that rate has little or nothing to do with the optimal burn found in another business.
The Low Burn
So, if each business has an optimal burn rate and we’re worried about running out of cash then shouldn’t we just maintain a low burn? Low burn rates are fantastic because they lower the company’s risk by extending its runway. Unfortunately, low burn rates slow progress and increase the odds that market conditions will change.
We want companies to be lean and efficient but we also want them to move at an appropriate pace. Reducing a company’s burn rate should only be about eliminating wasteful spending and locating the company’s optimal burn.
In every other way, a low burn is almost as harmful as a high one.
The Bubbly Burn
A high burn rate can indicate that a company is getting things done but it can also come with a significant amount of risk. Companies with high burn rates are more likely to enter into bridge loans between financing rounds that have onerous terms and conditions. They also frequently rush companies into their next round of financing, resulting in a lower valuation due to their vulnerable cash position.
But perhaps the most important downside to maintaining a high burn rate is that it fattens startups and, subsequently, kills their ability to adapt to changing conditions.
Agility is a critical startup characteristic that must be maintained if the company hopes to revise their business model and adapt, when needed. Established companies don’t need the same flexibility because they have proven business models that only require execution.
Fat startups must also manage the burden of raising larger sums of new money during subsequent rounds to support their bloated infrastructure. If the market turns on them, and cash becomes scarce, then no one will be around to lend a hand.
Lastly, burn rates (high or low) naturally rise over time as the business scales and early-stage companies with high burns leave little room for growth.
The Optimal Burn
The scant empirical research that we have on burn rates tell us that there is a U-shaped relationship between a company’s burn rate and their probability of failure. This means that a company’s probability of failure decreases as it spends more money until it reaches a spending inflection point, after which the company’s high burn rate actually threatens its survival. These results suggest that startups must focus their attention on maintaining a balanced level of spending if they want to beat the 75% failure rate that startups face.
This study also uncovered that when managers keep firms lean, they are more likely to exploit the most profitable opportunities first. As burn rates rise, companies have trouble finding new investment alternatives that yield equally high net present values.
Nevertheless, startup cash balances force them to pursue these opportunities anyway, lowering their company’s value and raising their probability of failure. The firms that were able to balance their burn rates enjoyed the lowest failure rates and the longest longevity.
The Hardest and Most Important Decision
The rate at which an entrepreneur spends their firm’s resources is among the most important and hardest decisions that they will have to make. As a result, entrepreneurs must find a way to get their company into their optimal burn zone.
Because entrepreneurs cannot accurately predict future demand and competition, they either spend too little (underestimate demand/overestimate competition) or too much (overestimate demand/underestimate competition).
Given that a higher burn rate is relatively more dangerous than a lower burn, it is recommended that early-stage companies begin with a lean burn rate and re-assess it after every hire, every project, every new expense, and every significant event.
Burn rates and runways are not static figures and require constant review. In addition, entrepreneurs are encouraged to stress test their burn rates across a number of different assumptions to ensure that they can withstand unpredictable events. These events should include rapid revenue declines (ex. -30%), rapid expense spikes (ex. +30%), and both situations occurring simultaneously.
Managers must understand the consequences of these special circumstances so they can have a contingency plan ready. A financing contingency plan may involve pre-negotiated bridge loans with favourable terms and a cash flow plan may involve identifying variable costs that can be cut to reduce burn (ex. contractor salaries).
Reducing your burn rate temporarily, during adverse situations, can be the difference between weathering the storm and succumbing to it.
As the academic community learns more about this complex metric, and as industry dialogue deepens, entrepreneurs will have more resources to help them navigate these murky waters.