What is Cash Burn and Why Does It Matter?
Cash burn is the rate at which a startup spends its liquid capital. In other words, how much cash is flowing out of a company over a certain period of time. Cash burn is normally calculated over a monthly period and is widely used by entrepreneurs and venture capitalists to better understand the current health of a startup.
Because this isn’t an actual US GAAP financial term and is open for interpretation, cash burn can be found in a couple of different ways. There are two different routes toward finding cash burn: net and gross. Gross is essentially just calculated utilizing the startup-in-question’s operating expenses. Net cash burn is a startup’s gross cash burn minus the revenue that a company generates in a given month.
And although this is a pretty straightforward concept, there are a couple of ways to get lost in the sauce regarding cash burn. First of all, most of the time when a VC asks what a startup’s burn rate is, they want to hear an average over the course of several months. And that means smoothing out operating expenses and taking into account the effect of one-time big purchases. For instance if a startup needs to make a huge expense in one month, such as a bill due to a major vendor, that number needs to be included throughout the cash burn calculation.
But how does a startup decide how to determine what the length of the calculation period should be? It should typically be the amount of months until a startup runs out of cash. Although that logic may seem circuitous, once you get the hang of it, it becomes fairly straightforward. Based on a startup’s projections, an entrepreneur should be able to determine how long until the company runs out of cash. Remember, projections are almost always incorrect, but good startups should have a solid grasp on their expenses. Plus, if you are the founder, just remember: you are the one spending the money - so you ultimately decide how to keep things within the budget.
If a startup has $20K in monthly operating expenses, a large one time expense of $60K and based on its financial model will run dry in 10 months, then the average gross cash burn is $26K per month. This of course can get tricky as large expenses of that nature are not always predictable.
So we now know what cash burn is - why does it really matter? Startups frequently become an effort in testing out various hypotheses until a company finds product-market fit. This testing takes capital and time. As a result, a startup’s leadership needs to know how much time they have remaining to continue testing their hypotheses and finding traction in the market. Cash burn is also important because it lets investors know the capital required for an investment. A lot of investors typically look for a company that maintains a low cash burn rate because this allows the company to survive longer and shows discipline by the management team.
That last point should receive some extra care. If you are an early stage company, investors are putting a ton of faith in the management team and founders. Most great endeavors require strong leadership and a degree of thoughtfulness and discipline. If you burn through your cash rate super quickly because of recklessness, what else are you going to be reckless about? Did you really do due diligence on the problem you are trying to solve? Are you going to be reckless regarding sales and not gain the support of early customers? Being reckless is not the best trait for a startup founder. Even if you aren’t being reckless, and instead just did a bad job projecting how much capital is needed to get your effort off of the ground, this might cause some investors a level of pause. Although, I should mention that projections are extremely tough, and no one expects you to be right all of the time - when you make a mistake in your budget, just make sure you really understand why and learn something from it.
Ultimately, cash burn is very subjective and can mean a lot of different things to a lot of different people. Like everything in startup finance, just make sure that you have a defensible reason for everything you put in front of investors and other stakeholders.