Money to burn: Understanding and managing burn rate

Money to burn: Understanding and managing burn rate

Burn rate – how quickly you are spending your cash reserves – is an important figure for founders to understand. You need to manage costs, but spend strategically between rounds to fuel your growth.

Here’s everything you need to know about the maths and management of your burn rate.

Quick maths: Calculating burn rate

There are two concepts that inform burn rate; unit economics, and cost of growth.

Unit economics is the amount your company makes every item you sell something. It’s linked to the gross profit you make per item, or customer. For example, if you sell a cup that costs HKD150 to make, package and deliver for HKD200, your gross profit is HKD50 per cup. If you develop a fitness app, you might spend HKD150 to build and advertise it, but customers could spend a HKD1,000 a year to subscribe. If they stay for a year, your gross profit for that customer is HK850. Although these are exaggerations, they show how important unit economics is.

Remember, your gross profits need to cover fixed costs like rent and employee salaries. What’s left is your net profit per unit – the base of unit economics.

Your cost of growth is determined by how many people you need to sell more units. It covers the expected cost of bigger, better premises or technology, and increased marketing. It’s how much you’re going to need to spend to reach your milestones.

Understanding your unit economics and cost of growth can help you work out your runway. That’s how long you’ve got until you run out of cash reserves. It also means you can make an informed decision on how much to you need to raise to keep meeting your growth goals: generally enough runway for 12 to 18 months.

To spend or not to spend: a balanced burn rate

The trick is to find a balance between sufficient and excessive burn rate.

For most startups, the aim should be to keep expenses as low as possible. Thankfully, there are loads of low- and no-cost business tools that can help you minimise operational costs. Offering fewer employee perks can also help manage spend, so unless you’re on track for unicorn status, you can probably do without free food and massages (although they may be a carrot to dangle in front of high-priced talent).

By far the biggest expenses for growing startups is people. Many first-time founders don’t accurately factor salaries and benefits into their future burn rate – which can mean they spend cash faster than planned.

Being responsible and resourceful is an important quality for investors. They are also subject to market conditions, and most will look for efficient businesses with an extended runway.

But it’s not all about playing it safe. Strategic spending that allows you to gain market share and win customers is important. Businesses that embrace great growth opportunities rarely capitalise on them unless they’re willing to burn through a lot of cash along the way.

It’s about balancing and managing regular spending so that you’re ready to put skin in the game when the time is right.

So, is there ever a right time to raise your burn rate?

What goes up should never come down

Sometimes, if you are beating your financial targets, it does make sense to pour on more jet fuel and spend more to capture market share. Although it may delay profitability, it’s a risk many fast-growing startups take because it gives them a stronger market position that ultimately translates into more customers and better profits.

By contrast, lowering your burn rate should be a last resort.

Carefully managing spend is one thing; but drastic cuts, which often involve letting people go, won’t impress the talent pool or your investors. Investors are focused on returns, and may not worry if you spend their initial investment maximising opportunity. Even if a company’s sales grow twice as fast as expected, investors would rather see additional spending to maintain or even increase the burn rate instead of keeping expenses flat to cut it.

Unfortunately, if your unit economics have changed and you have less than 12 months’ runway, you may need to take drastic action before it’s too late. In that case, reducing burn rate may be the only way to save your business.