The Burn Rate (#250)
/In this podcast episode, we discuss the burn rate. Key points made are noted below.
When We Use the Burn Rate
The burn rate measures the amount of cash being used up per month, which you can then use to estimate the amount of time it’s going to take for a business to spend its remaining cash reserves – and then presumably go out of business. This is an important concept for a startup company, which has been given a fixed amount of cash to get things going, and only has a certain amount of time to create a product and start generating sales, before the cash is gone. This isn’t just a financing issue. It’s also a concern for the auditor, who needs to figure out if a business is a going concern. Because if it’s not, that’s kind of a major disclosure issue.
Example of the Burn Rate
The burn rate is based on the amount of negative cash flow per month, which is divided into the amount of cash on hand. For example, if a business’ bank account balance is dropping by $50,000 per month, it’s said to have a burn rate of $50,000 per month. If it has $1,000,000 of cash in the bank, then it should be able to last 20 months until its cash runs out.
Issues with the Burn Rate
Of course, things are never quite that simple. The first issue is that the burn rate is not the same thing as expenses. So, a startup company might have operating expenses of $50,000 per month, but it’s also paying for computers for its staff, and rent deposits, and office furniture – none of which are classified as expenses. Those extra items are all classified as assets. So when figuring out the burn rate, you have to look at every possible kind of expenditure being made.
The second issue is that companies are a lot looser with their expenditures when they’ve just received a pile of funding, and a lot stingier when the last few dollars are about to be drained out of the account. That’s for two reasons. One is that a company needs to spend more money up front when the business is just getting starting, to pay for things like legal expenses, just to get properly organized. The other reason is psychological. When there’re many months remaining before the cash runs out, people tend to worry about it less than when the whole enterprise is about to close its doors.
So when the cash is nearly gone, management tends to scale back on purchases, lays people off, cuts pay, and so on. And that makes it a lot more difficult to figure out the burn rate over a long period of time, because the amount of cash being used tends to decline a lot when the end is near.
Another issue is the likelihood of obtaining additional funding. If the business is about to launch a promising new product, there’s some chance that it can line up an additional round of funding and keep things going longer. If management expects more cash, then it’ll be less inclined to scale back its expenditures when the cash balance drops, and instead is more likely to keep going full speed ahead – and might even increase its expenditures, so that the burn rate goes up over time.
This is why you occasionally see a startup company crash and burn very suddenly. They’re hiring more staff right up until the last minute, and then the funding doesn’t come through on time, and it collapses. But that’s still not the only issue with the burn rate. It’s quite possible that management has made promises to its employees and suppliers to hang in there just a bit longer until the next round of financing has been lined up, and then it’ll pay them for amounts owed.
The problem is that the people supplying the next round of financing are doing so based on an extension of the current burn rate. And they’re not too happy when the new funding goes into the company’s account and then there’s an immediate decline in the cash balance in order to pay off those overdue amounts. In essence, what just happened is that management has been disguising a higher burn rate than initially appears to be the case, because of the delayed payments.
And there’s yet another issue, which is whether the burn rate is a valid figure if the founders decide to cut their losses early, shut down the business, and take out their cash. This is based on a review of how well the company’s product development work is going, as well as a realistic review of whether or not it’s possible to get an additional round of financing. If the answer to either one is not good, then it can make sense to lay everyone off and liquidate the business, even though there’s still cash in the bank.
So far, I’ve been talking about additional funding as though that’s a realistic possibility. In many cases, it’s not. There’s going to be one funding round, and if the company can’t get its operations going with that specific amount of cash, then the game is over. And maybe that’s why venture capital folks have a term called the Death Valley curve. It’s a declining curve that shows the amount of remaining cash. At some point, the business runs out of money, and it dies in Death Valley.
The Burn Rate Applied to Older Companies
The burn rate concept is most applicable to new companies, but it can also be useful when an older business has a persistently negative cash flow. In this case, it needs to come up with some sort of strategic or tactical change in order to turn around its cash flow situation. In this case, burn rate is quite useful for telling management just how much time it has in which to make those changes.
But it’s not quite that simple, because the burn rate is supposed to represent a fairly consistent amount of cash being used up each month. And for a business going through a turnaround, that’s just not the case. Instead, it spends a lot of money up front on severance pay to let people go, along with paying for the things it needs to launch it in a new direction. Which may include payments for branding, like advertising to reposition the public image of the company. These payments tend to be lumpy, so the burn rate could vary a lot by month.
A Reason Not to Use the Burn Rate
Which brings me to my final point, which is that maybe the burn rate isn’t such a good measurement to rely on. Instead, it can make more sense to maintain a fairly detailed cash forecast that runs a good ways out into the future, and only tack on the burn rate for periods beyond what’s covered by the cash forecast. That way, you get the best possible visibility into when you’re going to run out of cash.