WHAT IS CASH BURN RATE?
Cash Burn rate is the rate at which a company is losing money, typically, the amount of money that the company loses in a month. Say a company spends Rs 500,000 in a month (this includes all costs – operating costs and the COGS which is the cost of making the product or service that it is selling) and earns a revenue of Rs 100,000 in the same period; then the cash burn rate for the company is Rs 400,000.
The term came in vogue during the ‘dotcom era’ in the late 1990s when the internet economy was new and the sky was the limit for investors and entrepreneurs. Entrepreneurs touted new technologies and market models and investors bought into the vision. Heavy investments were made and burned in a race to capture market share before competitors filled up space and competed for the profits that were sure to be forthcoming. Earlier businesses would have taken years to yield profits on investments but now anything was possible. The periods had compressed. Investors wanted more and sooner, It was not a matter of years but months. And a company burning cash might simply be doing what it was supposed to. It has since then continued to be an important metric, not only for internet-based technology start-ups and their angel investors but also for traditional businesses and their bankers who have picked up this metric especially when applying it to debt-stricken businesses.
WHY IS CASH BURN IMPORTANT?
Cash Burn Rate has become a critical metric for technology start-ups because it allows company management and investors to get an idea about the ‘runaway’ available for the company. Simply put if a company has Rs 100,000 in the bank and its cash burn rate is 10,000 then it going to run out of money 10 months. Hence the ‘runaway’ of the company is just 10 months. For the runaway to be extended company management will have to either increase revenues or slash costs or seek more money from investors (most probably a combination of all three). Right from the start investors would expect management to provide models in which cash burn would be a critical metric.
A runaway of fewer than 6 months can be considered to be a crisis for the company management team.
How to account for cash burn before and during running starting up?
The founder of a start-up can’t calculate ‘exactly’ what they would be spending in the next 12 months since the market place is new and dynamic. Work with ‘approximate’ figures taking into account market vagaries. Only then will you be able to convince the initial seed investors to part with their funds. You must create a business model with inputs for operating expenses, COGS and revenues. Only when you have detailed out the model, can you compute the cash burn rate and the runaway that the company can expect before it can take off.
Most seed investors look at this figure before determining whether or not they wish to invest. With the business up and running after the initial run of funding, there will be a more exact figure for the amount of cash burn. If the cash burn is fine and the runaway of the company is long and expansive then the founder should not have any problems in seeking more funds. Otherwise, you must take corrective steps, like cutting costs or seeking more investors with a greater appetite for risk.
CASH BURN TRENDS IN THE INDUSTRY
Cash burn trends tend to follow the national economy that the start-up is located in (as also the global economy which a lot of national economies now mirror). With credit flush in the system and investor confidence high, suitable start-ups benefit with adequate seed funding. In a buoyant economy, these same start-ups feel confident enough to spend huge sums on product development and marketing. Hence cash burns are high in the expectation of even greater returns. However, in depressed climes, the start-up environment is suitably subdued. New start-ups start smaller and aim lower — hence lower cash burn. Older start-ups already fighting in a competitive market with lesser money to go around trim costs, leading to a lower cash burn.
Management of companies that are not able to adapt to the less conducive environment will either file for bankruptcy or be absorbed by their creditors/investors/competitors. For example; in the hyper-competitive online food delivery sector in India, Uber Eats was recently bought by Zomato. Uber Eats was simply spending too much for it to be viable as a business any more in an area where Zomato and Swiggy dominate. All this may have been due to the downturn in the Indian economy since 2016. In a rapidly growing economy, there may have been a place for three major players in the food delivery market.
PREDICTING AND MANAGING CASH BURN IN A STARTUP
With a completely new business model, it may be difficult to determine cash burn, especially when factoring in economies of scale but it will still be necessary for the founder of the start-up to go through the exercise and create a model which may be purely theoretical. It may be based on related industries and related models but it is better than nothing. A business model has to be prepared which includes costs and scaling up. Assuming the business is up and running after the initial seed funding, then costs will be more clear and a more accurate model can be created.
Naturally, if the new business is simply a copy of an older business then the necessary changes may be done in the older model to increase efficiency. Start-up that is burning too much cash, must take the necessary steps so that the runaway not be reduced to less than six months: slash costs, seek more investors and modify the business model if needed to bring in more revenue in a shorter span.
Defining a burn rate for a first-time business, with a new business model is definitely tough. This is where experts come in to provide guidance based on their knowledge of various industries, economic climates and investor mindset. To know how much your business should be spending and reduce your burn rate, reach out to us: [email protected] | 044-46315959. Or drop us note on any of our social media pages: