Don't Burn All Your Money
The gross burn rate is the amount that is being spent every month. The net burn rate is the amount of loss. Both are of equal importance. One of the reasons that net burn is such a valuable number to investors is that it provides some idea of how long the business can continue to operate, assuming it doesn't increase its net burn. As such, the net burn can be a way to determine how many more months a startup can stay in business, based on the cash it has in the bank. A company with one million dollars in the bank might sound promising, but if its net burn is $250,000, it can only stay afloat for four more months unless drastic changes are made. So that scenario does not sound like a good investment at all.
The net burn rate can help current investors measure and determine their level of risk, and can also give them an idea of how quickly they will need their teams to focus on fundraising. New investors will also be interested in the net burn of a startup, because they will want to know how quickly they need to raise cash, and how much cash they will be asked to invest.
While it's important that startups keep their net burn as low (or at least as realistic for their company and industry) as possible, having a very low net burn actually can work against them if they're looking to raise a significant amount of money. To illustrate this point, a startup with a net burn of $150,000 wouldn't appear to need to raise millions of dollars right away, and asking for that kind of money might put investors off. Prospective investors could wonder why the company would need that level of capital. So simply seeing if investors will fork over large sums of money isn't a good practice for startups, and can lead to their being overcapitalized.
Here are some tips and questions for you to consider when reviewing a company’s net and gross burn rates:
1. Is the company responsible with money?
Make sure that company founders who are seeking your capital investment articulate why their company needs it. If the company’s net burn rate is low, why are they seeking a high–dollar investment? Are there other expenses that are not being disclosed? Be wary of companies who respond with the idea that “more money is always better”. These companies tend to develop a bad habit of unnecessary spending.
The burn rate of any startup should be similar to the burn rates of the competition, but the size of the company and its operating expenses will dictate the overall burn rate. It’s always best to invest in companies that have 10% month–to–month growth and at least 18 months of burn rate, as these companies have proven to be more viable in the long run.
2. who makes up for most of the company’s revenue?
Make sure that the company’s revenue is not reliant on a few customer accounts, and there is a varied distribution on where the company makes money. This provides a safety net for investors since market fluctuations cannot be easily foreseen and can happen quickly. Having a wide array of customers allows a company to survive any revenue losses due to unpredictable market fluctuations. SaaS companies are ideal for investors because their biggest customer may account for <5% of their revenue, and their revenue is ongoing and recurring.
3. Is the company spending on growth and development?
Pay attention to where the company does spend its money. A company may have a high gross burn rate due to growth and development expenses. It is a calculated risk that provides investors with longer–term rewards if the company raises the value of its product and broadens its customer base. Stay away from companies that have low burn rates in a stagnating market since these companies will provide little return of investment.