How to recalculate your startup cash burn rate going into a possible downturn economy
So as a startup founder, you might have started the year 2022, thinking you had everything figured out: you had a manageable cash burn rate, you had a clear amount of runway, and you had a business strategy built around both.
Now in a matter of a few months, there’s a downtrend in the stock market, supply chain issues are eating into revenues, talks of a recession are growing louder, and companies of all sizes are implementing cost-cutting measures, such as downsizing or cutting staff count as well as hiring freezes. As the economic crisis deepens, capital efficiency becomes a more pressing issue for startups. Not only is it necessary to maximize runway, but it also plays a larger role in how investors evaluate companies. A well-known VC investor David Sacks of Craft Ventures wrote in a post “while growth is always prized during good times or bad, investors increasingly scrutinize burn and margins during downturns. Startups whose burn is too high relative to their growth will find it hard to fundraise.”
So what do you do now?
There are a number of steps that startups can take to manage their financial position in a downturn, but we’re going to focus on the fundamentals: calculating your new burn rate and runway. I have written about the subject of Burn Rate before.
How To Calculate Your Burn Rate
Burn rate is one of the simplest, yet most fundamental metrics that investors and startups focus on. Investopedia states that ‘the burn rate is used by startup companies and investors to track the amount of monthly cash that a company spends before it starts generating its own income or becoming cashflow positive.” A company’s burn rate is also used as a measuring stick for its runway, the amount of time the company has before it runs out of money.
It pertains to the total cash spent by the business per month, which demonstrates both growth progress and the potential runway that the business has to survive. This article introduces the burn rate concept and the tactics that can be applied to optimize it.
The actual math for getting your burn rate is pretty straightforward: you subtract your cash balance at the end of the month from your cash balance at the beginning of the month, to get the amount by which your cash balance decreased. That amount is your burn rate.
- Gross Burn Rate is a company’s operating expenses. It is calculated by adding up all the expenses the company has, such as rent, salaries, and other overhead, and is often calculated monthly. In addition, it provides insight into a company’s cost drivers and efficiency, regardless of revenue.
Gross Burn Rate = Cash / Monthly Operating Expenses
- Net Burn Rate is the rate at which a company is losing money. This is calculated as the difference between the company’s operating expenses and its revenue. The calculation is done on a monthly basis. It reveals how much cash a company needs to continue operating for a period of time. One factor that must be controlled, however, is the variability of revenue. The fall in revenue without a change in costs can result in a higher burn rate.
Net Burn Rate = Cash / Monthly Operating Losses
By examining your average monthly cash burn, its trajectory, and how much cash you have on your balance sheet, you can estimate how much runway your company has to work with, i.e., how long you have until you run out of money (The startup bookkeeping software Pilot has a burn rate calculator to help you with this).
The issue that many growth-oriented startups are facing right now, you’re likely facing of course, is that the numbers that went into those previous calculations are now changing significantly. While some segments are more affected than others, virtually all businesses are likely to experience at least some impact from an economic downturn.
Getting Your New Numbers
t’s unfortunately safe to assume that customers are more likely to churn and it will be tougher to make new sales. This translates into downward pressure on your top line which increases your cash burn as your expenses stay the same. And with increased burn without new capital injection, you will have a shorter cash runway.
Updating your burn rate and runway means re-running your calculations with new numbers. To get those numbers, however, we have to take a step back. You need to have a solid model for making projections, so you can factor in how revenue, churn and spending over time will impact your burn rate and runway. And to do that, you have to have clean books.
We’ve talked before about how clean books are crucial for making good business decisions. Your books are the ultimate source of truth for your company’s financial status – they tell you how much cash you have, what your assets and liabilities are, and where your company’s money is going. If you can’t trust the accuracy of your books, then you can’t be sure that your financial decisions are based on reality. In the current economic climate, this is more important than ever.
Forecasting Your Startups Runway
When you’re confident your books are accurate, you can pull the numbers you need to re-run your financial models. Use these figures to get new revenue and churn predictions based on the current market, which then gives you a new projection for how much cash you’re likely to bring in. Finally, use that cash projection vs. your expected expenses to recalculate what your burn rate is likely to be for the next months or year.
It may be more difficult to fundraise during an economic downturn, you should generally ensure that your startup can remain solvent for the next 24 months without any additional infusion of capital.
Given the current uncertainty around inflation and the markets, you should consider running numbers for multiple scenarios. What might your numbers be in a month if the situation continues to deteriorate? What might they be if it stabilizes? This is where a sensitivity report for your current models is helpful. The company Pilot gives an example of a startup with $100,000 cash in the bank and $10,000 in monthly expenses, examining how its cash burn and runway change with different levels of revenue.
Doing this kind of analysis upfront helps you plan for situations that you may face, so you aren’t caught off-guard if the market continues to shift. Regardless of what the economy means for your original plans, you’ll be in a position to start making decisions about what your business needs now.
Why It Matters to Investors and a Startups Survival?
A low burn rate indicates the investors’ investment dollars will go further when a new business applies for startup capital. The chances of new businesses gaining traction and becoming profitable are higher with a low burn rate, thus yielding a higher return on investment.
Well-established businesses also rely on this metric. The lower the burn rate of your business, the more likely it will survive a low-revenue quarter. An indication of a healthy business is a low burn rate, which corresponds to a strong cash position. Despite being profitable on paper, a company can still fail due to a lack of cash. You can avoid this by having a low burn rate.
Coinbase lays off 18% of its workforce as executives prepare for a recession and ‘crypto winter’
CNBC just reported that crypto platform Coinbase CEO Brian Armstrong pointed to a possible recession, and a need to manage Coinbase’s burn rate and increase efficiency. He also said the company grew “too quickly” during a bull market. He told employees “We appear to be entering a recession after a 10+ year economic boom. A recession could lead to another crypto winter, and could last for an extended period,” Armstrong said, adding that past crypto winters have resulted in a significant decline in trading activity. “While it’s hard to predict the economy or the markets, we always plan for the worst so we can operate the business through any environment.”
If a company is experiencing a high burn rate, an investor may negotiate a clause in the financing agreement to reduce staff or compensation. It is common for large start-ups to lay off employees when they are trying to streamline their strategy or when they just signed a new financing deal. I have talked before about how clean books are crucial for making good business decisions (and we’re not just saying that because bookkeeping and accounting are our business). Your books are the ultimate source of truth for your company’s financial status – they tell you how much cash you have, what your assets and liabilities are, and where your company’s money is going. If you can’t trust the accuracy of your books, then you can’t be sure that your financial decisions are based on reality. Know where you are spending your money so you can manage costs, control your burn and look good to investors. Feel free to contact Huckabee CPA for a consultation about your startup’s specific situation.