Burn Rate and The Rocket Formula

No one really knows where the phrase “burn rate” comes from as it applies to companies. After doing some research, my best guess is that it comes from rocketry.

Rocket

In the late 1800s, the reclusive Russian scientist Konstantin Tsiolkovskiy began a complete study of jet propulsion. By 1896, he had discovered a deceptively simple equation now called the Rocket Formula.

screen-shot-2016-10-13-at-4-35-25-pm

His equation became the centerpiece of rocket science. It links together 3 concepts:

  • delta-v, or delta v, which is the predicted change in velocity of a rocket
  • ve, or effective exhaust velocity, which is the velocity of rocket’s exhaust propulsion
  • And the ratio m0 / mf, or the mass ratio, which is the ratio of the rocket’s mass with fuel (m0) to its mass without any fuel (mf)

In very simplified terms, the equation says a rocket’s “success” (delta v) relates to how effectively it “burns” its fuel (exhaust velocity) and how small its dead-weight is (the mass ratio).

You can see how this formula might apply to startups.

Burn rate is a hot topic once again (? pun intended). As the tech market slows down, the media, investors and companies are focusing on it more and more:

I have now lived through 2 big startup cycles. The dot-com era and the Great Recession. When we talked to investors in spring of 2015, they were disappointed we cared about profitability. They only wanted growth.

How things have changed! Valuation multiples dropped significantly at the beginning of the year. Unicorns like Zenefits and Lending Club have molted their horns. Lots of other companies are looking to manage burn for survival.

It isn’t all doom and gloom. For example, valuation multiples for Saas companies have already started to rebound.

SaasValuationRatios

This is all part of the normal startup cycle. The bull market for startups stumbled and we are now in a bit of correction.

Understanding burn rates becomes more important during market downturns. But smart entrepreneurs should understand burn rates whether the markets are up or down.

There isn’t much comprehensive or mathematical information on burn rates. We wanted to remedy that in two articles. This article is a basic primer. Our second article deals with advanced burn rate topics like burn rate optimization.

In this article, we will:

  • Distinguish gross burn rate vs net burn rate
  • Show you how to calculate gross and net burn
  • Define runway
  • Discuss the relationship between burn, investment, and runway
  • Explain why burn rates are expensive for companies
  • Provide you with an Excel model to forecast your burn

If you are just wanting our burn rate modeling spreadsheet, click here.

Gross Burn Rate vs Net Burn Rate

Burn rate refers is how fast a company is losing money. CFOs typically think about burn rate in monthly terms. People often shorten the phrase from “burn rate” to just “burn.” E.g., “our burn is $20K a month.”

There are really two important burn rates, gross burn rate and net burn rate.

How to Calculate Gross and Net Burn Rates

So exactly how would you calculate your burn? Let’s look at an example from Capshare. Here is a Quickbooks P&L from one of Capshare’s earlier months:

CapshareFinancials

The easiest way to find burn on the P&L is just to look at Net Income. Capshare’s Net Income in this month was -$38,164.65. So our burn rate for this month was about $38K.

What was Capshare’s gross burn?

To find gross burn we need to find a sum of all of Capshare’s expenses. That line is called Total Expense. So Capshare’s gross burn was $89,888.37. The difference between gross and net burn should be revenue. The revenue line item is called Total Income. It is $49,419.38.

If you subtract $89,888.37 from $49,419.38, you get $40,468.99. Why isn’t this number equal to the burn rate of $38,164.65?

The answer is that the P&L includes another source of income called Other Income of $2,304.34. If you add that Other Income to Revenue then subtract Total Expense, you get Net Burn.

Burn Rate and Runway

Burn rate is extremely important when a company has limited sources of funding to cover losses. If a company has a constant burn rate and a finite amount of cash, it will run out money.

In accounting terms, cash balance is a balance and burn rate is a flow. Burn decreases a company’s cash balance. This leads to a concept called “runway.”

Here’s the formula that relates burn and runway:

Runway = Cash Balance / Burn Rate

If a company has $500K in the bank and will burn $20K / month, it has a runway of 25 months ($500K / $20K = 25).

Some people will also use the term “zero cash date.”  Zero cash date is the date when you will run out of money assuming your current burn rate.  So the zero cash rate using the example above would be today’s date plus 25 months.

Burn rate often changes from month to month. So it is often difficult to know your runway with certainty. Because of this many CFOs simply estimate monthly burn. If they need more precision, they will build a more complex spreadsheet.

We have built a projections spreadsheet for you which you can download here.

Investors will often ask startup CFOs, “What is your runway?” Or they will say things like “this funding should give you at least a year or two of runway.”

Profitable companies don’t use the word “runway” because they don’t have burn rates. Technically, they have a negative burn rate which just means they are making profits. Not having burn also implies infinite runway.

Burn Rate and Investment

So what creates a runway for most private companies that are burning money? Investment!

Startups typically raise invested capital in a few ways:

  • By selling equity (or debt that converts to equity)
  • Through sweat equity (working for free gives you an almost infinite runway!)
  • By using “free” money–grants, etc.
  • By selling debt

Selling Equity

Selling equity involves raising money from people who become shareholders in your company. The most common ways include raising equity from friends and family, seed investors, angel investors, or venture capital firms.

Investors’ desires to buy equity in an unprofitable company depends on a variety of factors. But it is common for investors to want to invest in high-growth companies with the promise of future profits.

In practice, most startups sell equity in rounds. Investors evaluate how well companies use their runway from previous rounds of funding. If they like it, they will often invest more money in a new round.

Sweat Equity

Many startups use “sweat equity.” Sweat equity represents free work donated to the startup. Many founders contribute sweat equity especially in the early days of a company.

This approach has a lot of benefits. Sweat equity allows early workers to secure their equity through work not cash. This means the founders don’t have to dilute their equity by selling some to outside investors.

Many startups fund their growth with sweat equity until they can either raise money from investors or get to profitability.

“Free Money”

Using free money is always a great option. It will increase your runway at no cost. Unfortunately, as economists frequently remind us, there is no such thing as a free lunch.

The most common sources of free money come from government grants or winning business plan contests, etc. Finding this kind of funding requires work. So these sources aren’t really free. A lot of scrappy startups use grants as a way to get going.

Selling Debt

Selling debt involves raising money who buy debt in your company. This is often hard for early-stage startups. Debt investors want lower risk and early-stage startups are risky. Up to 75% fail. So most early-stage companies cannot raise traditional debt.

Why Burn Rate Is Expensive

Of the funding sources discussed above, the most common is selling equity to investors. Burning investors money may not psychologically feel “expensive” to you, and so you might think that burn isn’t expensive.

But it is! Every dollar you burn represents ownership in your company that you had to give up. Additionally, your reputation is at stake. If you waste investors money, don’t expect to raise a second round for your current company. And when you company folds, don’t expect to find too many investors lining up for your next venture either.

Here are some additional reasons why giving up equity in your company is expensive:

  • When your company sells, IPOs, or becomes profitable, you will have to split those proceeds with other equity holders. These can be BIG checks that you will give to other equity holders. That money could have gone to you if you sold less equity.
  • Equity holders often require significant legal protections that can limit what you can do in your business without their approval.
  • Equity holders often require a legal say in how you run your business. If you end up selling more than 50% of your business, the new equity holders (as a group) will gain control of your business
  • Structuring equity deals requires a lot of legal work and cost

Even if you fund burn in some other way, it will generally involve creating long-term obligations for you. So burning cash is expensive. This is one reason why companies think carefully before increasing their burn rate.

Why Would You Want to Burn?

So after all of this, why would you want to burn cash? Even the very word “burn” sounds bad.

The short answer is that creating a successful startup is hard. Most entrepreneurs can’t create an immediately profitable startup.

There is often a relationship between the type of startup you start and time-to-profitability. Services companies often get to profitability quickly. Product companies often take longer.

Biotech companies, for example, often have years of R&D before they have a commercial product. It just isn’t possible for companies like this generate profits early on.

So these companies will need to burn some money before they can achieve profitability.

Additionally, some companies choose to have a burn rate even when they may not need to because burning more cash can help accelerate a company’s growth. Cash is an accelerant, just like rocket fuel!

Sometimes high growth is a more important goal than profitability. Growing revenue rapidly can establish your company as the market leader, lead to greater profits, , and higher valuations.

There are good reasons to burn money.

A recent comparison of bootstrapped and venture-funded Saas companies supported this conclusion. The comparison showed:

“…[burning] money doesn’t buy better core metrics but it buys growth speed.”

So the decision about burn rates can also relate to your desired growth speed.

Like the Rocket Formula shows, if you burn more fuel, you can go faster. Many companies that want to grow fast are willing to burn quite a bit of money to achieve their goal.

In our next article, we’ll talk about burn rate optimization and how to model out your path to profitability. If you want to get a jumpstart on that conversation, download our financial projections model.

You can download our financial projection model here. This model will help you model out your project revenue, gross burn, and net burn.