A company's burn rate describes how fast a venture is going through its funds, giving decision-makers and investors a better understanding of an organization’s fundraising needs. A high burn rate is usually a red flag, as those companies are often unable to sustain themselves for very long after financing rounds.
Out of all of the elements that compose a company’s burn rate, there are four primary factors to consider. An entrepreneur who can manage these factors effectively will significantly decrease the venture capital burn rate.
1. Customer acquisition costs
Operating costs have a significant impact on the success of a new venture, but many startups place too much emphasis on aspects like minimizing office space and labor expenses, and not enough on the costs that are really relevant.
For startups, some of the most important components of operating expenses are customer acquisition costs (CAC). CAC figures encompass all of the expenses associated with attracting, engaging, and retaining clientele, including:
- Advertising and marketing campaign costs
- Wages for sales and marketing staff
- Marketing and sales software, such as market analytic programs and e-commerce platforms
- Professional marketing and sales services, such as designing and consulting
The closer the CAC is to the ROI a customer provides, the less valuable each patron becomes. If the cost of acquiring new customers surpasses the customer rate of return, then the company will not survive.
Ultimately, it’s about more than simply lowering customer acquisition costs. Startups must work to make customer acquisition more efficient to maximize the funds that go toward this vital task. By eliminating waste and ineffective sales approaches, organizations can reduce and sharpen the sales cycle. This increases profits and slows the burn rate by replenishing spending with revenue. Those extra funds also allow companies to grow faster by increasing the amount allocated to CAC, creating a self-perpetuating cycle.
2. Investment in capital assets
Capital expenditures are necessary for any venture to acquire or upgrade assets such as buildings, vehicles, equipment, and other property that are essential to the operation of the organization. Other times, ventures use funds to increase production capacity, provide new products or services, or bolster supply in anticipation of increased demand. Those costs are unavoidable, and often less controllable than operating costs.
However, “less controllable” does not mean uncontrollable. While some of these expenses may be difficult to negotiate, decision makers can save a considerable amount of money by examining whether the expenditures need to happen in the first place. By analyzing the need for and benefits of the purchase or upgrade, companies may find ways to increase the performance of their existing assets, or discover lower-cost solutions.
3. Gross burn vs. net burn
When experts talk about burn rates, they're actually discussing two different numbers. The first is the gross burn rate, which is the total amount a company spends within a given time period. The second is the net burn rate, which subtracts collected revenues from the gross burn figure. This tells you how long a firm's capital will last. For example, if expenses equal US$100,000 per month and the company receives $50,000 in revenue each month, then the gross burn rate is $100,000 and the net burn rate is $50,000. With a million dollars in the bank, it will take 20 months for a firm to exhaust its capital with no revenue coming in.
While both of these figures are important for telling different sides of the story, comparing the two is particularly helpful for determining how vulnerable a company is to revenue fluctuations. Big differences between the gross and net burn rates can mean that an organization's current operational strategy is not sustainable. This is especially true for companies that find themselves with only a few customers who make up the bulk of their earnings, or for companies who rely on the business of startups and other less-than-stable organizations.
However, a high gross burn rate does not always mean trouble. If this spending relates to growth and development, the gross burn rate can actually signify a calculated risk strategy that can yield high returns if the company manages to increase the value of its products and services while also broadening its reach.
Companies that are fighting for customers will need to burn more capital to establish and expand their market share. However, businesses that can work within a specific niche will oust much of their competition, decreasing the rate of those expenditures.
The key is for companies to focus on areas of the industry in which they have a competitive advantage. For example, accounting software startups may decide to specialize in healthcare, construction, or government sectors. Customers in those industries will likely be more interested in working with businesses that have knowledge and insight into their particular trade, eliminating competing companies that can't offer the same expertise. In other cases, a company can focus on a single aspect of their offerings -such as price savings or an innovative approach to an age-old issue- to become the leaders of a completely new branch within their targeted market. Being choosy about verticals helps startup organizations penetrate the market easier and decreases marketing costs, leading to lower burn rates.