Cash Burn Rate: The Basics
The startup and entrepreneurship game has undergone a lot of changes in the recent past. Earlier, having a free cash flow was the hallmark of a successful business. All businesses including startup businesses were valued on the basis of the profitability or the free cash flow which they generate.
To date, most startup valuation models suggest using a profitability metric such as profit before taxes and then assigning a multiple to it in order to derive a valuation. However, over the years this has changed.
New-age startup companies such as Facebook, Twitter, Airbnb, and Uber have negative cash flows. A lot of these companies have not seen any significant profitability. In fact, in most cases, these companies are losing money on a month on month basis. However, this loss of money is different from the loss which is realized during normal business transactions. This planned and controlled mechanism to strategically lose money is called a burn rate.
Over the years, the cash burn rate has become a very important metric in the startup ecosystem. In this article, we will explain some of the details related to the concept of the cash burn rate.
What is Cash Burn Rate?
Over the years, there has been a massive change in the collective wisdom of the entire startup community. Whereas earlier, the startup community was focused on “cash is king”, over the years, they have changed their belief to “growth at any cost”
Companies like Facebook and YouTube had a huge role to play in this attitude shift. Facebook and YouTube did not use their platform to generate money for a very long time. Over the years, these companies steadily lost money while focusing on the growth of their user base. It was only after these companies grew so large that they almost became monopolies in their own fields that these companies decided to monetize their platforms. Now, since users are hooked onto these services, companies can safely earn money from a larger base.
The cash burn rate is the result of a belief that gaining a strong and loyal user base is a bigger goal for a startup company as compared to the goal of short-term profitability.
For instance, if YouTube has started monetizing its videos before it became a behemoth, it would have left the door open for some of its competition. Till that point in time, the user base of YouTube was not so large. Hence, it was possible that a newer service could have provided competition to YouTube. By deliberately burning cash in a planned and strategic manner in the early years, YouTube virtually eliminated the competition and guaranteed itself a larger cash flow during the later years.
The cash burn rate is symbolic of a change in the investor mindset from short-term profitability to long-term market dominance and growth.
Types of Cash Burn Rate
Even though the name suggests cash burn rate, it is possible for some entrepreneurs to refer to accounting burn rate when they discuss the issue. As an investor, it is important to clarify the type of figure which is being quoted.
An accounting burn rate uses the accrual principle. This means that it uses techniques such as capitalization, depreciation, and amortization in order to spread out costs during different periods. On the other hand, the cash flow-based burn rate does not believe in these principles. It simply considers the amount of cash inflow and the amount of cash outflow. If the outflows are greater than the inflows, then the resultant figure is called the cash burn rate.
Within the cash flow-based burn rates also, there are two different types of burn rates.
- One of them is called a gross burn rate. This rate calculates the total amount of operating expenditures that lead to negative cash flows every month. This rate does not take into account any kind of cash flow.
- On the other hand, there is another metric called net burn rate which measures the difference between the cash inflow and cash outflow. When investors refer to the cash burn rate, in most cases, they are referring to the net cash burn rate.
A Higher Burn Rate Does Not Have a Negative Connotation
Most entrepreneurs and investors have been primed to view negative cash flow as a negative event. However, this does not need to be the case. Over the years, investors have evolved to realize that a higher burn rate need not necessarily mean that the firm is incurring losses. Instead, it could mean the opposite.
A lot of investors view a higher burn rate as a positive occurrence if it is also accompanied by a correspondingly large increase in the user base.
A higher burn rate could mean that the company is acquiring a lot of customers and hence needs to pay the costs associated with this acquisition upfront. It could also mean that over the years, a relationship can be developed with these consumers in order to obtain stable cash flow from such customers.
All said and done, a burn rate is common in a lot of internet-based businesses. Companies find it very difficult to stop the competition from entering the market. Hence, they try to use network externalities to their advantage by creating a very large user base.
An individual user of a social network does not have much choice when most of their friends are on a particular social network. Hence, cash burn has been strategically used by companies to develop a strong user base before trying to earn a profit.
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