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The concepts of cash burn and cash burn rate are relatively new to the investor as well as to the entrepreneur committee. Hence, even though investors have gradually started accepting cash burn to be a normal part of setting up certain types of businesses, they are not really aware of how it needs to be managed.
In this article, we will have a closer look at how the cash burn rate needs to be managed during the entire startup funding process.
Firstly, it is important to note why the cash burn rate is important. The cash burn rate is important because running out of funds is probably the number one reason why startups shut down. Since the cash burn rate is directly related to the availability of cash to the company, it becomes very important. Also, a high cash burn rate is required in order to get good funding.
Most investors typically disburse investment funds based on the burn rate of the firm. The logic is that if the burn rate of the firm is low, then they will not utilize the investor’s money. Instead, the money will be lying around in a bank account. Hence, startups are having a high burn rate since it allows them to grow faster and also obtain more funding as compared to their peers.
A strategic burn rate does mean that the firm will experience a negative cash flow. That is how the process has been designed. However, firms also experience negative cash flows when they use their funds in a wasteful and inefficient manner. Hence, it is important to know how to differentiate between the two cases.
Startup companies need to have a host of metrics in place which allow them to ensure that their higher burn rate is not because of inefficiency. They need to constantly benchmark themselves against businesses that have a similar operational structure. The concept of unit economics and cost of growth is also used in order to make this comparison.
These concepts have been explained in detail in a later article.
Different investors and entrepreneurs have different ideas about what an ideal burn rate is. However, almost everyone agrees on the fact that the solvency of the business should not be impacted by the cash burn rate.
Hence, another metric called the cash runway is calculated in order to quantify the amount of cash a company has in relation to its burn rate.
The total cash in hand that a company has is divided by the average burn rate of a company over the past six months or the projected future burn rate. This provides a time frame regarding when the company will run out of cash.
The normal advice given to entrepreneurs is to maintain six to twelve months of runway. This means that at any point in time, the company should have anywhere between six to twelve months of expenses on hand. As soon as the number goes below the threshold, they should start raising more funds.
Companies that have stable long-term investors who are likely to invest in the next round of funding can start the funding process a little later. However, other companies need to start early given the fact that a round of funding can take anywhere between six to twelve months.
Another important thing to note about the cash burn rate is that it can be downward sticky. This means that it is very difficult to reduce the cash burn rate without sending negative signals to the investing community. Hence, entrepreneurs must be careful when they raise their cash burn rate beyond a certain limit since it could be a semi-permanent decision.
Investors generally look down upon a reduced cash burn rate since it could be bearing bad news. For instance, a reduction in the burn rate could mean that the growth of the company is slowing down. This could mean that the market for the product has saturated or that competitors have entered the market.
Alternatively, this could also mean that the customers have lost interest in the product. Also, if the cash burn rate of the company is being reduced since it is doing cost-cutting that could also backfire. This is because employee-related costs account for the largest expenses of any startup company.
Hence, in order to reduce its cash burn rate, the company would have to lay off its employees. In the short run, this could mean that the company is able to save some cash. However, in the long run, the company may find it hard to attract the right talent. Here too, a declining burn rate could be a negative indicator for the company.
The bottom line is that managing the cash burn is a very complex task. There is a very fine line that separates throwing money away from strategically spending it. A lot of the time, this line is not clearly visible and the entrepreneur has to rely on intuition in order to make decisions.
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