It's (Not) Rocket Science: The Burn Rate In SaaS
“We are burning $30K per month,” or “we need to reduce our burn rate.” If you are interested in the startup scene, you have likely heard or read quite a few of those statements from CEOs or CFOs.
But what exactly is this “burn rate,” how do you calculate it, and why is it important for your SaaS business? What is the best way to manage a burn rate? Or should you avoid having one altogether?
Let’s break this down.
What Is a “Burn Rate”?
First off, what is this “burn rate” that everyone is talking about? The “burn rate,” or “burn” for short, indicates how much money a company is losing over a given period of time. For example, your SaaS startup could be losing, i.e. “burning,” $40,000 every month, or $480,000 per year.
The origins of the term “burn rate” are unclear, but the most likely contender is rocket science. Money is fuel for companies: It propels your startup forward on its path toward growth and profitability. If you use your fuel inefficiently or burn it too fast, you might not reach your goal or destination.
So how do you use your cash fuel wisely? In order to figure this out, we need to get a better understanding of how the burn rate is calculated.
Gross vs. Net Burn Rate
There are two types of burn rate?? Yes, but don’t worry, they are super easy to understand.
The gross burn rate is the total of a company’s expenses during a given period of time such as a month or a year. Everything you spend adds to your gross burn rate.
Net burn rate occurs when a company spends more than it earns. It is calculated as a company’s revenue minus its total expenses, i.e. its negative income. For example, your SaaS business might make $50,000 in revenue per month and spend $60,000, leaving you with a net burn rate of $10,000 per month.
This means that only companies that are losing money have a net burn rate, profitable businesses have, well, profits, i.e. positive income.
Typically, when people talk about “burn rates”, they refer to a company’s net burn rate.
How to Cover Your Losses
Help! So your company is bleeding money every month? No need to freak out, there is a way to make up for your losses: your cash balance.
A cash balance includes the funds a company has to cover losses; in other words, it denotes the company’s “savings.”
When a company’s cash balance runs out, it’s basically game over: You’re out of money to keep running your business.
And I Think It’s Gonna Be a Long, Long Time…
So how long can a SaaS rocket ship burn fuel till touchdown brings it around again to find that it is completely out of cash?
The amount of time you can keep burning money is called the runway. It indicates how long your cash balance will be able to cover your losses. This is how you calculate it:
Runway = Cash Balance / Burn Rate
Let’s look at an example: If your company has a cash balance of $1,000,000, and your monthly burn rate is $50,000, you have a runway of 20 months, so almost two years.
The date when you will finally run out of money, is called the zero cash date.
Burn Rates Are Not Constants, However; They Can Vary
Your burn rate can decrease: You might make more money this month than the month before, awarding you a higher revenue, or you might spend less and thus lower your expenses.
Along the same lines, your burn rate might also increase, if you make less money or spend more than you did before.
Since the burn rate varies, it can be hard to tell how long your runway is and when your zero cash date will be.
How to Extend Your Runway
So how can you make your runway longer? In other words: How can you buy your SaaS company more time to become profitable and get rid of its burn rate?
You need to increase your cash balance, i.e. you need to find money!
You can do this by increasing your revenue, of course. When this is not possible or sufficient, the most common option for startups, including SaaS businesses, is to sell equity for funding from investors such as business angels or VCs. This means that you give up part of the ownership in your company in exchange for an extension on your runway, i.e. more time to get your business to a point where it produces a positive income. By giving you funding, your investors are “betting” on your ability to yield future profits.
There Is No Such Thing as a Free Astronaut’s Meal
Burning investors’ money may not seem “expensive” for you at first glance, but it is. Why?
First of all, funding is usually granted in several “rounds”, spread out over time. If you don’t put your investors’ money to good use, you are very unlikely to receive a second round of funding.
Moreover, money received from investors represents ownership in your company that you had to give up. You want to give up as little equity as possible, though, because it will impact your paycheck in the future: If and when your company becomes profitable, the more equity you still have, the more money you earn.
This means that you want to have to rely on investors’ money as little as possible – so you need to make the time you need to become profitable as short as possible.
Why burn at All?
If burning investors’ money is expensive, why would you even want to deal with a burn rate in the first place? There are two main reasons:
1. Because sometimes it is the only option
Most SaaS startups are not immediately profitable; they require some time to get to a position where their revenue is higher than their expenses. This means that they need a sufficiently large cash balance to cover enough of a runway for them to reach positive income.
2. To accelerate growth
Sometimes high growth is a more important goal than profitability. This is especially true for the SaaS space. Growing revenue rapidly can help position your company as the market leader, yield greater profits, and lead to higher valuations.
Come On, Baby, Light My Fire…
At first glance, burning money may not seem like a great idea for any business, SaaS or otherwise. However, if managed well, it may be a very viable way for you to build a profitable company and ensure a paycheck for yourself and your team in the future.
Take the time to do the math properly and to get a thorough understanding of what a feasible burn rate might be for your startup. It may take a little while, but you can definitely wrap your head around it…it’s not rocket science, after all. 🙂