It may well take money to make money, but it requires intelligence and vigilance not to lose it. Too many entrepreneurial enterprises and crowdfunded projects suffer from the initial "high" of newly-found capital, and spend quickly and unwisely. Having a detailed budget at the outset -- a budget that incorporates your enterprise's "Burn Rate" of capital per month -- is essential to enable your business to survive and thrive.
As a word (in advance) of advice, establish a realistic application of proceeds and a month-to-month budget prior to seeking any infusion of capital. For the well-being of your company, strategic and tactical budgeting are disciplinary tools to keep your company in proper operating condition.
The burn rate is that amount of funds which your company must spend per month (i.e., necessary fixed costs, without any allowance made for revenues -- a "zero revenue" assumption) in order to continue its operations.
Be certain that while you are calculating your monthly burn rate that you do not include sunk costs relating to pet projects. Sunk costs are those costs which tend to relate to pet projects which are being treated as investments, but which are really cases of "throwing good money after bad". Don't make a provision for sunk costs -- simply identify them and stop incurring them by accepting (although this may be difficult emotionally) that they are merely an accumulation of waste -- stop feeding failed projects and cut your losses as early in your company's evolution as is possible.
After you've calculated your monthly capital burn rate, divide it into the amount of available capital (cash from investors, credit lines and from accumulated earnings) and the result produced will be the number of months that your company can sustain itself without generating any revenues. This computation yields your company's estimated lifespan if it were to generate no revenues.
Before commencing any negotiations for capital (through debt, equity, or otherwise), know your company's anticipated burn rate and multiply it by the number of months forecasted to be required prior to your company's initiating an adequate contribution margin (this latter number can be obtained by taking your company's price per unit sold, reducing that number by direct variable costs [such as direct labor and direct materials, as applicable] and multiplying that result by the number of units sold in a month) and you will have produced a conservative estimate of how much capital your company will require to sustain its existence until the contribution margin is fully adequate to cover the burn rate amount.
Some other important considerations and distinctions about your company's capital burn rate:
1) Gross burn rate is the total amount of money you are spending per month. Net burn rate is the amount of money you are losing per month. So if your costs are $500,000 per month and you have $350,000 per month in revenue then your net burn (500-350) is equal to $150,000. The reason that most investors quickly zero in on net burn is that if you have $3 million in your bank account and have a net burn of $150,000 per month you have more than 18 months of cash left provided your net burn stays constant. Conversely if you’re burning $600,000 per month (yes, some companies do) then you only have 5 months of cash left.
2) The answer is more complex than just Gross Burn Rate vs. Net Burn Rate. There may well be a trade-off between growth & profits.
Gross margin (GM) is the amount of profit you make per sale of your product or service taking into account your total costs of selling that product or service. If you have a very low gross margin (10-30%) it can be very hard to build a large, scalable business because you need to make a lot of sales to cover your operating costs.
Some industries work well with players who have low gross margins but these tend to be industries with very large, well established players and hard for new entrants to compete. In startup world low GM almost always equals death which is why many Internet retailers have failed or are failing (many operated at 35% gross margins).
Many software companies have > 80% gross margins which is why they are more valuable than say traditional retailers or consumer product companies. But software companies often take longer to scale top-line revenue than retailers so it takes a while to cover your nut. It’s why some journalists enthusiastically declare, “Company X is doing $20 million in revenue” (when said company might be just selling somebody else’s physical product) and think that is necessarily good while in fact that might be much worse than a company doing $5 million in sales (but who might be selling software whose sales are extremely profitable).
3) In doing your burn rate calculations, it may well be advisable to add a percentage-based "contingency" or "reserve" factor to the base burn rate. I typically take the burn rate as it is calculated, and multiply it by a factor of 1.10, which represents a contingency or reserve factor of 10%. While the burn rate will appear slightly higher, it is reasonable and responsible to provide for contingencies. If these surplus funds are not needed, they can be allowed to accumulate as cash or in some other liquid investment to be used when as and if necessary. I advise you to err on the side of caution.
Every fiscally responsible entrepreneur or executive should know his or her company's burn rate; further the burn rate should be recalculated every several months using a zero-based budgeting approach. This is because fixed cost structures and amounts expended per month do (despite their name) tend to change in a sort of stepped function at certain critical levels of revenue production.
Thank you, as always for reading me. Please visit our GEI website at the following address: http://GlobalEdgeInternational.com and visit our official blog as well at http://GlobalEdgeInternational.blogspot.com.
Douglas Castle
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