Nearly all startup founders will have a sleepless night occasionally. The reasons might seem varied: it could be bugs in the product one night, hiring challenges or sales stresses the next. But most of these sleepless nights come back to one common problem – running out of cash. Cash flow management could be responsible for more than 80% of business failures.
In a tighter economic climate, founders hear much more about cash conservation and less about ‘growth at all costs’. In particular, two terms have featured in more news articles and LinkedIn posts: burn rate and runway. So why do burn rate and runway matter to growing companies?
Just as a plane has a certain amount of tarmac before it has to take off or abort the flight, a business owner can calculate how many more months of operation they can afford to fund, based on their current expenses.
Those operating expenses are quantified as your burn rate: how much cash you spend on average in a given time period (e.g. per month). Assuming your income stays the same, increasing your burn rate (i.e. spending more every month) shortens your runway. Decreasing your burn rate lengthens your runway.
Runway and burn rate are important metrics when the economy is good. But in difficult times, it’s even more critical to be on top of these measurements.
Of course, with stronger financials, the more cards you hold in conversations with investors. Alternatively, if fundraising isn’t an option, you need to know that the cash you have on hand can see you through until the storm has passed and the economic climate changes again.
Here’s how to look ahead at your runway, how to calculate burn rate, and key considerations for leaders right now.
How to calculate runway and burn rate
To calculate how much longer your cash will last (i.e. your runway), you need to know how much cash you’re spending every month (your burn rate).
There are different types of burn rate to consider. Depending on your circumstances, you’ll either want to use gross burn rate, which only factors in expenses, or net burn rate, which factors in your income as well as expenses.
If you’re an early-stage startup with no revenue or income, or with revenue that fluctuates significantly, it could be more meaningful to use your gross burn rate as the default metric. However, if you have a predictable amount of cash coming in, including through fundraising and loans, it may make more sense to track your net burn rate rather than your gross rate.
To calculate gross burn rate, add up all your monthly expenses. (Hint: You can track this data on your Ledgy dashboard.)
To calculate net burn rate, choose a specific time frame and subtract your end cash balance from your starting cash balance, then divide by the number of months. Let’s look at a simple burn rate example.
Starting cash balance from June 1, 2020: £500,000
End cash balance from April 1, 2021: £300,000
(£500,000 - £300,000) ÷ 10 months = £20,000 monthly net burn rate
Once you know your company’s burn rate, you can calculate how many more months your cash will last if you continue to spend money at the same rate.
If your burn rate is £20,000 and you have £220,000 in cash:
£220,000 ÷ £20,000 = your runway is 11 months
Why runway matters
Obviously, it’s important to know your cash flow position. You need to know how much you’re spending every month, and how long you can sustain those expenses with your current revenue and taking into account forecasted revenue growth.
Your calculations might change a little depending on whether or not you’ve sought external funding. Many startups backed by venture capital (VC) have expenses that are higher than their revenue. They need VC fundraising to give them the runway to continue growing and developing their product. are not typically as concerned with building out a long runway as a bootstrapped business funding on their own. Since bootstrapped businesses rely on their profits to cover their expenses, and usually aim for positive cash flow on an annual basis, they have to closely monitor their burn rate to ensure a long runway.
In contrast, startups expect to have high burn rates in their early stages, when they’re investing heavily in hiring, research, development, and marketing. Many VC-backed startups have negative cash flow, where their annual expenditure is greater than their annual income. If you plan on a high cash burn rate, the only way to build out your runway is by bringing in more money. If these startups are making little to no revenue, they boost their cash reserves through fundraising.
When the economy is good, investors are more willing to take calculated risks on new companies, including those with shorter runways. But in lean times, when investors are spending less overall, they’re more interested in the startups with strong underlying financials. Runway is one measure of this sustainability and resilience.
In more bullish economic environments, investors might see runways between 12 to 18 months as reasonably solid. (In this context it’s not unusual for startups that are actively fundraising to have runways under six months.) However, the dynamics can shift in a less bullish economic environment.
Given that fundraising is predicted to get harder over the next couple of years, some top investors now recommend that startups build out a runway of 18 to 24 months. Some are even pushing for 36 months.
In other words, startups should make sure they have enough current cash – or expectations of future cash generation – to cover their expenses for two or three years, given the uncertain fundraising environment that could still lie ahead.
That aim is certainly ambitious for lots of companies, but unfortunately, no one knows for certain how long the predicted recession will actually last. The Bank of England predicts it will last five quarters, or 15 months. Across the Atlantic, the average recession in the US lasts 17 months.
So even though the downturn might not last three years, raising funds can take many months even in good times. Startups with higher burn rates may face additional funding challenges in a bearish economic climate. For some companies, this might mean difficult choices in the months ahead, such as whether to optimize for lengthening runway or continuing to spend in pursuit of growth.
Runway is calculated on the assumption that your burn rate is at least somewhat predictable. However, burn rate can shoot up unexpectedly, and revenue can dip just as suddenly, both of which shorten your runway. Scenarios that might cause either of these include:
- More competitors: Your relatively quiet market has been invaded by competitors. Your marketing budget increases rapidly as you compete to be heard over the noise, raising your monthly burn rate.
- Big churns: Your largest account hasn’t renewed their contract: suddenly, your runway calculation has lost a significant chunk on the income side.
- Legal costs: Unexpected legal or administrative issues are a drain on financial resources, increasing your burn rate.
- Market expansion: Unlike the other examples, this is an event companies plan ahead of time. Expanding into a new market comes with an expensive price tag that will be reflected in your burn rate calculation, but it can also generate more revenue. As long as your revenue increase outpaces your growing burn rate, a new market can ultimately lengthen your runway.
How to strategically manage your runway
Runway is a big picture calculation. It doesn’t need to be something you obsess over on a daily basis. However, in a tough economy, runway becomes increasingly relevant to startups and investors. You don’t need to think about it every day, but there are ways to incorporate runway into your planning.
Determine accountability for decision-making
As with every big financial strategy, decisions on managing runway will most likely be made based on insights from the CFO in partnership with the CEO.
It may be that cash flow isn’t a concern, either because you already have a long enough runway, or because you’re confident that you can raise more income if necessary.
If runway is a concern, the next decision is whether you try to extend it by lowering burn rate or by increasing funding. The answer to that depends on many factors, including your business model, how easily you can raise equity or debt funding, and opportunities for growth.
Set your transparency level
Investors aren’t the only ones who get jittery in a recession. Reading about economic uncertainty worries your employees too. Being transparent about how much runway the company has can help relieve some of that anxiety.
Consider how transparent you need to be at board level, at leadership level, and with the company as a whole. A monthly update on your burn rate and net cash position is advisable for investors and the leadership team. Quarterly company updates can also engage and motivate team members: total radio silence may only make people feel excluded from important decision-making.
Slow the burn
The most appropriate method for slowing burn rate varies by company. Crunchbase recommends slowing down on what are often two of a company’s biggest expenditures: hiring and real estate (most commonly office space).
But there’s no one silver bullet for slowing burn and increasing cash runway. It will depend on your market position, strategic plan, and much more besides. That’s why it’s important for the CFO and CEO to look at the numbers and treat this as a strategic question. (We hosted a CFO event with Sequoia Capital this summer covering how the CFO and CEO can partner in difficult economic moments. You can find the full write-up here.)
The bottom line
Although there are general guidelines around how much runway startup companies should have, it’s not the only measure of how your business is doing. Nor is runway and burn rate the only predictor of how you'll grow and prosper in the months and years ahead. You understand your strategy and your financial plan better than anyone else.
A slow economy can raise the pressure on founders to make sure your runway can see you through stormy weather. But your runway and your burn rate needn’t keep you up at night. Treat them as another set of tools that can help you make better informed strategic decisions.
To learn more about planning for your company’s financial future, read more articles from Ledgy.
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