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The Logic of Burn Rate

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Entrepreneurs seeking capital might have been asked how much money they have spent in order to arrive at their current stage. The motivation of financiers by asking this question, is to arrive at an estimation of the ‘burn rate’. At Pro Business Plans, we have often found that this question chokes business owners up because they are not sure how to determine the amount of money invested so far. Questions arise such as, should we be inclined to determine a high number of a low number?

Understanding the logic behind the question and why it is asked can better prepare companies seeking capital to answer it more clearly. Companies should never seek to intentionally manipulate a response to an investor; the purpose of our post on the logic of burn rate is designed to help you determine a more accurate a clear response. The best approach for answering questions about burn rate is to be honest with investors and not attempt to direct responses around that you think they ‘want’ to hear, but illustrate a clear picture of the situation. The worst event that can occur is if investors realize that responses to their questions are intentionally misleading.

 

What exactly is meant by ‘Invested’?

 

Our team has discovered that many startup companies are afraid to ask questions for the fear of sounding incompetent in front of an investment team. While this fear is irrational, a software engineer is not expected to understand the lingo of a venture capitalist, it does exist. Therefore, we will attempt to deconstruct the logic behind the unclear terminology to help you provide a clearer picture of what is wanted. This term typically is independent from your time, donations, or fixed assets scrapped together from your personal life. While your time and personal assets do have value, they are looking for liquid investments that your team has purchased so far. Spending on external research & development, the purchase of new assets and lunches may all fall under this category.

 

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The motive behind asking about burn rate

 

There are two motives behind asking about the amount of money invested so far, but the specific motivation behind burn rate is to quantify the risk of the startup. If an investor places $10.0 in a new company that spends investment money with very little traction, they may be more inclined to seek an investment that has made great strides with very little capital. Quite simply, they want to see that companies are capable of effectively managing money and spending it frugally rather than frivolously. The other component for earlier stage companies is to potentially aid in determining the valuation. If your company has spent $20.0 M in fixed assets, a valuation of $40.0 M will only be 2x your fixed assets.

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