SaaS finance is an overwhelming subject for many founders. Wouldn’t it be easier to think of exciting software, develop it, and live on without thinking about funding?
Unfortunately, this fantasy world doesn’t exist, and all owners face harsh financial realities. One way is to try and learn as much as possible. If you do, you might even start enjoying it.
In today’s article, we’re touching upon the concepts of burn rate and runway, discussing how they relate, and why they’re essential for a growing startup.
What is Burn Rate?
If you’ve read our previous article about the SaaS burn rate, you’ll already be familiar with the concept. However, let’s go through it again as a refresher.
Burn rate is the sum of all your expenses like the cost of goods sold, research and development, sales and marketing, and overhead costs. This is the amount you ‘lose’ if you don’t have any revenue. The term mostly refers to startups with an initial capital and without an income: these companies ‘burn through’ funding.
There are two types of burn rate. ‘Gross’ is the sum of all the expenses, and ‘net’ is total revenue minus gross burn rate.
Most often, software companies that are just starting to sell to customers might not cover their expenses. In this case, their net burn rate will be negative, and they’ll need additional funding. As sales pick up, the company will reach the break-even point. Eventually, it’ll begin to generate positive cash flow.
What Is Cash Runway?
Let’s discuss what will happen if it takes too long to make the product viable. After some time, the startup will run out of money. According to a CB Insights report, 29% of startups fail because of this exact reason.
Cash runway is the amount of time you can survive without revenue before the startup runs out of money. In other words, it’s the time left until the dreaded zero cash date. Here’s the formula for runway calculation:
Runway = Cash left / Burn rate
While the thought of facing the runway’s end unprepared can be scary, things won’t get too bleak if you start planning for the date early. In this case, you might even manage to postpone it.
Paying attention to the SaaS Runway can save you much future trouble. When you know the forecast, you’ll be able to think ahead and come up with solutions for many typical startup issues.
The essential knowledge you’ll gain is how long you have to achieve milestones, and when your next funding round should happen. While a lot depends on your industry and product, a standard time frame is fifteen to eighteen months. Usually, startups take about a year to fifteen months to achieve some key objectives, plus three to six months to find new ways to fund the business.
As you might’ve guessed, the runway isn’t a fixed number. If needed, you can optimize and stretch it.
How Burn Rate Correlates With Runway?
As we’ve established, your burn rate is the primary variable in the SaaS runway calculation equation. It directly impacts the timeframe your business will stay afloat. Changing its value changes the runway length.
Here is a scenario that’ll make all the concepts more clear.
Suppose you’re developing software, burning $10,000 a month (you work alone from home and don’t need office space). You managed to raise $200,000 via angel investors, but no revenue yet. Let’s calculate:
Runway = $200,000 / $10,000 = 20 months
You work for a month, then think of a new, revolutionary software feature that you can’t develop alone. Bringing in an R&D team and renting an office space for an additional $10,000 becomes a necessity.
You’ve already spent $10,000 out of the initial cash balance in the first month, and only $190,000 is in your account now. The new calculation will look like this:
Burn rate 1 = $10,000 + $10,000 = $20,000
Cash balance 1 = $190,000
Runway 1 = $190,000 / $20,000 = 9.5 months
You hire the developers. They take two months to develop the feature, and due to it, you manage to sell the product to 50 customers. As each customer pays you a $100 subscription, you get a $5,000 revenue monthly (for the sake of simplicity, let’s keep the payments monthly).
Burn rate 2 = $20,000 – $5,000 = $15,000 (net burn)
Two months passed: you have less money in the bank.
Cash balance 2 = $190,000 – $40,000 (spending for the two previous months) = $150,000
Runway 2 = $150,000 / $15,000 = 10 months
This example illustrates the connection between burn rate and runway and reaffirms how critical it is to keep an eye on these SaaS metrics.
Figuring out the best way to use money in a startup can be tricky, especially when you don’t know if the product is worth it. Optimizing spending, keeping an eye on your runway, and following other SaaS metrics can help you improve financial decision making.
It’s true; a competent SaaS CFO will masterfully minimize spending and have the money last for as long as possible. However, any startup founder needs to have the basics covered in all business areas.
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