If you are a SaaS business, then you must read this article for the following reasons:
- Understand what is SaaS Burn Rate and why you must calculate this metric?
- How to calculate SaaS Burn Rate?
- How can your SaaS business improve this financial metric?
Gross and Net Burn Rate metrics are important for SaaS businesses. This is because the working capital requirements of SaaS businesses are higher and their payment terms are often back-end weighted.
SaaS businesses typically showcase significant positive Free Cash Flow (FCF) long before they turn GAAP Cash Flow positive. This means a SaaS business can turn its Burn Rate or negative cash flows into positive cash flows as it grows. Once this happens, it can start tracking FCF instead of operating cash flows.
Note that Free Cash Flows are the cash flows that a business generates through its normal operations before making interest payments but after deducting any capital expenditures. Whereas, operating cash flows refer to the cash flows that a business generates through its normal operations.
Thus, a SaaS company gets a good sense of the steady-state health of its business through tracking Committed Monthly Recurring Revenue (CMRR) and Burn Rate.
So let’s understand what is SaaS burn rate, how to calculate burn rate, and what are the ways in which a SaaS business can manage its burn rate.
What is SaaS Burn Rate?
SaaS Cash Burn Rate is the rate at which the cash pool of a SaaS business gets depleted in a loss-generating scenario. It is a key SaaS metric that every SaaS business must understand and know.
In other words, the cash burn rate of a SaaS business is the money it has set aside to ensure the business has adequate funding during lean times. It is the rate at which a SaaS company loses its cash reserves to fund its overhead expenses.
Now, there are two types of Cash Burn Rates: Net Cash Burn Rate and Gross Cash Burn Rate.
I. Net Cash Burn Rate
Net Burn Rate is also called Burn Rate. It indicates the speed at which a SaaS business loses cash out of its cash reserves to finance its overhead expenses. Net Burn Rate is simply all cash received during the month minus all the expenses, which nets out to the cash burned in the month.
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This means when the operating costs of a SaaS business are higher as compared to its total revenues, it has a positive Net Burn Rate. However, when a SaaS business earns profits and generates positive cash flows, it has a negative Net Burn Rate.
It is important for SaaS businesses, specifically startups, to calculate the net cash burn rate. This financial metric enables the CFO’s and top executives of the business to determine whether the company has the risk of running out of cash soon.
Note that SaaS businesses showcasing rapid growth rates have a higher chance of running out of cash. That’s because such businesses may be burning cash at a much higher speed than anticipated. Although, it may seem that such high-growth businesses are approaching profitability.
Thus, it is important for SaaS businesses to keep their Net Cash Burn Rate at a lower level for a fairly good period of time. A low Net Burn Rate may help the SaaS business to avoid bankruptcy or to find a challenge in attaining the next round of funds.
Net Cash Burn Rate formula
The following is the Net Cash Burn Rate formula that one can use to calculate the amount of cash lost:
Net cash Burn Rate = Operating Expenses – Gross Margin
Gross Margin = Revenue – Cost of Goods Sold
The burn rate of a SaaS business showcases how high the monthly negative cash flows of the business are. It indicates how much money per month the business would need at hand to survive without making money.
In other words, the SaaS burn rate indicates how much cash is the firm burning to generate each incremental dollar of ARR. As a result, the higher the SaaS burn rate, the more is the firm burning cash to achieve each unit of growth. On the contrary, the lower the SaaS burn rate, the more efficient the growth is.
Note that startups whose burn is too high as compared to their growth will find it challenging to raise funds. Therefore, it is important for SaaS businesses to think about achieving capital efficiency.
In the case of SaaS business, the following SaaS COGS would include:
- Application Hosting Costs
- Customer Onboarding Costs
- Customer Service Costs
- R&D Amortized Costs vs Capitalized Costs
- Third-Party Fees Such As Software License and Data Fee
Further, the revenue in the case of SaaS businesses can be tracked using Annual Recurring Revenue (ARR) and Monthly Recurring Revenue (MRR) metrics.
Finally, the operating expenses of a SaaS business may include:
- Sales and marketing expenses
- General and administrative expenses
- Customer support expenses
- Expenditure on IT operations
- R&D expenses
Net Burn Rate Example
Let’s consider Amazon Inc’s statement operations for the year 2019 to calculate its net burn rate.
|Particulars||Amount (in Million $)|
|Net product sales||160,408|
|Net service sales||120,114|
|Total net sales||280,522|
|Cost of sales||165,536|
|Technology and content||35,931|
|General and administrative||5,203|
|Other operating expenses (income), net||201|
|Total operating expenses||265,981|
|Other income (expense), net||203|
|Total non-operating income (expense)||(565)|
|Income before income taxes||13,976|
|Provision for income taxes||(2,374)|
|Equity-method investment activity, net of tax||(14)|
Using the following formula to calculate the net cash burn rate for Amazon:
Net cash Burn Rate = Operating Expenses – Gross Margin
Gross Margin = Revenue – Cost of Goods Sold
Gross Margin = 280,522 – 165,536 = $114,986
Net cash Burn Rate = 265,981 – 114,986 = $150,995
II. Gross Cash Burn Rate
Gross Cash Burn Rate refers to the total amount of cash that a SaaS business spends on its overhead expenses. In other words, it refers to the total cash that a SaaS business spends on its operations. That is the total cash outgoing in a given period.
Typically, a SaaS business calculates Gross Cash Burn Rate on a per-month basis. As mentioned above, a SaaS business may spend cash on the following operational expenses:
- Web development costs
- Cost for hosting service and providing support
- Costs of data center capacity
- Depreciation or operating lease expense associated with computer equipment
- Allocated overhead and amortization expense associated with capitalized software related to application service and acquired technology
- Rent and occupancy charges
- Salaries of employees including web developers
- Overheads, interest, and taxes.
Accordingly, the following is the Gross Cash Burn Rate formula to calculate the total amount of cash spent on operational expenses:
Gross Cash Burn Rate = COGS + Salaries and Overhead + Depreciation and Amortization + Other Operating Expenses + Interest and Taxes
This may include the cost of subscription and support revenues. Such costs may include expenses related to hosting service and providing support, or the costs of data center capacity. Further, it may also include depreciation or operating lease expense related to computer equipment, and costs associated with website development activities. Allocated overhead and amortization expense associated with capitalized software also forms a part of the COGS of a SaaS business.
The salaries may relate to the payroll and related expenses for employees involved in the research and development of new and existing products and services. It may also include salaries of employees responsible for the development, design, and maintenance of websites or applications, display of products and services made available in online stores, and infrastructure costs.
- Depreciation and Amortization
Infrastructure costs include costs of servers, networking equipment, and data center-related depreciation and amortization. It may also include rent, utilities, and other expenses necessary to support the SaaS business. Collectively, these costs reflect the investments a SaaS business makes in order to offer a wide variety of products and services to its customers.
What is a Good Burn Rate?
The question of how much a startup should burn becomes increasingly important when a SaaS business is in its later stages of growth. SaaS businesses are witnessing record-setting growth rates, all thanks to the easy and inexpensive access to venture capital funds.
Although SaaS businesses witnessing high growth rates are rewarded. But, now the focus has shifted from rewarding just high-growth firms to rewarding efficient growth firms. This is especially the case with the SaaS businesses seeking funds in the later stage of their business.
What does this mean for SaaS business owners? Well, the above scenario indicates that SaaS business owners must spend cash reserves cautiously. Though, every SaaS business is seeking to achieve high growth numbers as quickly as possible. But this does not mean that it should burn its cash reserves to achieve the desired growth.
To know what is the maximum amount of cash burn a SaaS business can undertake in order to sustain its business, it needs to adopt a top-down approach as suggested by Tomasz Tunguz.
As per this approach, a SaaS business needs to adjust forward revenue multiple. The forward revenue multiple is nothing but the value of the company calculated by multiplying some number multiplied by the sum of the next twelve months of revenue.
Multiple is a function of many factors. These include growth rate, market attractiveness, team qualification, margins, and other considerations. Today, public SaaS companies trade at about 13x median EV / Revenue multiple.
The below is a hypothetical SaaS business. This chart showcases the valuation of the startup right from the Seed Stage to Series A and then to Series B. Say, the SaaS business anticipated a forward revenue of $2M at Series A and a forward revenue of $5M at Series B.
Accordingly, there can be two scenarios.
The first scenario in blue showcases that the SaaS business raises funds at 15x median EV / Revenue multiple during Series A and Series B rounds of funding.
Then, the second scenario in green showcases the impact on the SaaS business valuation if the forward EV / Revenue multiple of 8x is achieved between Series A and Series B. That is half of what is achieved in scenario one.
In the blue scenario, the valuation of the SaaS business increases from $30M to $75M. As a result, the company raises about $15M – $20M in Series B.
However, in the case of the green scenario, the valuation of the SaaS business increases modestly from $30M to $40M. Accordingly, the company raises $10M.
The above numbers showcase that the value of the SaaS business after considering the new funds raised does not change despite a 150% growth in revenue.
Revenue Growth at Series B = [($5 Million – $2 Million)/$2 Million] x 100 = 150%
Revenue Multiple at Series B = EV/Revenue = $75 Million/$5 Million = 15
This is the outcome that SaaS business owners may not have expected.
The objective behind using this approach is to know:
- How much growth the SaaS business must achieve in order to raise funds at a higher valuation as compared to the last round in case the multiples are halved
- Whether the SaaS business has enough cash flows to fund its operations through to that period plus enough time for fundraising. Note that if the SaaS business does not have sufficient funds to finance its operations during this period, it is important for the business to reduce its cash burn or raise more money.
Though there are some caveats here to use this approach:
- The first is if the revenue multiple corrections will happen or not
- Next, it is not necessary that the multiples will fall and would reduce to half
- Third, forward multiples are more common in the Series B and later rounds, and less common in Series A and Seed. This means that early-stage SaaS companies may not have been priced or valued this way in the past. However, they may be valued in such a manner as the companies progress.
Thus, a SaaS business can perform a top-down analysis like the one above when determining how much cash the business should spend. This analysis will also help a SaaS business in ensuring that it is always in a position to raise capital at a more attractive valuation than the previous round.
Startup Burn Rate Calculator
Enter your firm’s cash balances from the past ‘n’ months to determine the burn rate and cash runaway. The number provided in the Startup Burn Rate Calculator below is the rate at which the cash is depleting in your business. The rate will be negative if you earn more money than you spend.
Click here to calculate the burn rate of your business.
How To Improve Burn Rate?
The following are the ways in which you can improve your cash burn rate:
I. Reduce Expenses
A SaaS business can consider removing or reducing expenses. The business must remove or reduce only those expenses post which its operations do not get impacted. Thus, a SaaS business can consider taking any of the following actions in order to reduce costs:
- Remove all unnecessary costs
- Hire staff on contractual basis
- Negotiate a rent deferred payment plan
- Start certain contracted services in-house
- Shut down loss-making segments of the business
A SaaS business can review its financial statements to understand what all expenses the business can cut or remove. Remember, there are a lot of expenses within the business that need to be cut down. If this is the case, then now is the right time.
II. Increase Cash Reserves
Note that cash reserves are extremely important for a SaaS business to remove smoothly without any interruption. The more cash a SaaS business has, the longer it can sail through the lean periods or periods when the sales are low.
However, there can be a scenario where it’s been long since a SaaS business is in a financial crisis. Further, the business owners know that the firm will soon run out of cash given the current level of cash reserves. In such a scenario, there is a need for the SaaS business to raise additional capital.
Note that traditional methods of raising funds like bank loans, overdrafts, and owner’s capital can help the business get access to cash for a certain period. However, sooner or later, the SaaS business has to identify alternative sources of cash.
The following are the ways in which a SaaS business can increase its cash balances:
- Liquidate any unused assets
- Reduce stock levels
- Clear out obsolete raw materials
- Crowdfund or seek external investors
- Explore Government subsidies or grants
In addition to the above, a SaaS business can also have a business savings plan or contingencies plan in place. Regular contribution towards savings or contingencies plan can help the business increase its cash balances.
III. Delay Payments
Another way through which a SaaS business can reduce its burn rate is by delaying its payments to a future date. Delaying payments does not mean that the SaaS business is not liable to make payments to the suppliers. It simply means that the business gets some additional time to make the payments to its suppliers.
For instance, a SaaS business can shift to interest-only loans. Further, the business can ask suppliers whether it can pay partial payments or make complete payments at a later date. In addition to this, a SaaS business can even contact the IRS and ask about deferring any tax payments.
IV. Identify Alternative Sources of Revenue
A SaaS business can also think about generating alternative sources of revenue to deal with the financial crisis. For instance, it can identify new customer segments or look for new geographic markets. Besides this, the SaaS business can even come up with additional services for its customers.
How Much Cash Should Your Startup Burn?
The venture capitalist Tomasz Tunguz uses a rule of thumb to calculate the burn rate of a Series A startup.
As per this rule of thumb, multiply the number of employees by the average salary of an employee in a specific location. Say, for instance, you can multiply the number of employees by $10-12k depending on the location of the company.
Once you calculate this number, you need to reason out in case the startup’s current burn rate substantially exceeds this heuristic.
Tomasz used a basket of about 60 publicly traded consumer and SaaS companies. He aggregated the net income patterns by years-since-founding of both the consumer and SaaS companies. Then, the venture capitalist eliminated outliers to just focus on the patterns of the “typical” public startup.
As you can see, the chart above showcased the median monthly net income by sector and years-since-founding. It is clear from the chart that a median public SaaS company burns $1M or less per month for the first 4 years. As the business scales or expands, this number increases to about $1.5M. At this point, the SaaS company goes public. Further, the burn rate falls again to sub-$1M per month after the company raises additional capital and is subject to additional scrutiny of public investors.
Also, the white lines in the chart above represent the median values. The edges of the boxes in the chart represent the 25% and 75% percentile values. Whereas, the extreme end of the whiskers indicates the 5% and 95% percentiles. The outliers are eliminated.
Since the benchmarks are set, now the venture capitalist calculates the “risky” burn rate. There is no definite answer for every SaaS company when it comes to revealing the risky burn rate and a conservative burn rate.
However, as per the venture capitalist, a SaaS business can always consider a host of factors in order to calculate the risk and conservative levels of burn rates.
These factors include:
- Ability of the SaaS team and business to raise capital
- How market responds to SaaS product’s positioning in the given market conditions
- Months-of-cash remaining relative to the timing of the next milestone
- Unit economics of the SaaS business