Assessing startup financial health is an important component of the due diligence process. An investor needs to fully understand a startup’s financial discipline in order to gauge its potential viability and longevity. But how can investors assess how a startup’s finances are doing? In this blog, learn more about assessing startup financial health and some key metrics to consider when conducting due diligence.

Assessing Startup Financial Health

When conducting due diligence, it can be a good idea for investors to understand or even calculate a startup’s burn rate and runway. The efficiency at which a startup operates with limited capital can help provide insights into how a startup will utilize proceeds from a funding round. Additionally, it can help investors understand a startup’s operational discipline and timeline to its next milestone or funding round.

Startup Burn Rate

A startup’s burn rate is the rate at which it spends its cash reserves over a specific period, typically monthly. It is the most direct measure of a startup’s negative cash flow. There are two types of burn rate that investors should consider:

Gross Burn Rate – This is the total amount of capital a company spends each month on all operational expenses, including salaries, rent, software, marketing, and research and development (R&D). Gross burn rate can be calculated by considering the startup’s total monthly operating costs.
Net Burn Rate – This is the amount of money a company loses each month, accounting for any revenue generate. It can provide a more accurate picture of financial pressure, but it truly only applicable once a startup begins generating revenue. It is calculated as: (Monthly revenue – Cost of Goods Sold) – Gross Burn Rate = Net Burn Rate

Example: A SaaS company has $50,000 in total monthly operating costs. It generates $20,000 in revenue a month in the form of monthly recurring revenue. Its Cost of Goods Sold is $5,000. To calculate its net burn rate:

($20,000 – $5,000) – $50,000 = -$35,000 → The startup is net burning $35,000 per month, despite generating revenue

Startup Runway

A startup’s runway is calculated from its burn rate. Runway represents the amount of time, typically in months, that a startup can continue operating at its current burn rate before it runs out of liquid cash reserves. It is a forward-looking metric that looks at the time a startup has before needing to ramp up revenue generation or secure its next round of funding.

The formula for runway is: Current Cash Balance / Monthly Net Burn Rate = Startup Runway (in months)

Example: Using the same SaaS company as above, let’s say the startup’s current cash balance is $420,000. To calculate its monthly runway:

$420,000 / $35,000 = 12 months runway

For this example, if the startup does not generate any additional revenue beyond the $20,000 a month it is currently doing, if management does not reduce burn rate, and it does not raise any additional capital, it could run out of cash at the end of 12 months.

Interpreting the Metrics

So, what is a good burn rate for a startup to have? Unfortunately, there is not a universal “good” burn rate. It is an inherently relative metric that is dependent on the company and industry. However as a general rule of thumb, a runway of 12-18 months is a relatively positive area for a startup to operate within. A runway below 12 months can indicate pressure to raise capital or generate additional revenue. A runway longer than 18 months might suggest excessive caution or even an inability to deploy capital efficiently to help accelerate growth.

Investors should consider evaluating a startup’s burn rate against the company’s stage and its growth trajectory. A high burn rate may be justifiable by rapid growth in customer acquisition and market share.

Identifying Pivots

When considering a startup’s burn rate and runway, investors should also consider how startups pivot in the face of extended burn rates and limited runway. The ability for founders to pull specific levers to help extend their runway can provide insights into how well the startup is able to pivot in the face of challenge.

Some of the levers founders are able to pull include:

Driving Revenue Growth – In what some consider to be the most effective method for extending runway, increasing top-line revenue can help directly improve net burn rate without needing cuts to operational costs.
Cutting Non-Essential Expenses – Another direct approach for reducing burn rate, cutting non-essential expenses may look like canceling certain subscription services for administrative tasks that can be done quickly and manually or decreasing marketing spend on channels that aren’t generating strong growth.
Improving Operational Efficiency – In what could be known as doing more with less, improving operational efficiency may look like automating processes, renegotiating vendor contracts, or optimizing customer acquisition costs.
Utilizing Alternative Financing – Another option for extending runway include securing additional funding to increase cash balance. If another funding round isn’t an option, a startup may pursue options like venture debt, lines of credit, or corporate credit cards in order to bridge gaps and extend runway without immediate equity dilution.

Final Thoughts

Assessing a startup’s financial health is an important skill for investors conducting due diligence. Metrics like burn rate and runway can provide insights into how the startup is currently doing. Additionally, seeing how a founder pivots in the face of extended burn rate or limited runway may indicate how the startup might pivot in the face of future challenges. Being able to calculate these metrics in addition to understanding how they impact startups can help investors conduct thorough due diligence.

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.

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