When many businesses, particularly ones working in innovative fields, set themselves up, they are often expecting to make a loss until their product comes to market.
As a result of this, investors who specialise in funding startups cannot look necessarily at existing profit and loss statistics to get an accurate view of a company’s future and instead will turn to how effectively they are using that money.
In some cases, when a startup is making money but still had huge operating overheads, investors will consider the “net” burn rate, which is the amount of money a company is spending, minus the amount it has made.
What is critical to the success of a company is that your company is spending the right amount of money on the right areas. A huge burn rate, such as the obscene $6bn per year WeWork burned in 2018, can be a red flag for investors.
It suggests a company that is either expanding too quickly, spending money unnecessarily or a business that is unlikely to make any of its money back and leads to calls to cut spending to avoid bankruptcy.
On the other hand, spending too little can also be an issue for investors, and a burn rate that is too low suggests a company that is focused on subsistence rather than development and getting a product to market.
These are generalisations, but an investor often is working with large portfolios that cannot always be looked into in detail. But a simple, clear metric like burn rate can highlight immediate issues that they may look into.