How it works (Example):
Let's assume newly formed Biotech Company ABC has just been granted venture capital (VC) funds to pursue a groundbreaking new drug. The VC firm gives ABC a certain number of years to reach breakeven or even become profitable.
If Biotech Company ABC is spending $100,000 per month beyond what they are bringing in, they have a burn rate of $100,000 per month or $1.2 million ($100,000 x 12 months) per year. The VC firm knows that it will need to provide enough cash to cover that shortfall each period.
Why it Matters:
Investors look at the burn rate versus expected future revenues of a company to decide if it's worthwhile to invest in the firm. If the company's burn rate exceeds forecasts or if its revenues are not growing at a reasonable pace, it may be too risky to invest in the company. A company may reduce its burn rate by becoming more operationally efficient.