Burn rate refers to the rate at which a company is giving out stock from its existing shares to employees as compensation. If a company burns through too much of its existing shares, it will be forced to issue new ones if it is going to offer them to employees, which means each existing share could be worth less and carry less voting power.
Defining Burn Rate
Burn rate, or run rate, generally refers to how fast a company is going through a limited resource. Sometimes the term is used to mean how fast an unprofitable startup is spending investor money.
In the context of employee stock and equity plans that give workers stock or stock options, the term refers to how fast the company is using another limited resource: stock. The simplest way to calculate burn rate for a given time period, usually a year, is to divide the number of shares given as compensation that year by the total number of shares outstanding.
For example, if a company has 1,000 shares of common stock outstanding and it gives out 100 in a year as employee compensation, its burn rate is 10 percent. In practice, financial experts may use more complicated formulas for burn rate, because so much equity compensation is given out in the form of stock options - which often aren't immediately available to use and which employees may never exercise - and restricted shares, which vest only after an employee has been at a company for a certain amount of time. That makes determining how many shares ultimately will be distributed to employees more uncertain than if an employer simply gives out ordinary shares of common stock.
Understanding Investor Dilution
A higher burn rate means it's more likely a company is going to have to issue more stock since it simply would run out of stock to distribute as employee incentives. When new stock is issued, each individual outstanding share potentially is worth less and brings less voting power. This process is known as dilution.
For example, if a company has 1,000 shares of common stock outstanding and one shareholder owns 250 of those shares, that shareholder generally has 25 percent of the votes in any shareholder decision. If the company then issues another 1,000 shares, that shareholder still holds 250, but the total amount of shares outstanding is now 2,000, meaning that shareholder owns only 12.5 percent of the company and votes.
Because of this dilution effect, shareholders often will vote against employee compensation plans with excessively high burn rates, since shareholder gains from the company in attracting quality workers by distributing stock can be outweighed by their losses from dilution.
