Whether you’re totally bootstrapping your new venture or seeking a business loan or investment funding, starting a business requires that you include a reasonable projection of your startup costs.
Potential investors will scrutinize those cost figures carefully, looking to see how they match up with the general funding market for your type of business and how well you’ve thought out your business plan. Having a thorough assessment of your startup costs can help get your funding request into an investor’s “approved file” a lot faster, says Ken Segal, managing director of BRG Capstone, a subsidiary of Berkeley Research Group, a business advisory firm headquartered in Emeryville, California.
“There are different methodologies to calculate your expenses,” says Segal, whose firm consults with many business owners seeking early-stage funding. “But I think the key is to have something thoughtful and dependable to get a potential investor to move (your proposal) from the left side of the desk to the right.”
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Find the ballpark number
To arrive at a number that an investor will find credible, you’ll need to take marketplace averages into consideration, says Jonathan Sposato, CEO of PicMonkey, a Seattle-based company that created a photo-editing application for the Web. Sposato is a serial entrepreneur who sold 2 of his startups to Google, and he’s an angel investor in other technology companies.
Most of the seed-round funding requests Sposato deals with fall into the $1.2 million to $1.5 million range. That amount can usually sustain a tech startup team of 3 to 6 people for about 9 to 12 months, he says.
At the lower end of the scale, Kim Tavares, CEO of PacWest Accounting in Newport Beach, California, has seen many home-based sole proprietorships launch for as little as $3,000. With a clientele that includes a large number of entrepreneurs, Tavares says her average client spends between $3,000 and $5,000 to start a business.
Factor in your business structure
The legal and organizational structure of your company can have a big impact on its startup costs. This is where legal fees and the cost of hiring, training and paying employees — if you intend to have them — come into play. Determining the legal identity of a business is step 1 for Tavares’ CPA firm when consulting with business startup clients.
“The first thing we typically do is go through their business plan with them to see if we can figure out what legal structure is the best for them,” Tavares says.
You may not need to hire a lawyer to help set up your business if you’re doing a sole proprietorship. But you’ll probably need that expertise if you’re forming a partnership, a limited liability company, a C corporation or an S corporation.
In the tech arena, for example, Sposato says he’s seen legal fees range from $15,000 to $35,000, depending on such variables as the company’s legal structure and whether the owners have intellectual property to protect through patents.
Costs of human resources
If you hire people to work for your business, your additional expenses will include not only their salaries, but also things like recruitment costs, payroll taxes and training.
Speaking of salaries, don’t forget to take into account paying yourself as the business owner, says Candace Klein, chief strategy officer for Dealstruck, an online lending platform.
Lenders expect entrepreneurs to include their own salaries in the profit and loss statements they present as part of their loan application packages, or else the documents won’t be seen as realistic financial assessments.
“If you’re not paying yourself, that’s a red flag that the company is not going to survive because you’re not going to be able to pay your own bills,” says Klein, who is the founder and former CEO of 2 startups.
Add up operational costs
Besides legal fees and salaries, there is a long list of other costs that may be associated with running a small business, including insurance, business licenses, inventory, office furniture and equipment, office rent, and marketing.
Depending on the type of business you have, you may need insurance coverage of general liability, property, commercial automobiles, workers’ compensation or professional liability (sometimes called errors and omissions insurance).
If you are making a product, you may want to have a robust research-and-development budget to get you through the design and testing phases, Tavares notes.
Klein offers this money-saving tip for entrepreneurs whose businesses are based on product sales: “When you’re buying inventory, purchase the smallest amount you can possibly survive on for your first quarter so that you can understand how quickly that inventory sells before you make any large purchases,” she says.
Don’t go overboard with business loans
Thorough cost projections are key to creating a viable business plan and making sure you have adequate funds on hand to get your startup through its first few years. But especially when it comes to taking out a loan or acquiring outside investment, there’s a risk of being overfunded.
An outsized business loan could saddle you with unmanageable repayment bills. That’s why Klein says her lending company requires businesses to have been operating and generating income for at least 12 months before they are eligible for a loan.
“We always try to discourage small-business owners from taking on debt before they’ve been through 4 seasons of bootstrapping with their own equity,” Klein says.
For those raising investment capital, Sposato says one of the potential downsides of too much funding is that business owners may overspend because the abundance of cash on hand makes them underestimate their financial risk. On top of that, he says, the more people who have a financial stake in your business, the more opinions you have to listen to about how to run it.
It’s better that “you don’t raise an egregious amount and you learn to be really frugal,” Sposato advises. “You learn to be very clever about revenue efficiency. Better yet, you learn to get to revenue-neutral or revenue-positive faster. That’s how you create long-term value.”