In a recent Wall Street Journal article, the venture funding “party” has stalled due to several economic factors ranging from rising interest rates to rapidly growing inflation. As a result, many significantly funded startups with historically high valuations are not meeting growth targets. Additionally, they are experiencing unanticipated rising costs. Suddenly, it’s time for startups to embrace frugality and focus on breaking even, the gist of founders quoted in the article.
A startup should always exercise financial discipline, a practice beginning from the earliest stage of development. As I work on this startup finance series, it is clear how vital financial discipline is for the founders to embrace early. In this post, I will focus on pre-launch startup costs and spending in general. There is much to learn by focusing on one’s early spending and cost forecasts.
For a new venture, we break up the essential cost elements into startup costs, costs of goods sold, product development costs, customer acquisition costs, and other general administrative expenses required to operate the venture. Several cost estimates can be straightforward, such as specific startup or fixed administrative costs that you can quickly look up purchase details. For example, if you need a computer for your business, you can decide which one you need and research the best price to either buy or lease it. However, some of the costs, especially variable expenses such as costs of goods sold and customer acquisition costs, are more challenging to estimate. This post will focus on startup costs incurred before opening for business.
Startup costs are expenses incurred before you officially launch your business for revenue generation. In my experience, most founders underestimate the potential resources required to build a business plan and prepare for subsequent market entry. Every company will have its own unique set of requirements to prepare for market entry. Ventures that require physical assets such as brick and mortar locations, large starting inventories, or extensive research and development activities will face significant resource needs and associated expenditures. Other ventures can navigate the pre-launch phase with minimal costs. In either case, planning for financial needs pre-launch facilitates a vital leadership discipline that serves founders well throughout the journey.
As you prepare to brainstorm all potential startup costs, you should consider categorizing them in various ways. First, you should remember that some costs count as “expenses” and others as “assets” acquired before the business opens. Additionally, you want to separately record startup assets (required to launch) and expenses for accounting purposes.
There are implications for taxes and potentially ownership equity discussions. For example, expenses may be tax-deductible in the current year, while the purchase of assets may be accounted for differently. So it is worth planning for and properly documenting these different transactions. The IRS guides founders on how to account for startup costs. Founders should make these decisions with advice from a certified public accountant.
It is also vital to divide into one-time charges versus recurring expenses. Thinking about startup expenses helps founders plan for immediate versus longer-term cash needs. As part of your early financial planning, you will also consider how much cash is required as you open for business.
You can start this process by brainstorming all the items you will need before being able to implement your business model. Let’s begin with startup assets.
The costs of startup assets are commonly tangible items acquired before launching your venture. Before launching your venture, the amount you should spend depends on the business itself. In some cases, there is a need for extensive capital expenditures, usually associated with either physical assets or product development.
You can subdivide startup assets into these categories:
- Physical assets that pertain to land, buildings, leasehold improvements required to ready business space before launch, office furniture, store fixtures & signage.
- Tangible assets pertain to manufacturing, such as the plant, machinery, and other equipment necessary for production.
- Inventory-related assets, including starting product items and raw materials.
- Essential vehicles such as trucks and automobiles
- Office equipment and computers
- Intellectual property acquired before launch.
Founders can delay the purchase of certain physical assets while they perform product and market tests. For example, I have worked with food and beverage startups that aspire to open a brick-and-mortar establishments. While I encourage them to work on plans in terms of location and space design, the critical path task items are getting the product in the hands of the customers for taste testing, packaging reviews, pricing sensitivities, and distribution channel selection. These early activities can be done via pop-ups in existing establishments, from small grocery stores to campus building lobbies.
One of my student founders recently wanted to establish a unique space for tutoring and learning. In the early stages, the founder focused on the location and the type of space aligned with the proposed strategic mission. The founder could find a place to host a test learning environment for a nominal fee by brainstorming options. However, the projected capital requirements to meet the long-term vision were relatively high, and it was essential first to establish the validity of the product offering with minimal expenses. In this case, the costs of running the pilot are considered deductible expenses and not assets. If renovation of a new location is eventually required, the founder can amortize much of the costs.
Inventory requirements can be another critical challenge for founders. Estimating how much inventory you will need depends on several complex factors to project without historical data. Depending on the product category, it can be challenging to secure initial stock for marketplace entry. For example, physical technology products are typically expensive, from design effort through producing prototypes to actual manufacturing for inventory. Each element is costly.
Working with a team who envisioned an innovative countertop composting product, early development started with simple drawings and 3D renderings to illustrate the design and look of the product. This effort was followed by laying out the product’s technical specifications to their ability. With technical specs in hand, the next step is to approach manufacturing partners to validate design feasibility and provide estimated production costs. Once the founders validate that the design is workable and production costs are within required margins, they can explore funding options like crowdfunding, corporate partnerships, and government funding pending the product to cover initial capital expenditures. Unfortunately, most startups never make it through all these phases before pivoting in another direction.
Consumer retail products are another category that typically requires inventory before the venture starts to generate revenues. Like other physical categories, consumer products need to go through design – prototype – ready-to-sell phases, from fashion to food. Founders start with increasingly detailed designs for fashion items, usually culminating in tech packs. Tech packs are documents that contain detailed visual design sketches, bill of materials required, and measurement specifications. With this information, founders, designers, and manufacturers can work together to create a cost sheet that includes materials and labor costs. This information will be the foundation of the startups’ costs of goods sold estimates. The costs of making the tech pack depend on who is driving the product design. I have worked with founders who designed their products and others who hired outside designers to create the final designs. Designers work in different ways, with some charging per hour while others are charging a flat fee for a specific style. As a result, the cost can vary depending on the complexity of the design. From design to ready-to-sell inventory can be a costly proposition. Many consumer-driven products navigate some costs by applying a pre-selling model, whether via eCommerce sites or crowdfunding campaigns. These methods help to offset the initial pre-launch inventory costs.
You should be diligent about documenting any expenses related to starting inventory. Some elements of the early product preparation may be deductible as a startup expense as part of the current IRS cap of $5000. However, early inventory stock should be considered an asset, a balance sheet item. Once you start to sell products, the costs of producing the product will count as a cost of goods expense.
For startup assets, you should work with your accountant to decide which costs can be deductible in the current year under the $5000 cap and which may be amortized over a specific period. In the latter case, you will deduct a particular amount of depreciation expense during each year of the amortization period.
You can break pre-startup expenses into the following areas:
- Research and development costs
- Fees such as installation fees, deposits, licenses, permits, legal fees, professional fees, insurance, office supplies
- Pre-launch marketing materials, logo, brochures, website, and other promotional materials
- Pre-operational training or labor costs
- Additional miscellaneous costs specific to the nature of the business
Research and Development
This expense area that can be challenging for startups is the capital requirements for product development. For certain ventures, building early versions of the product require extensive research and development. I cannot tell you how many times founders despair over forecasted costs for creating new technology. Sometimes, especially when the hardware is involved, finding a way to navigate the development costs can be tricky. However, whether it be software or hardware, it behooves the founding team to plan development in cost-effective steps. Each step focuses on increasing the fidelity of the product so you can build support for future innovation.
Typically R & D startup expenses may include:
- Hardware and supplies to build your prototype.
- Costs of leasing computers used for R&D activities.
- Fees to third-party contractors to support early product development.
Founders working in specific technological areas may be eligible for a US Research & Experimentation Tax Credit that allows you to deduct these expenses up to $250,000 if your startup qualifies.
I find it interesting the percentage of founders who try to avoid spending funds on legal fees. Of course, frugal behavior is essential at the early stage of development at some level. However, specific legal services are crucial to the startup’s long-term viability.
There are three categories of legal services and associated expenses that founders should consider before launching – incorporation, founder agreements, and intellectual property protections. From experience, founders can find lawyers that offer a basic startup legal package that includes filings for incorporation, basic founder agreements, and confidentiality agreements that apply in various business relationships. Founders can procure these essential services around USD 5K, not including local and state fees.
You will spend more if you plan to apply for a patent or register a trademark for intellectual property protection beyond basic confidentiality agreements. I have worked with many startups that have applied for a provisional patent or trademark registration. Provisional patents help founders create a short-term placeholder for their intellectual property, providing an inexpensive and relatively quick way to establish first-to-file status. While it allows for relatively no protection, it gives you time to complete the more detailed non-provisional patent application. Trademark applications protect your venture’s brand. Once you have decided on a company name and associated brand elements, it is worth doing due diligence early to ensure that the name is not already protected. Provisional patents and trademark registration are two startup expenses well worth the investment.
Marketing & Branding
There is plenty of opportunities to spend on marketing and branding development during a startup’s pre-launch period. Fees range from paying designers and brand consultants as founders find their way to unique brand identity. You may pay for the initial website design, marketing collateral materials, and associated printing costs. Some founders are responsible for creating their early brand identity, while others find it worthwhile to solicit professional advice. Some startups find a balance between the two approaches to keeping these essential costs down to a minimum. I have had several students use designer marketplaces and crowdsourcing platforms to develop their branding elements to great success. Additionally, founders have plenty of template-driven sources to support website design and marketing materials.
Founders should set aside funds for experimenting with different promotional channels starting early in the venture development process. As I have mentioned in an earlier post, customer discovery and MVP iterations are an optimal time to test and measure various marketing channels. Even small amounts such as USD 100 can provide insights into the effectiveness of a specific channel, such as Google or Facebook ads, for future customer acquisition strategies.
Customer acquisition costs are one of the most critical cost areas for new ventures. Typically, the marketing costs for a startup are one of the highest expenses, along with product development and human resources. One calculates Customer acquisition costs by determining all sales and marketing costs of acquiring a single average customer. Early experimentation and testing can ensure that founders spend these funds wisely.
Many startups have zealous, passionate founders who don’t mind delaying compensating themselves until the enterprise is up and running. However, there are many situations when external experience and skillsets are needed and compensation required. In many cases, additional expertise is necessary for product development. Depending on the product category, you may need designers or software engineers. As mentioned earlier, I always push entrepreneurs to actively participate in the early design and testing of their MVP as their skill allows. At some point, you may need technical expertise beyond the team’s capabilities. You have options to hire them as an early employee or as an independent contractor. In either case, these labor costs are inevitable.
There are times when founders may need specific education or training before operations. These are typically one-time costs but are essential to running the business. For example, a couple of years ago, a founder required certification to become a drone operator pilot for the future aerial photography business. Funds were needed for both training and licensing. Most pre-launch training costs qualify as startup expenses. Generally, there are many potential opportunities for founders to attend trade shows and industry conferences in pursuit of validating the feasibility of their venture opportunity.
You will be surprised how your technology needs can quickly add up. Of course, many of your technology needs will be recurring expenses. But I find that the pre-launch phase is where you tend to test various technologies to see what works for you and your team. These technologies can include platforms that support everything from project management to tracking early customer relations.
The good news is that many of these technologies provide either free options with limited features or trial periods to experiment with everything the service offers. While time-consuming (and you need some discipline), taking advantage of these trial versions allow you to learn what will work best for you and your team. I constantly test out new products for my venture or support student founders.
Start by focusing on critical performance areas and outcomes that require technical support. I suggest that you always review technology use from both an internal and an external perspective. Does a particular technology help the team to manage product development more efficiently? However, does the technology also provide proper customer engagement and communication support? Most times, technologies will have internal and external-facing interfaces, so stay focused on both. I tend to emphasize the external over the internal interfaces. If you support the customer in the best way by using a specific technology, I may overlook if the internal design is less effective and clunky.
Eventually, you will find the right mix of technologies to support your business. As you start using these technologies more comprehensively, you will incur a growing annual expense. Many of today’s products and services have recurring revenue models, and these monthly costs add up. My current technology stack costs around $2500 per year.
For many new ventures, the startup expenses can be minimal but are usually more than you at first consider. Therefore, it is worthwhile to speak with other startup founders to check some of their upfront expenses to understand better what to expect.
Generally, I find some expenses to have well-defined, published costs. This situation is accurate for many technology platforms, government licenses & fees, and office supplies. But in many cases, founders need to investigate thoroughly as costs for specific services may be less confident such as labor costs, professional services, and real estate prices. Here it is crucial to research similar items and services online and speak directly to vendors and service providers to assess the actual costs.
As I have said in other writings, it is essential to institute a financial discipline during the early stages of venture development. It is a balancing act between minimizing your expenses as best you can while not taking advantage of meaningful opportunities that may make a difference in your eventual success. No matter how much effort you place in these estimates, you will want to set aside some additional funds for the unexpected.
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