Businesses spend money before they ever open their doors. Start-up expenses are those expenses incurred before the business is running. Many people underestimate start-up costs and start their business in a haphazard, unplanned way. This can work… but is usually a harder way to do it. Customers are wary of brand new businesses with makeshift logistics.
Use a start-up worksheet to plan your initial financing. You’ll need this information to set up initial business balances and to estimate startup expenses. Don’t underestimate costs.
- Startup expenses. These are expenses that happen before the beginning of the plan, before the first month. For example, many new companies incur expenses for legal work, logo design, brochures, site selection and improvements, and other expenses.
- Start-up assets. Typical start-up assets are cash (the money in the bank when the company starts), and in many cases starting inventory. Other starting assets are both current and long-term, such as equipment, office furniture, machinery, etc.
- Start-up financing. This includes both capital investment and loans. The only investment amounts or loan amounts that belong in the Start-up table are those that happen before the beginning of the plan. Whatever happens during or after the first month should go instead into the Cash Flow table, which will automatically adjust the Balance Sheet.
Timing is everything
Some people are confused by the specific definition of start-up expenses, start-up assets, and start-up financing. They would prefer to have a broader, more generic definition that includes, say, expenses incurred during the first year, or the first few months, of the plan. Unfortunately this would also lead to double counting of expenses and non standard financial statements. All the expenses incurred during the first year have to appear in the Profit and Loss statement of the first year, and all expenses incurred before that have to appear as start-up expenses.
Don’t count expenses twice: they go in Start-up or Profit and Loss, but not both. The only difference is timing. Don’t buy assets twice: they go into the Start-up if you acquire them before the starting date. Otherwise, put them in the Profit and Loss.
Expenses vs. assets
Many people can be confused by the accounting distinction between expenses and assets. For example, they’d like to record research and development as assets instead of expenses, because those expenses create intellectual property. However, standard accounting and taxation law are both strict on the distinction:
- Expenses are deductible against income, so they reduce taxable income.
- Assets are not deductible against income.
What a company spends to acquire assets is not deductible against income. For example, money spent on inventory is not deductible as expense. Only when the inventory is sold, and therefore becomes cost of goods sold or cost of sales, does it reduce income.
Generally companies want to maximize deductions against income as expenses, not assets, because this minimizes the tax burden. With that in mind, seasoned business owners and accountants will always want to account for money spent on development as expenses, not assets. This is generally much better than accounting for this expenditure as buying assets, such as patents or product rights. Assets look better on the books than expenses, but there is rarely any clear and obvious correlation between money spent on research and development and market value of intellectual property. Companies that account for development as generating assets can often end up with vastly overstated assets, and questionable financials statements.
Another common misconception involves expensed equipment. The U.S. Internal Revenue Service allows a limited amount of office equipment purchases to be called expenses, not purchase of assets. You should check with your accountant to find out the current limits of this rule. As a result, expensed equipment is taking advantage of the allowance. After your company has used up the allowance, then additional purchases have to go into assets, not expenses. This treatment also indicates the general preference for expenses over assets, when you have a choice.
Why you don’t want to capitalize expenses
Sometimes people want to treat expenses as assets. Ironically, that’s usually a bad idea, for several reasons:
- Money spent buying assets isn’t tax deductible. Money spent on expenses is deductible.
- Capitalizing expenses creates the danger of overstating assets.
- If you capitalized the expense, it appears on your books as an asset. Having useless assets on the accounting books is not a good thing.
Types of start-up financing
- Investment is you or someone else puts in the company. It ends up as Paid-in Capital in the Balance Sheet. This is the classic concept of business investment, taking ownership in a company, risking money in the hope of gaining money later.
- Accounts payable are debts that will end up as Accounts Payable in the Balance Sheet. Generally this means credit-card debt. This number becomes the starting balance of your Balance Sheet.
- Current borrowing is standard debt, borrowing from banks, Small Business Administration, or other current borrowing.
- Other current liabilities are additional liabilities that don’t have interest charges. This is where you put loans from founders, family members, or friends. We aren’t recommending interest-free loans for financing, by the way, but when they happen, this is where they go.
- Long-term liabilities are long-term debt, long-term loans.
Expect a Loss at Start-up
The loss at start-up is very common…at this point in the life of the company, you’ve already incurred tax-deductible expenses, but you don’t have sales yet. So you have a loss. Don’t be surprised; it’s normal.
Cash Balance on Starting Date
Cash requirements is an estimate of how much money your start-up company needs to have in its checking account when it starts. In general, your Cash Balance on Starting Date is the money you raised as investments or loans minus the cash you spend on expenses and assets. As you build your plan, watch your cash flow projections. If your cash balance drops below zero then you need to increase your financing or reduce expenses. Many entrepreneurs decide they want to raise more cash than they need so they’ll have money left over for contingencies.
However, although that makes good sense when you can do it, it is hard to explain that to investors. The outside investors don’t want to give you more money than you need, for obvious reasons—its their money!