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Startup Costs: How Much Cash Will You Need?
When starting a business, you must answer an important question: How much money do you need? Here's what you need to know about funding your startup.
Starting a business may be an exciting process, but it costs money. When determining business startup costs, it's important to be realistic. Things like office space, legal fees, payroll, business credit cards and other organizational expenses can really add up.
If you're thinking about launching a new business, you may not know where to start with your finances. Here's how to figure out how much you'll need to launch your business and the best ways to get funding.
1. Start small.
You most likely have high expectations for your company. However, blind optimism may cause you to invest too much money too quickly. At the very beginning, it's smart to keep an open mind and prepare for issues that may arise later.
Cynthia McCahon, founder and CEO of business plan software company Enloop, said business owners should start with a bit of healthy skepticism.
"A prospective business owner should start planning a small business by simply understanding the potential of the business idea," she said. "What this means is not assuming your idea will be successful."
The best approach is to test your idea in a small, inexpensive way that gives you a good indication of whether customers need your product and how much they're willing to pay for it, McCahon said. If the test seems successful, then you can start planning your business based on what you learned. [Read related article: Small Business Financing Options Without a Traditional Bank]
2. Estimate your costs.
According to the U.S. Small Business Administration, most microbusinesses cost around $3,000 to start, while most home-based franchises cost $2,000 to $5,000.
While every type of business has its own financing needs, experts have some tips to help you figure out how much cash you'll require. Serial entrepreneur Drew Gerber – who has started a technology company, a financial planning company and PR firm Wasabi Publicity – estimates that an entrepreneur will need six months' worth of fixed costs on hand at startup.
"Have a plan to cover your expenses in the first month," he said. "Identify your customers before you open the door so you can have a way to start covering those expenses."
When planning your costs, don't underestimate the expenses, and remember that they can rise as the business grows, Gerber said. It's easy to overlook costs when you're thinking about the big picture, but you should be more precise when planning for your fixed expenses, he added.
Indeed, underestimating costs can decimate your company, McCahon said.
"One of the main reasons most small businesses fail is that they simply run out of cash," she said. "Writing a business plan without basing your forecasts on reality often leads to an unfortunate, and often unnecessary, business failure. Without the benefit of experience or actual historical financials, it's easy to overestimate a new company's revenue and underestimate costs."
3. Understand what types of costs you'll have.
The SBA states that there are various types of expenses to consider when starting your business. You need to differentiate between these costs to properly manage your business's cash flow for the short and long term, said Eyal Shinar, CEO of cash flow management company Fundbox. Here are a few types of costs for new business owners to consider.
One-time vs. ongoing costs
One-time expenses will be relevant mostly in the startup process, such as the expenses for incorporating a company. If there's a month when you must make a one-time equipment purchase, your money going out will likely be greater than the money coming in, Shinar said. This means your cash flow will be disrupted that month, and you will need to make up for it the following month.
Ongoing costs, by contrast, are paid on a regular basis and include expenses such as utilities. These generally do not fluctuate as much from month to month.
Essential vs. optional costs
Essential costs are expenses that are absolutely necessary for the company's growth and development. Optional purchases should be made only if the budget allows.
"If you have an optional and nonurgent cost, it may be best to wait until you have enough cash reserves for that purchase," Shinar said.
Fixed vs. variable costs
Fixed expenses, such as rent, are consistent from month to month, whereas variable expenses depend on the direct sale of products or services. Shinar noted that fixed costs may eat up a high percentage of revenue in the early days, but as you scale up, their relative burden becomes negligible. [Read related article: Direct Costs vs. Indirect Costs]
Most common startup expenses
It's important to understand the different types of costs you'll have as a new business. Theoretically, it's good to take note of what costs are fixed, variable, essential or optional. But let's get concrete. Here's a short list of costs you'll likely have as a new business:
Web hosting and other website costs
Rental space for an office
Insurance, license or permit fees
Advertising or promotions
Business plan costs
Typical costs for startups
The following table estimates very basic fixed costs for a hypothetical startup company with five employees. Variable costs will depend on each business's situation and are not included in this table.
4. Project your cash flow.
Another important aspect of a startup's financial planning is to project the business's cash flow. Bill Brigham, director of the New York Small Business Development Center in Albany, advises new business owners to project their cash flows for at least the first three months of the business's life. He said to add up not only fixed costs but also the estimated costs of goods and best- and worst-case revenues.
"If you borrow money, make sure you know not only how much you borrowed but also the interest you owe," Brigham said. "Calculating these costs puts a floor on the revenues needed to keep the business viable and provides a good picture of the cash necessary to start it up."
This is an essential step in maintaining your business’s financial health. Without being realistic about your cash flow and debt, you won't be able to get your business off the ground, especially as other costs begin to build.
Gerber recommends starting a business without borrowing at all, if possible. Borrowing puts a lot of pressure on any business and its owners, he said, as it leaves less room for error. Do your best to explore all of your funding options. If borrowing is your only option, work closely with your lender to ensure your business is financially able to handle the commitment. Keep in mind that when it comes to small businesses, personal assets are also often on the line.
5. Figure out your financing methods.
Once you've determined your costs and projected your cash flow, you'll need to consider how to pursue financing. How you obtain funds will affect the future of your business for years to come. Personal savings, loans from family and friends, bank and government loans, and grants are just a few potential funding sources. Many companies use a combination of different sources.
According to Herndon Davis, mortgage loan officer and real estate agent at Mortgage Real Estate Services, most startups are self-funded. However, there are other options.
"Additional funding can come through establishing business credit and different lines of credit through piggybacking scenarios," Davis said. "There's also small business loans and angel investors willing to step in at certain stages. At this point, your startup should show established client/customers, growth since inception, a unique positioning in the marketplace, and a clear business plan on how to grow with the additional funding."
One place to go for help is SCORE. Formerly known as the Service Corps of Retired Executives, this volunteer organization partners with the SBA and offers training and workshops for small business owners and aspiring entrepreneurs. Most importantly, SCORE offers counseling from people who have been in the business you might want to be in and know the specific issues you're likely to encounter.