Starting Up: How Much Money Do I Need?

From smSmallBiz

IN 2001, WHEN Wade Tinney co-founded Large Animal Games, a New York online game developer, he and his partner Josh Welber had a woeful understanding of start-up costs. "We went into it pretty blindly," says Tinney of the business the two partners launched toward the end of the dot-com boom. Faced with a number of upfront expenses but knowing little about how much it all cost, Tinney says "we lived off credit cards and a bit of savings" and wound up about $15,000 in debt.

"We just knew that we wanted to make a living by creating games, and we knew there was a demand for that type of content," says Tinney. But that wasn't enough, he admits. While the venture is now thriving, "if I were starting a new business today, I would certainly do things differently."

It's well known that small businesses rarely make it past the two-year mark and even fewer survive more than four years. The lack of staying power, according to the U.S. Small Business Administration, is due in large part to businesses running out of money before they reach sustained profitability.

That's because starting and running a business, even for those lucky enough to be flush with cash, is often riddled with obstacles and unforeseen money drains. These not-at-all-pleasant surprises can quickly wipe out both business and personal savings, as well as cut into secondary priorities such as marketing and training employees. In short, not planning can leave you with a mountain of debt, or worse, bankrupt.

To insure against an untimely demise, figure out what you'll need and how much it's going to cost before you open your doors. Here's how to assess your business's start-up costs:

About Start-Up Costs

Start-up costs, which are essentially the expenses incurred getting a business off the ground, vary widely depending on what type of business or industry you're in. For example, says Joseph Anthony, a small-business tax professional in Portland, Ore., a service-based business may have to hire and train a large staff while a product-based business may need to spend a substantial sum on patents and trademarks.

Start-up costs are generally broken down into two categories: "pre-opening expenses," such as marketing, advertising and administrative costs, and "organizational expenses," like legal and accounting fees.

What Do You Need?

To figure out what to buy and how much to pay for it, look at what others in your industry are doing, suggests Anthony. Your direct competitors might want to keep mum, so "contact someone who does the business you do but in another market," he says. If your aspirations are high, consider checking out the balance sheet of a publicly traded company in your industry. An accountant well-versed in businesses like yours can be a good cost reference; so can trade publications and industry groups. The SBA offers counseling and assistance through a number of programs .

Calculate Costs

Once you've determined what products or services to buy, figure out whether you can afford it. Many entrepreneurs scrape together enough money to launch a business using a combination of personal savings, credit cards and contributions from friends or family. Try this start-up calculator to see if you've got enough cash to set up shop.

Going forward, you'll also need to come up with a pricing plan for the products or services you sell to customers. Not sure? Check out how much the competition charges, suggests Ross Marino, a financial planner at Raymond James in Wilmington, N.C. Then, do the math. You may be forced to cut corners or push off some purchases to be competitive. Once your prices are set, estimate how much you can expect to bring in as income, which will help you develop an operating budget, Marino says.

Build a Cushion

Most entrepreneurs run into problems by overestimating initial sales and underestimating expenses. Rusty Cagle, a financial planner in Greenville, S.C., warns entrepreneurs not to overlook the importance of setting aside enough operating capital as they're considering start-up costs. He suggests providing a cash-cushion or establishing lines of credit to help keep your business afloat for three to six months in case profits don't come readily or if outside economic shocks take their toll. Even in down times, "you have to pay vendors and you still have to pay employees," Cagle says.

Create a Budget

In the beginning, says Marino, it's less about showing off and more about "what'll it take to keep the doors open." He adds that "you'll [also] need to be able to invest back into the business." In your budget, separate costs that recur monthly, such as rent and wages, from one-time upfront costs, such as permits or the fee for creating a limited liability company. Also, be aware that some expenses — for instance, the price of raw materials — may be subject to price fluctuations. He suggests padding your budget by 10% to 20%. "There will be extra expenses that you didn't anticipate," says Marino. Plus, he adds, when problems arise and you need to take time to deal with them, you'll need to compensate for that time you're not producing.

Be sure to also include one-time expenditures such as continuing education courses or attendance at an important industry conference. "People are pretty good about meeting monthly expenses," says Elizabeth Potts Weinstein, a financial planner and small business attorney in San Jose, Calif. "But then a big once-a-year payment hits, and those are the expenses that will put people under water." Once you have a budget in place, she suggests revisiting it once a month. See if your estimates were on point and, if not, revise as needed.

Take Advantage of Tax Breaks

Uncle Sam provides a few tax benefits to offset the risk that newbie entrepreneurs take on. New businesses may elect to deduct up to $5,000 of start-up costs (defined by the IRS as expenses related to investigating or setting up a new business, such as a marketing analysis or advertisements for a grand opening) and $5,000 of organizational costs (more strictly, the direct cost of creating a corporation) in the first year of doing business. The deductions are reduced when start-up costs start to exceed $50,000, and disappear entirely when costs rise above $55,000. (Note: Sole proprietors receive no deduction for organizational expenses.)

Thomas R. Pope, an accounting professor at the University of Kentucky in Lexington, Ky., offers this example: If a business owner spent $32,000 on both start-up and organizational expenses, he or she could deduct up to $10,000. The amount remaining could then be amortized over a 15-year period. For more on this, see the Internal Revenue Service's Publication 535.

"Starting Up," a weekly column written by Diana Ransom for smSmallBiz.com, follows entrepreneurs through the early stages of launching a business. Write to her at dransom@smartmoney.com

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