Truth 22. Calculating your initial start-up costs
The first step in determining how much money it will take to start a specific business and whether you’ll need to pursue outside financing is to determine your start-up costs. A business’s start-up costs refer to the total cash needed to get the business up and running. All businesses incur expenses before they make their first sale. A common mistake that business owners make is to underestimate their start-up costs and get caught short on cash before their business even opens.
A common mistake that business owners make is to underestimate their start-up costs and get caught short on cash before their business even opens.
How to calculate your start-up costs
Prepare a budget that lists all the costs that you’ll incur to launch your business. You need to consider four categories of costs.
Capital costs— This category includes real estate, buildings, equipment, vehicles, furniture, fixtures (shelves, wall brackets, cabinets), and similar capital purchases. These costs vary considerably depending on the business. A restaurant or retail store may have substantial initial capital costs, while a home-business may have little to no capital expenses.
“One-time” expenses— This category includes legal expenses, fees for businesses licenses and permits, deposits for utilities, Web site design, business logo design, and similar one-time expenses and fees. All businesses incur at least some of these expenses.
Provisions for initial operating losses— Many businesses require a ramp-up period in which they lose money until they are fully up to steam and reach profitability. For example, it usually takes a new fitness center several months to reach its membership goals. It’s important to have cash set aside to make it through this period. If you have a business plan, and the plan includes pro forma (or projected) financial statements, you should have an accurate estimate of your initial losses. If you don’t have a business plan, experts recommend that you set aside six months of your business’s estimated monthly operating expenses to see you through the ramp-up period. You’ll need to estimate your monthly operating expenses to arrive at this figure.
Provisions for living expenses— Experts also recommend that you set aside six months of living expenses for you and your family to see you through the ramp-up period. The need to do this depends on your individual situation. Some business owners have spouses who are working that can cover their living expenses. Other businesses start part-time, and the business owner keeps his or her full-time job until the business is cash-flow positive.
Don’t get caught unaware regarding start-up expenses. It is better to overestimate rather than underestimate the amount it will cost to launch your business, and adding a cushion is a good idea. Murphy’s Law is prevalent in the start-up world—things will go wrong. It is a rare start-up that doesn’t experience some unexpected expenses during the start-up phase.
Finding information on start-up costs
You need to estimate start-up costs as accurately as possible. There are several ways of finding the information you need, all of which involve a little legwork. You can estimate your expenses item by item by contacting the appropriate vendors, government agencies, and people who can provide informed estimates. For example, if you’re thinking about leasing space in a strip mall, you can usually obtain data on what strip mall space goes for from a local realtor or property manager. Another way to identify start-up costs is to talk to the owners of businesses that are similar to the one that you’re planning to start. You should try to find businesses that are outside your trade area so the owners don’t see you as a potential competitor. Many first-time business owners are surprised by how cooperative and helpful other business owners are. Another approach is to contact a trade association that represents businesses in the industry you’ll be entering. Many trade associations compile statistics on start-up costs. There are also online resources that help business owners connect with people who are eager to help. For example, Startup Nation (www.startupnation.com) is an online community that allows business owners to connect with one another and chat about start-up costs and other business-related topics.
Determining the financing that you’ll need
Once you know what your start-up costs will be, you’ll be in a position to determine the most appropriate way to finance your business. The five ways to finance a new business include (1) personal funds (including loans from friends and family and bootstrapping), (2) debt financing, (3) equity funding, (4) grants, and (5) other potential sources of financing. These sources are discussed in Truths 23 to 27.
Once you know what your start-up costs will be, you’ll be in a position to determine the most appropriate way to finance or fund your business.