To determine the size of your financing round, not only do you have to consider the length of time for which you are raising capital, but to also figure out which costs you should and should not include.
In this article, and the corresponding video, we discuss how to properly calculate your funding needs and we specifically focus on those costs that startup founders often forget, which results in them running out of cash and scrambling for funds much earlier than they are ready to raise the next round.
Below are the five categories of costs that you must keep in mind:
If your company is pre-revenue, I do NOT recommend that you consider any revenues you project to generate because they would decrease your funding needs. It further follows that if you don’t include any revenues, you should ALSO not incorporate any costs that arise as a result of those revenues, or vary with the level of sales. Examples: the costs of raw materials, shipping, packaging, etc.
There is one exception to this rule: if your costs are greater than your revenues and you generate a gross loss, like may be in the case of a referral program. In this scenario, your projected revenues would result in a capital need, rather than a benefit, and therefore must be included as part of your funding calculations.
Further, you must account for those variable costs that vary based on the level of customers or users, rather than sales. Examples: customer service costs, AWS costs, etc.
These are the costs you incur to run your business day- to-day: salaries, rent, marketing expenses, legal and bookkeeping, admin, meals & entertainment, etc.
All of such costs do not vary with the level of revenues and thus must all be considered when determining the company’s funding needs.
Founders often neglect to account for the insurance costs, IT support, and business licenses as well as the costs to cover payroll taxes, healthcare and retirement benefits for the employees.
Working capital, often overlooked by startup founders
As we discussed in our blog, “What is Working Capital and Why Does it Matter?”, working capital arises in the following three situations:
- Accounts Receivable: a company extends credit to its customers. We do not recommend that you consider them unless the revenues that generate the Accounts Receivable also generate a gross loss, as discussed above.
- Inventory: a company has to manufacture a product first before being able to sell it. Inventory must be included in funding needs.
- Accounts Payable: a company gets credit from vendors and suppliers. We recommend that you don’t consider them, to be conservative, since Accounts Payable reduce your capital needs.
Fixed assets, often overlooked by startup founders
Fixed assets, or all capital expenditures, must be included in the company’s funding needs. They are typically small for software startups and quite significant for product startups. Examples: computers, furniture, lab equipment, manufacturing equipment, etc.
Contingency, often overlooked by startup founders
The contingency funds are your safety cushion and are typically calculated as 10-20% of the sum of the costs detailed above, to allow for reasonable budget overruns.
To learn more about the accounting concepts we have mentioned here, take Course # 1 on Financial Accounting and Analysis for Early-Stage Startups.
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