How Much Does It Cost To Start A Business

The Cost of Starting a Business And Hofstadter's Law

Before getting into the details of how much it costs to start a business, I want to bring your attention to Hofstadter's Law. Hofstadter's Law states: "It always takes longer [and costs more] than you expect, even when you take into account Hofstadter's Law." From my experience, understanding how much it costs to start a business is crucial, and Hofstadter's Law is absolutely true.

 As a business owner, if you come up short of the amount of cash it takes to start, the consequences can be very painful. This is why it is so important not to engage in wishful thinking (believing your own BS) and always deal in facts!  

Major Component of Startup Costs

There are two major components to business startup costs. The first is your initial startup costs, which include everything required to start the business but not your ongoing operating expenses. These could include the first and last months' rent on a building or office space, a damage deposit if you're renting space, down payments on equipment, and leasehold improvements such as signage.

The second component is working capital, which covers any gap between your sales revenue and operating expenses—often referred to as your "burn rate." This gap will exist until the company reaches its breakeven point, where revenue consistently matches or exceeds expenses.

However, if your business will offer credit to customers, there is a third component to consider: the collection period. This is the time between making a sale and receiving payment. For example, if you offer "net 30" terms, you may need to wait at least 30 days for payments. During this time, you'll need additional working capital to cover your expenses until you receive customer payments.

TIP: When planning your cash flow, it's wise to assume that customers may take longer than the stated credit terms to pay.

As a startup, if your expenses are higher than your revenue, it's essential to plan for additional working capital to cover this shortfall.

You will need much less working capital if you do not need to offer credit terms and get paid when a sale is made. If you start a business selling products on a platform like Amazon, you will need to figure in a short delay in getting paid because platforms like Amazon pay once or twice per month.        

Build Pro Forma Statements to Project Startup Costs

To determine your working capital requirements, you must build a pro forma income statement and a pro forma cash flow statement. Pro forma means projected or what you think is going to happen. 

Start with a 3 to 5 year pro forma income statement and cash flow statement, and build your first-year projections on a monthly basis for 12 months. 

Your pro forma income statement starts with your sales revenue projects. Then, subtract your direct costs of producing the product or service, giving you your "gross profit." Then, you subtract your administrative cost from your gross profit to determine your "net profit." Your administrated expenses include everything you spend to keep the doors open and marketing costs such as wages, rent, and office expenses. See Chart A below.

Please note: I do not include "non-cash" expenses in the administrative costs because this exercise aims to come up with your startup cost. A discussion of non-cash expenses is beyond the scope of this article. Accounting for non-cash expenses is not necessary to determine your startup cost.

Please Note: Administrative Expenses do not include interest expense. In the case where you secure a line of credit, you would have to include interest expense in your monthly expenses.

Regarding your cash flow statement, there are many different ways to approach building one. The one I suggest is simple to use. It is designed to show you how much working capital you will need, taking into account your burn rate. 

Here is what I suggest. You start with your "Beginning cash." This is the amount of money you start with. If it is zero, it is zero. Then, below this number, you put in your revenue collected. Next is your Direct Expenses. Below are your total administrative cash expenses. Finally, add your beginning cash and collected revenue and subtract your direct expenses and Administrative expenses to arrive at your ending cash. Your ending cash for any given month becomes your next month's beginning cash. (This is not as complicated as it sounds.)   See Chart B below. 

Once you have completed your cash flow, looking at your Ending Cash, you will see which month you have the highest shortfall. This number represents the minimum amount of cash you will need to get started to cover your cash flow. See Chart B below. 

Please note: Hofstadter's Law. When coming up with the final amount you think you will need to cover your working capital requirements, add a comfortable cushion to ensure you do not run out of cash before you reach breakeven and profitability. 

If you are using an Excel spreadsheet to build our pro forma income statement and cash flow, you can pull numbers from your pro forma income statement to build your cash flow simultaneously. You can also use accounting software if you have access to it. 

Final Calculation to Determine Cash Required

Finally, you add your startup cost and working capital requirements to determine what it will cost to start your business. 

I cover this entire process in detail in my course How to Start And Finance a Business Even if You Don't Have Any Money. Check it out.

Conclusion

The key takeaway for aspiring entrepreneurs is that once you have arrived at what your business startup will cost, you can begin figuring out how to stack your financing sources.  For example, depending on the business you are starting, you might secure a Small Business Administration guaranteed bank small business loan, credit cards credit, or other types of startup business loans.  For a detailed description of how to stack funding sources check out my FREE Special Report on how to Stack funding sources.  Check it out Here.