Question

Why is it important to calculate an accurate approximation of start-up costs and what are the downsides of presenting an inaccurate approximation to lenders or investors?

Answer 1

Estimating potential costs of starting and running a startup is one of the important requirements of having a sound financial plan. Correctly estimating the costs that may be required to start the new business helps in estimating the breakeven point, and thus the potential profits. You also get a good idea of the likely tax deductions that you can benefit from. Many entrepreneurs underestimate startup costs and thus their business plans are flawed, incorrect and lead to massive problems for the startup.

Startup costs can be divided into two categories :

1) One-time costs :

• Permits and licenses.
• Designing the website.
• Down payment on leased office space.
• Renovating the leased office space.

2) Recurring costs :

• Rent.
• Taxes.
• Paying salaries to employees.
• Availing and retaining the services of a lawyer (legal expenses).
• Insurance premiums.
• Marketing costs.

Many entrepreneurs start a business without carefully evaluating the potential expenses that may arise due to delayed cash flow generation, or due to some other external factor beyond the entrepreneur's control, they run out of cash much earlier than they had anticipated. Most investors and lenders are wary of investing or loaning to a startup that has displayed such a fatal error.

Downsides of presenting inaccurate data to investors or lenders :

• Presenting unreal valuation of your startup : Many entrepreneurs fail to secure funding or loan for their startup when they present an unrealistic expectation of what their new business is worth. Most investors are put off when an entrepreneur with no cash flow, and no realistic route to profit generation, asks for million dollar valuations for their startup that was started a few weeks ago.
• Presenting Unrealistic Projections : Many times, an entrepreneur will exaggerate the estimated future revenue of their business, when the past revenue doesn't support their claims. If entrepreneurs have flawed data that they have used to estimate their future growth, a business with minimal real revenue will be wrongly evaluated to be earning in millions in the near future.
• Decrease in company's market valuation : If an entrepreneur presents wrong, inaccurate or incomplete data in his presentation to an investor or lender, it causes an immediate down rating of the company's valuation, because no one wants to invest in a company that cannot even handle their data correctly.
• Loss of potentially valuable data : If the data is incomplete or inaccurate, potentially useful information about future opportunities may get lost. Additionally, an inaccurate data may hide problems that need prompt corrections, and this may cause a major financial or legal issue in the future.