This week we’re having tea with Scott Orn, COO at Kruze Consulting, a startup CFO consulting firm. Prior to joining Kruze, where he runs the Venture Debt consulting practice, Scott was a Partner at Lighthouse Capital and has been part of deals like Upwork, Impossible Foods, and Freshbooks.
Highlights from Series Tea with Scott Orn
This interview has been lightly edited for length and clarity.
What’s a good way to think about forecasting?
Many founders choose either an aggressive plan or a plan that is too small, which VCs don't want to fund. There's a careful balance. The best startups can usually do $1-20 million in three years. That's when you've got product-market fit and you're in revenue-execution mode.
I like to use three or four KPIs that will drive revenue and hiring plans. If you're a SaaS company, you can use the number of deals, average selling price, and churn. Consumer, it's the number of users and layering in the cost of advertising and fees that users pay. In the SaaS example, as you get that revenue plotted out, you can start thinking about the headcount you need to support that.
A financial model is a tool for you to talk through the vision of the company and its milestones. Investors are not so focused on the specific number. They want to get a general gist of where you're going. Experienced investors will use that to sanity-check your milestones and see how ambitious you are.
How important is it for that model to be exponential?
You've just got to be realistic. People glorify “up-and-to-the-right every month.” That should be the case but there's going to be some bumps.
If it's not generally up-and-to-the-right, something's wrong. You've got to either check your accounting or sanity-check what's going on with deals and if you are serving your customers correctly.
How many years out should the forecast be?
I typically like to do three years. Investors understand that you've got visibility for only a year to 18 months. But the three-year forecast is a way for them to sanity check where you're going.
You'll get some investors who want a five year. I would give that to them but caveat it and err more on the aggressive than conservative side. You could also use public company growth rates and layer those on your model.
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How often should you redo your forecast and budget?
For a baby startup, like a seed stage, once a year. As you're starting to progress, every six months.
How do you budget for the true cost of employees, taking benefits and taxes into consideration?
The big other things you have are employer taxes and health benefits. Everyone who gets a paycheck every two weeks says, “The government's taking a big portion of my paycheck out in taxes.” Well, guess what? Your employer is also paying taxes on top of that number. The government double dips.
The early-stage companies typically hire younger people. The benefit expenses are around $400-500 a month per employee. But as you start hiring older employees, healthcare premiums start going up. So you can see how as your company matures and you start hiring senior managers, directors, and VPs, your health benefit costs go up.
We recommend companies budget an extra 20-25% of the salary to include benefits and employer taxes.
How far out do you budget hiring costs?
It's good to do three years. Employee expenses tend to be about 50-75% of a startup's spend.
There’s another place where budgeting can be super helpful. Maybe the CTO is trying different software apps, or one of the engineers forgets something in AWS and leaves it on. If you don't catch that within a month or two, it can cost you a lot of money. Keep an eye on your web services.
Another thing is staff perks, including meals and entertainment. It's a great perk. But that's a bucket where you can start seeing dollars leak out if it's not monitored.
Should you revisit and double-check your budget every month?
Yeah. It's so easy to color code and see what's on-target, green, and what's off-target, red. The CEO might only need to spend 15 minutes on it.
So much of succeeding as a startup is building habits. The best startups send their investor updates out within the first 10 days. The companies that struggle are the ones that ignore these questions for three to four months. Getting in a good habit and doing it once a month will make your life so much easier. It comes to building confidence in investors and de-stressing your life.
If you miss paying taxes or declaring taxes to the IRS, how much penalty can you get hit by?
The IRS is good at figuring this stuff out. The good news is you're not going to get a crazy penalty if it's a de minimis amount. I see companies getting in trouble if they forget to do their Delaware franchise tax, which can make it so you forfeit your corporate entity.
If you're a nonprofitable startup, what taxes do you have to pay besides payroll and franchise taxes?
There are a few others. We have dedicated tax calendars with deadlines for all the startup hubs on our website. The big ones you need to worry about are 1099 notifications of what you paid your contractors, those are due January 31st.
The next one is your Delaware franchise tax, which depending on how much capital you've raised, can be as small as $250 or as big as $20,000. You need to file that every year by March 1st. The California franchise tax is due April 15th, and you’ll have to file that if you're operating in California and you're a foreign corporation. Again, they'll take it out of your account later and more if you don't.
Nowadays if you don't have offices, what's the definition of operating in California?
Great question. You establish nexus if you have employees, assets, property, or potentially a lot of revenue in that state. The moment you register, the state knows and is going to be looking for income tax filing.
When you do your federal taxes, you can attach an R&D tax credit to it. We did $8.5 million of R&D tax credits last year.
The one caveat to that is if a lot of employees are working in different states. In our team, we had people move to Wyoming, Virginia, New York, and Texas. All those states have lower payroll taxes than California. They all requested that we start listing them as working in that state. That triggered a bunch of state filings that we had to register.
You mentioned R&D tax credits. Can you quickly go over them?
The treasury and IRS said, "All these startups are spending money on R&D. We should let them use this against their payroll taxes." I think it's around 6% tax.
You can capture a credit on a percentage of your employee and contractor spend that are building true R&D. So it can't just be like a designer making something look prettier, it has to be true R&D. You typically want to allocate the exact projects by employee. But you can allocate 80-90% of someone's salary to R&D if they're a hardcore engineer.
So you can get up to 6% back on employees?
There's a cap of $250,000 on the R&D credit. I would recommend working with a CPA firm, whether it's us or not. The R&D tax credit is part of the tax return. We have gone through audits on the R&D tax credit. So just work with someone reputable.
How do I know if I have to file quarterly reports to IRS and pay taxes on them?
If you're profitable, you have to pay estimated taxes. There are not a ton of startups that are profitable. But if you are, then that is an issue. Your accountant should be giving you estimated tax projections.
Sometimes we have companies that swing into profit mid-year. We have a system internally to flag that and start doing the estimated payments.
So if you become profitable even for a quarter, you can't just wait till the end of the year to pay?
If you're only profitable for a quarter but lose money the rest of the year, then you're fine. As long as you lost more money over the rest of the year than that quarter. It's on an annual basis.
But if you swing into profit Q2, Q3, and Q4, you know you're going to be profitable for the whole year. So, you should make that payment now.
What is the tax rate for startups being profitable?
The federal is capped around 30%. The state tax is dependent on which state. California is around 12%. There are not many profitable companies so it's more about filing the tax returns. Some founders think that if they're not profitable, they don't have to file a tax return. You do have to file a tax return.
Companies that have a Delaware C Corp, but have foreign owners or owners with a subsidiary in another country, will trigger a 5471 or a 5472. If you fail to file those along with your tax return, then it's a $20,000 fine per form per year.
If you are bootstrapping, what's a good way to neatly manage your finances so that if you do raise the money, it's as easy as possible to work with an accountant?
The simplest way is to teach yourself QuickBooks. Import the bank transactions, allocate them as you should, and create a simple P&L. We also have a lot of founders coming to us where they download their bank statements every month in a CSV and figure out their burn rate. That's enough for them.
As long as you use QuickBooks and tag out each transaction, you can figure it out later?
Money can always solve those problems -- it's just to what degree. Sometimes people come to us with two years and it's horrible. They think we are enjoying all of this cleanup work but our team doesn't enjoy that.
If you do put some company assets into Bitcoin or other cryptos, how do you do the accounting for it?
We are not crazy about doing that. We will accept clients that have Bitcoin where it's just sitting in a savings account or not changing. Where you get in trouble is when you're trying to use Bitcoin, or some other crypto, to pay your employees. It's so volatile. The actual true amount on a dollar basis that you've paid someone takes a lot of figuring out.
I would say if it's your personal assets, do it, go crazy. But if it's your company, keep it in dollars and not worry about it.
If you're just holding Bitcoin, not using it for transactions, that's pretty simple for accounting?
It's probably okay but if we start seeing transactions in and out, that's where we get concerned about money laundering.
Is it really necessary to do an 83(b) election as the founder?
Yes, file the 83(b), do it within 30 days.
But if it's only if you have vested founder shares, right?
Yes, or if you're getting founder shares/restricted stock that you're going to invest over time -- you can lock in the price just then.
You need to send that to the IRS via certified mail and keep that certification. The IRS could lose stuff. You do not want to have an IPO, ten years from now, and find out the IRS lost your 83(b).
If a foreign founder is working from their home country, can they be an employee and do payroll through a US entity?
You have to use either a global PEO, which allows you to piggyback on an entity that's already been set up by this PEO entity, or create a subsidiary in another country. There are times where you see founders try to pay themselves as contractors, which the IRS frowns upon. They look and they say, "You own a lot of equity in this company, how could you be a contractor?" The IRS interprets that as trying to avoid payroll taxes.
I recommend the global PEO before you start setting up subsidiaries. The subsidiaries are expensive.
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