By Karen Firestone
Starting a new business involves a host of challenges, and chief among them is knowing what to spend your money on—and how much to spend. You have to consider salaries, marketing budget, office size, technology services, and on and on.
These spending choices require tradeoffs, so entrepreneurs must first develop a strategy for allocating limited resources across a wide range of available options. Too often, assumptions about the potential market and its clients can cloud our judgement about expenses. Let’s examine two cases, one a former colleague and the other a close friend.
The first is Colin. After managing a sleeve of a successful hedge fund in London for five years, and building ample savings, Colin was ready for his own shop. From past experience, he believed that attracting wealthy clients required high-end office space; so he leased space in a West End office building at a price that would rattle anyone’s teeth.
Colin was sure his revenues would exceed costs within a year, but the large clients he expected never materialized. In fact, he began to notice that prospects would react negatively to the extravagance of his office, décor, and furnishings. So not only were the current fees too weak to support his fixed costs, but future clients were turned off by his apparently excessive tastes.
To address those cost overruns, Colin subleased some space, cancelled a redundant and very expensive trading service, and let one person go. Two years later, his fortune began to turn around as stronger performance helped bring in business, and he finally showed a profit. Looking back, Colin knew that his overspending had nearly cost the firm its life.
Let’s look at another example: Serena had completed her master’s degree in political science at Berkeley, but decided to pursue a longstanding interest in cuisine by turning a vacant storefront in her Oakland neighborhood into a gastro-pub. While her waitressing job in college was Serena’s only eatery experience, she had plenty of enthusiasm and enough savings to start.
The costs soon proved much greater than expected. She hired a consultant and a contractor, who found structural obstacles that were expensive to address. She replaced the first builder, but the second insisted on making even more renovations. And although her dream gas-fired brick oven was far outside her price range, she bought it anyway.
By the time she opened Candlebar, it was 100% over budget. Serena had run through all her money, and resorted to borrowing from several friends. But she convinced herself, each step of the way up, that the expenses were worthwhile and would eventually pay off. Unfortunately, she failed to break even during the first year, and lost her head chef in a struggle over the menu and staffing.
Hoping to bring in a partner with both cash and expertise, she met with potential investors and business partners, mostly chef/owners of small pubs or cafes. These experienced restauranteurs valued Candlebar well below what Serena had invested. When she expressed surprise, they told her that her place was beautiful and very functional, but her price was far beyond what they would pay: code for “you overspent for the location and construction.” Eventually, Serena had no choice but to sell the business, taking a major loss but learning a lifelong lesson.
These cases show the consequences of overspending. But of course, it’s not always easy to know where to draw the line; underspending can also hurt your new business. A dinghy office without sufficient staff can give the appearance of not having enough business or being cheap. Each cost item comes with expected returns—for example, adding staff means a higher payroll, but also clearer lines of responsibility and a lowered chance of burnout.
Both Colin and Serena should have more carefully and conservatively forecast the timeline for expected revenues and managed their costs accordingly. This would have helped them avoid a cash crunch. They were both naïve to think that creating a high-expense, polished operation would automatically enhance their business. In reality, it only added to the breakeven level, which can kill a new enterprise’s chance of survival.
Let’s look at one last example, this time of two associates of mine, who started with a sensible spending strategy. Jerome and Evan decided to leave their top tier accounting firm and set out on their own. They were realistic about their expenses and budgeted carefully. They leased a third-floor space in a Boston neighborhood, and they hired two people — the minimum they needed — for the approximately twenty accounts they had at launch. While Evan initially wanted to hire a senior partner at a high-end law firm and rent space in a popular office tower, Jerome vetoed these moves as too expensive for the startup period. The potential tradeoff was missing an opportunity or two that a well-connected lawyer or a more dramatic view might bring them, but they agreed that those likelihoods were remote.
Several clients followed them, and within a year, they could afford to add more staff. Prospective customers offered positive feedback about the office space, so they knew it wasn’t over the top or below an expected standard. Jerome and Evan were pleased that they had right-sized their investment in the new entity.
So how do you know what tradeoffs to make when it comes to allocating resources to build a new business? It’s hardly straightforward. But here are some questions to ask yourself to help you overcome your own spending habits and assumptions:
1. What is the impact of your expenses on potential clients? If your goal is to attract and not repel revenues, imagine yourself as walking into your office, surveying your website, or using your app to see how what impressions you take away as a customer — and how you’d feel about the quality of the service.
2. How will your employees react to spending patterns? If your startup spends a lot on office design or executive first-class travel, consider the impression on your staff. If the paintings on the walls are worth more than their annual salaries, they may see themselves as low priority. Think about whether you are providing what they need in terms of technology, benefits, and a comfortable environment.
3. Do your colleagues understand that your spending is meant to benefit everyone? In the early stages of the firm, remember to communicate with your co-workers about key strategy costs that are required to grow the business and how their returns will justify the expense.
4. What is your business’ core competence? How can you focus your spending on that? For Colin, having a strong research analyst in the conference room would have been more important for his business than Bose speakers. For Serena, in choosing between a better oven or the best table linens, she was wise to go with the oven. And for Jerome and Evan, purchasing state-of-the-art accounting software was money well-spent compared to having a better view of the river.
5. What can you afford to lose? Finally, when you can’t hit breakeven, ruthlessly comb through your costs and consider what is non-essential and what you can live without until revenues climb higher. Do this while there’s still time.