After two decades of low inflation in Australia, we are beginning to see some pretty scary figures – spurred in part by Russia’s war against Ukraine and the supply chain hangover stemming from the pandemic.
High inflation translates to increased costs of capital (e.g., interest rates) and goods & services which will affect all businesses – albeit to varying amounts.
Whilst startups perhaps operate in an ecosystem slightly separate from conventional businesses, they are not immune to the impact of inflation. A good portion of businesses that would identify as being ‘startups’ are pre-revenue and rely on a limited pot of money.
That is not to say that conventional businesses do not also have limited funds, but what makes early-stage startups unique is that they almost always rely exclusively on equity funding and operate on a shoestring budget.
The impact of inflation on a startup
A startup will often determine the amount of capital that it will need to raise to get to a certain milestone (e.g., completion or release of a minimum viable product). In a period of high inflation, they may find that the funds that they raised don’t go as far.
Established businesses with pre-existing revenue streams can simply pass on their increased costs to their customers (subject to the elasticity of the demand for their products and services). However, a pre-revenue startup does not have that luxury but must instead think creatively and take action to navigate through the instability.
They are then presented with two typical pathways – to get more money, or spend less.
Pathway 1: Get more money
Raise more money
The path of a startup’s survival and prosperity is often predicated upon the accessibility of funding. The problem with raising capital is that, even at the best of times, it is a long and laborious process that detracts critical time from founders that could perhaps be better spent growing the business or developing the startup’s product.
Furthermore, high inflation is typically combatted through increased interest rates which translate to increased costs of capital. This means that investors will want a higher return on their investment, which could mean that they would require a larger ‘slice of the pie’ thereby further increasing the dilution to founders and early-stage investors.
Take advantage of government and industry grants
Rather than raising capital when the cost of capital is high, you may wish to divert your attention to government and industry grants (GIGs). GIGs are consistently available throughout the year via Federal, State and Local Government programs in addition to those funded by other private and industry groups (e.g., universities).
There are a broad range of GIGs – including unsecured interest-free loans, in-kind contributions (e.g., donations of labour by research teams at universities) and outright grants of cash with limited or no ‘strings attached’.
Avail yourself to the R&D tax incentive
Another alternative is to take advantage of the research & development (R&D) tax incentive. The R&D tax incentive provisions are not simple and making a claim often requires assistance from an expert. For this reason, many startups simply do not avail themselves to the (potentially) huge buckets of cash that could be put back into their pockets.
Establishing a relationship with an R&D tax incentive expert can take a lot of the leg work and risk out of preparing an application. Many of those experts will also work on a success fee basis (i.e., they will take a percentage of the claim) and so there is usually an arbitrage for startups.
Pathway 2: Spend less money
The problem with reducing expenditure to combat an increasing burn rate is that it may jeopardise the development of the startup’s product. Founders may compromise the potential success of the venture by cutting staff, reducing the scope of the project (e.g., removing product features) or giving up on critical expenditure.
This can be counterproductive as doing so may inadvertently expand the runway and delay the release of the product which may have had the potential to help further fund development. If you do need to go down this route, a good accountant can assist you in preparing a three-way cash flow forecast (i.e., projected balance sheet, profit & loss and cash flow statement) to properly understand how any budgetary decisions may impact your runway.
Use an employee share scheme
An alternative is to try make your money go further without reducing expenditure. That can often be easier said than done, but one possible way is to use an employee share scheme (ESS) to remunerate and retain staff. With the current global worker shortage causing inflated wages and increased superannuation costs startups may find it difficult to compete with established businesses and tech giants to remunerate staff at current market rates.
A tax-effective ESS can help subsidise your employee costs whilst remunerating staff at market rates by providing them with equity incentives in the venture. Whilst it may lead to dilution to founders and early-stage investors, you might find yourself having to raise additional capital to support higher employee costs which could inadvertently lead to that same dilution without the added benefit of retaining key employees.
Furthermore, an employee who has a vested interest in the success of the firm should (in theory) be more engaged and committed in their work and align their interests with that of the startup and its investors: that’s agency theory 101!
When it comes down to it every startup has two options: do something or do nothing. You can either choose to be proactive (whether that is to raise more capital, reduce expenditure, tax advantage of GIGs or possible tax incentives) or you can be reactive and then have to deal with the blows as they come.
Responding to macroeconomic influences is unfortunately one of the less exciting aspects of a startup. The path to success is paved with the corpses of great ideas that died too soon. Don’t let your great idea starve you from being reactive rather than proactive to external threats. Setting up your startup for fiscal resilience can only stand you in good stead – whether that’s during a period of unknown stability or to lay a foundation for future success.
This article was written by Andrew Ravenscroft, a tax advisor at RSM who provides specialist tax consulting services to pre-seed startups through to large listed companies.
Andrew’s primary focus is advising business owners and investors on the tax structuring of their affairs and on the tax outcomes of mergers, acquisitions and exit events.
Andrew is the former treasurer of eGroup, and a former co-founder and CFO of a Perth-based tech startup that has raised seed investment and sold products to over 30,000 customers across 60 countries.
RSM is a sponsor of Startup News.