How Does My Startup Deal with Founders’ Expenses Prior to Formation?

Founders often pay for expenses to test a minimum viable product before officially incorporating. Sometimes, these expenses are just a few hundred dollars in server fees, while other times founders have maxed out their credit cards. In either case, this is personal money, not company money. Therefore, it’s understandable that the founder would like to be reimbursed.

This post provides founders with an overview of the situation. However, it’s primarily an accounting question, not a legal one. So, consult with your accountant to ensure that the specific expenses are eligible, and your process is correct.

Types of Expenses

The main principle to remember is that any expense, whether incurred before or after incorporation, must be a legitimate deductible business expense by meeting all of the following criteria:

  • Related to the Business: The expense must be incurred in order to generate income for the business.
  • Ordinary and Necessary: The expense must be common and accepted in the business world.
  • Reasonable in Amount: The expense must be reasonable in relation to the business’s nature, scale and industry standards. Excessive or lavish expenses may be subject to limitations or disallowance.
  • Not Personal: The expense must be for the business, not for the personal use of the business owner or employees.
  • Documented: The expense must be well-documented. This includes receipts, invoices, contracts, and other relevant documents that demonstrate the purpose, amount and business-related nature of the expenses.

To determine what expenses qualify as a deductible for your business, consult with your accountant for specific guidance. Examples of expenses that may be a deductible include:

  • Travel expenses incurred by founders attending business meetings or conferences
  • Meals and entertainment expenses incurred by founders while entertaining clients or potential clients
  • Technology and equipment costs
  • Rent expenses
  • Office supplies
  • Marketing and advertising expenses
  • Legal and accounting fees

While these expenses can generally be deducted on the startup’s tax return, there may be limitations. For instance, meals and entertainment expenses are only deductible if they’re directly related to the business and not lavish or extravagant.

If an expense meets the criteria above, then the founder may be reimbursed by the company. In most cases, this takes the form of either a standard reimbursement or a founder loan.

How to Track and Record Founders’ Expenses

Accurately tracking and recording founders’ expenses is crucial for maintaining a company’s financial records. This can be done by creating a spreadsheet or using accounting software to document all expenses incurred by the founders before the company’s formation.

Founders must keep receipts for all expenses, including travel, meals, equipment and other costs related to starting the business. These receipts should be attached to each expense entry in the spreadsheet or accounting software.

It’s also important to categorize each expense appropriately so that it can be easily tracked and reported later. For instance, if a founder incurred travel expenses for meetings with potential investors, those expenses should be categorized as “Business Development” instead of “Personal Expenses.”

Keeping accurate records of founders’ expenses helps the company understand its financial position, and make informed decisions about future investments and expenditures.

Reimbursement

Startups must work with their accountant to establish a process for approving and verifying founders’ expenses before reimbursing them. This process helps ensure that all expenses are legitimate and necessary for the business.

The first step is for founders to submit expense reports detailing all expenses incurred prior to formation. These reports should include receipts or other documentation supporting each expense entry.

Once submitted, the expense report should be reviewed by someone in the startup’s finance department or another designated person responsible for approving expenses. This person should verify that each expense is eligible for reimbursement based on the startup’s policy and guidelines.

If any discrepancies or issues are found during the review process, the founder should be notified and given an opportunity to provide additional information or clarification.

After approval, the startup can then proceed with reimbursing the founder for eligible expenses, according to its established timeline and payment process.

By establishing a clear process for approving and verifying founders’ expenses, startups can ensure that they are managing their finances responsibly while also maintaining strong relationships with their founders.

This approach generally works well for low amounts, typically in the hundreds or thousands. However, when the amounts increase beyond that, the founder may want to consider a founder’s loan instead.

Founder’s Loan

If expenses become too high or a founder is continually investing cash into the company, it may be better to structure those expenditures as a loan to the company.

A founder’s loan is a type of loan that a founder may extend to the startup. Typically, this loan is used to cover expenses or provide working capital during the startup’s early stages before it generates revenue or secures funding.

Founders’ loans are typically structured as debt, with the startup agreeing to repay the loan with interest over a specified period. The loan may be secured or unsecured, depending on the agreement between the founder and the startup.

One benefit of a founder’s loan is that it provides the startup with a source of funding without requiring the founder to give up equity in the company. This can be especially valuable during the early stages of the startup’s development when equity is most valuable.

A variation on the founder’s loan is the founder’s convertible note or founder’s SAFE. The same concept applies; the founder is repaid for funding the startup’s activities, but the mechanism is different. For more information, check out the Founder’s Guide to Convertible Notes and the Founder’s Guide to SAFEs.

However, there are also potential drawbacks to a founder’s loan. If the startup is unable to repay the loan, it can create tension or conflicts between the founder and the startup’s other stakeholders. Additionally, if the loan is secured, the founder may be at risk of losing collateral if the startup is unable to repay the loan.

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