Every startup has dreams of changing the world and making a ton of money at the same time, and yet it’s not uncommon for a new company to struggle with the latter portion of this vision. While it can take a long time to actually start turning a profit in the tech industry, the expenses tend to begin almost right away. Even if you don’t have much in the way of overhead, there are usually some sort of costs to consider (i.e. your people), and when you’re making little to no profit, that can be a tough equation to solve.
We’ll be the first to say that cash is king, and without it no company can survive. However, depending on how you look at it, incurring more expenses than you generated in revenue, also termed as a net operating loss, could actually be a good thing. While it’s not ideal to continue to function year after year in this manner, there can be some tax benefits to an NOL situation (and to be clear, we definitely don’t think you should run your business at a loss, but sometimes it happens, and it helps to understand the potential tax upsides).
Putting It On Paper
Every startup needs to have a very clear set of financial data at any given moment, so it’s crucial that you utilize accounting methods that allow you to view your revenue and expenses at a glance. Whether it’s in quarterly reviews, closing out the year, or tax time, you’ll be able to see if you, in fact, came out ahead, or if you lost money during that period.
Even (perhaps especially) in your first or second year in business, it’s not unusual for a startup to have a slower season of growth, so it’s important to consider how a net operating loss can affect you at various stages in your company’s lifetime. Ultimately, the one benefit to being in the red comes from your ability to use a net operating loss deduction come tax season.
Breaking Down a Net Operating Loss
Let’s say that your company is in its first year of business and you’re still working on generating a product that’s ready for market. You know that you have people to pay and an office to run, and expect at least $250k in expenses in year one. Hopefully you have some true believers in your product and were able to acquire funding in the amount of $500K. As the year draws to a close, you haven’t yet made a sale, so your profits are zero. The math here is easy – you incurred a net operating loss of $250K.
Now here’s the important part to keep in mind when you’re staying up late wondering how you can possibly spearhead a company that is so far into the red: the IRS allows companies the ability to utilize this NOL almost like a future tax credit, thus reducing your tax liability during a year when you did turn a large profit. Under current IRS regulations, startups can use a net operating loss deduction to offset up to 80% of their future taxes indefinitely until it’s been used entirely. To be clear, this isn’t money in the bank today but something to keep track of for the future.
Even More Benefits
Utilizing your net operating loss deduction clearly helps you to retain cash during an exceptionally successful year, but many see that it can completely change the game when it comes to securing funding. Prior to 2018, there were limits on NOL use when ownership changes occurred, something that happens fairly often within the startup space. Now, your deduction is protected for the first three years no matter what happens.
This allows budding companies the ability to have more flexibility in venture capital activities from a tax perspective, as they don’t have to worry quite as much about ownership changes and also allows startups to save more money to invest back into their business. NOL balances can even be included in pro-forma company valuations, ultimately increasing a startup’s attractiveness and showing VCs that they have even more to offer in terms of financial returns.
Are There Drawbacks?
At first glance, of course, it doesn’t look great to see a net operating loss on a company’s financial statements, but beyond that initial shock, there isn’t much about an NOL that can hurt a startup. Now that the IRS has made changes to the stipulations surrounding the use of the deduction, there’s far less to fear when it comes to seeing red all over your books.
If you’re not sure how to take advantage of your net operating loss deduction or you simply need assistance in streamlining your startup’s finances, let airCFO help. With a dedicated team of professionals who know the intersection of startup taxes, accounting, finance and tech, we’re here to show you how to maximize your financial activity and foster your company’s growth.