Author Topic: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years  (Read 1662 times)

cryptobull

  • 5 O'Clock Shadow
  • *
  • Posts: 4
I'm saving up 3 years worth of runway ($300K), after which I'm going to start my own SaaS company.  For the idea I have in mind, it will take a while to build out.  So it might go something like this:

Year 1-2: No revenue.  $20k/year in cloud and contractor expenses.  $80k/year in personal living costs, health insurance, etc.
Year 3: Hopefully revenue starts coming in, otherwise back to the rat race.

In year 3, assuming it hits escape velocity and I can make enough to live on, then S-Corp will be the perfect structure from a taxation point of view.  I can do the 60/40 salary/distributions approach, and take advantage of the recent 20% deduction for pass-through entities*.

But what about the first and possibly second year while there is no revenue?  I plan to do an S-corp from day 1, since the ultimate goal is to get to significant revenues by year 3.  I will incur losses those first two years that I will want to carry forward, for things like paying contractors to help me build the SaaS.  So having an S-corp and a corporate credit card seems like a great way to easily separate all those expenses. 

How do I "fund" the business?  With no revenue, and with the business needing to pay some expenses like cloud servers, paying for contractors, I will need to take some of my runway money and put it into the business checking / credit accounts.  Is it as simple as getting a corporate credit card and then paying it off using my personal runway funds?  Or should I do a lump sum initial funding of the business, like transfer over $100K into the business so that it can get itself off the ground, and then pay the corporate credit card out of the business checking?

Some other areas that are super murky that I'd love to get some advice on:

* 401k/IRA - I would want to max out my 401K and IRA contributions from day 1 as well, so I would contribute to a solo 401k from my personal savings.  Could I setup employer matching?  Or will the business have to generate some revenue before I can do employer matching?

* Health Care - I will need a health care plan, would I just pay that out of pocket or am I better off setting up an employer health care plan?  Again, will the business need revenue first?

* Social Security - During these two years I won't be taking a salary and therefore won't be paying self-employment tax and paying into social security.  That seems like a bad thing, because I will have less social security paid when I retire.  Is there any way to pay into social security even without getting a salary?

* Other stuff? - Will I have to deal with things like workers comp insurance in this case?  Company life insurance plan?

* From Listen Money Matters, episode on Feb 11, 2019.
« Last Edit: December 05, 2020, 02:44:57 PM by cryptobull »

Smokystache

  • Bristles
  • ***
  • Posts: 447
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #1 on: December 05, 2020, 07:38:44 PM »
You have done a great deal of thinking about how to maximize tax, financial, and banking matters. Others are better-suited to comment on those things and if you're lucky SeattleCPA will be by to teach you everything about S-Corps.

I hate to be the guy that asks a different question than what you're posting about and I may be making a huge mistaken assumption, but have you thought this much about the service you hope to provide, your future clients and if they will pay for what you want to provide them, and the mechanics of making money? I have personally gone down the path of:
1) I have an idea!
2) What name should I give my new company?
3) LLC, S-Corp, sole-prop, etc?
4) I should design business cards!
5) How do I make a website for this?
6) I have a new idea for the name of my company?
7) I need to change those business cards
8) google: "how to write-off marketing costs in a new business"
...
25) I should probably work on the product service and find people who will pay me for it.

Maybe that's just me. Perhaps you've got a great service and plan in mind. But I can't imagine why you would think it should take you 2 years to see significant revenue. That's true if you're building a hydro-electric dam or rentals in a new skyscraper, but not for a SaaS. Build a smaller version quickly. Try to sell it. If you can't, you've saved yourself 2.5-3 years.

This may sound snarky or cheezy, but it comes from a place of genuine love. Or put another way, I wish someone had written this to me about 6 years ago - would have saved me 2-4 years.

maizefolk

  • Walrus Stache
  • *******
  • Posts: 5746
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #2 on: December 05, 2020, 09:17:02 PM »
One initial thing to clarify, are you talking about an actual S-corp or an LLC which elects to be taxed as an S-corp? The rules are modestly different for the two although the pass through tax break would apply either way.

In either case you probably want to avoid co-mingling of funds so it would be best to structure money you put into the business as an investment or a loan, not paying for business expenses directly out of your personal bank account.

If you can buy insurance as a small business it'll probably be better and cheaper than unsubsidized insurance purchased through the individual markets. However more and more insurance companies seem to be shifting to a minimum number of full time employees (think 2-3) before they'll let businesses buy company health insurance plans.

I would want to max out my 401K and IRA contributions from day 1 as well, so I would contribute to a solo 401k from my personal savings.  Could I setup employer matching?  Or will the business have to generate some revenue before I can do employer matching?
.... During these two years I won't be taking a salary and therefore won't be paying self-employment tax and paying into social security. 

If you aren't paying yourself a salary and there is no taxable income flowing through the S-corp, you won't have earned income and wouldn't be able to contribute to a 401k plan in the first place.

How bad not paying into social security is for a couple of years depends on 1) have you already qualified for social security, or will you have qualified by the time you retire/hit FI?* 2) Are you past the first bend point for social security, or will you be by the time you retire/hit FI?** If the answer is yes, don't worry about a couple of years of missing social security contributions, it won't make a big difference in the end.

*Roughly: Have you earned at least a few thousand dollars of income that you paid social security taxes on for at least ten years in your life.

**Roughly: Have you earned at least $420,000 in income in your lifetime that you paid social security taxes on?

Edit: I agree very much with @Smokystache, two years before you can start getting revenue for a SaaS seems surprisingly long. Is there any way for you to pare down the features of product you're trying to launch and have a minimum viable product ready in less than two years? Even if it doesn't bring in a lot of revenue at first, there is no substitute for feedback from genuine customers to both refine your product design and refine your business model (or to maybe discover your business model doesn't work before you've already burned through your entire runway).
« Last Edit: December 05, 2020, 09:49:58 PM by maizefolk »

cryptobull

  • 5 O'Clock Shadow
  • *
  • Posts: 4
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #3 on: December 05, 2020, 11:21:44 PM »
I was thinking actual s-corp, but maybe I should look into the LLC that elects to be an S-corp.  I remember that one of the Listen Money Matters hosts mentioned they were taking that approach.

Also, totally hear you both on the whole "maybe you should iterate on your SaaS product faster" feedback.  Originally I was going to say it's "orthogonal", but if it's true that I can't contribute to a 401k without earned income, then it does become a bit more problematic to "boothole" for so long.  (I just made that term up, but it's like you're not only lifting yourself up from your own bootstraps, you first dig a deep hole and then bootstrap yourself out of the hole).

The business I was thinking of pursuing is very R&D heavy.  So imagine you have a proven market, but a very, very high technical barrier to entry.  For example, lets say you want to build a commercial OCR engine (optical character recognition) from scratch.  Building something like this is really freaking hard.  But if it turns out that it works significantly better than the competition, then it would not be that hard to find customers or licensing deals with companies like HelloSign, Docusign, etc.  So maybe calling it a "SaaS" was a bit misleading, but I mentioned that since it's easy for people to grok, and even something like an OCR engine would probably much better released as a SaaS to start with.

If I can't contribute to a 401k until I get some earned income, at least I can contribute a bit to an IRA.

Yes and yes for the social security questions.  Sounds like I don't need to worry about that too much.

Thanks for all the answers!  Seems like a really cool community.  It feels like a relic of the internet of yesteryear.. :-)

Smokystache

  • Bristles
  • ***
  • Posts: 447
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #4 on: December 06, 2020, 08:13:11 AM »
Thanks for the clarification on your business model.  I like the "boothole" term you invented -- that's very descriptive of that definition.

Yes, poke around here -- there's a wealth of information on a variety of topics. Best of luck in your venture - I really hope to see your post in 3-5 years where you've sold/licensed your tech and you're in the Post-FIRE section a lot.

cryptobull

  • 5 O'Clock Shadow
  • *
  • Posts: 4
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #5 on: December 06, 2020, 08:32:55 AM »

In either case you probably want to avoid co-mingling of funds so it would be best to structure money you put into the business as an investment or a loan, not paying for business expenses directly out of your personal bank account.
 

If I'm understanding correctly: lets say to start with the s-corp issues 1000 shares and buy them all at $50 each ($50k total), and now the s-corp has some capital to work with and I own 100% of the shares.  6 months later if the s-corp burns through all the capital by paying contractors (not me) and cloud expenses, then it would need to raise another round and dilute all the shares of the existing shareholders (me).  I would then buy more of the post-diluted shares, again owning 100% of the shares. 

I guess pulling money back out might be trickier though, maybe a stock buyback?  Any stock buyback would probably have to be advantageous for the company though, and not arbitrary, otherwise the IRS would probably frown upon this.  Is this where loans are a bit easier?

sailinlight

  • Stubble
  • **
  • Posts: 199
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #6 on: December 06, 2020, 08:45:48 AM »
Why is it so important to create the S-corp from the beginning if you don't even know if the product will take off? Wouldn't you accomplish the same thing by just paying for all the startup expenses out of personal funds and when you get your first big contract, then create the S-corp and "sell" the product to it so your contracts with your customers can be between them and the S-corp?

maizefolk

  • Walrus Stache
  • *******
  • Posts: 5746
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #7 on: December 06, 2020, 08:55:28 AM »
Keep in mind your IRA contributions are also limited to the lesser of $5,500 or your total earned income for the year so if you're making absolutely no money that also rules out an IRA contribution.

You can be a little strategic about when you push the big red eject button to start your business to cut down to only missing one year of contributions instead of two though. If you resign at say the end of January/February you'll still have taxable income in that calendar year, so you could still contribute to an IRA in year 1, miss contributing in year 2, and even with year 3 starting in February/March instead of January 1, I'd imagine by the following November or December you'll either have taxable income through the business or have gotten a regular job again and either way can go back to contributing.

Using the OCR analogy, building a SaaS OCR company requires getting at least three business functions:

1) Have an algorithm/implementation which is enough better than the competition that people notice.
2) Build a UX that is not so uncomfortable or unintuitive for users they're not willing to use it to get access to your better algorithm.
3) A customer acquisition pipeline to bring in people/businesses willing to pay for your awesome new SaaS.

If it takes two years to get your better OCR code, standing up #2 and #3 to the point where you have $100k in revenue within a year could well be possible, but it's risky. You may be planning to do this yourself, in which case you'll be learning as you go, or you may be planning to hire contractors to do it, in which case you'll be trying to figure out who actually knows their stuff and who doesn't. And it'd be a big shame to spend three years of your life and $300k just to have to walk away because you need another 6-12 months of runway to get to the point where the business is self sustaining.

Just brainstorming on the OCR case (which wouldn't necessarily map onto your actual target market): could you quickly implement an existing published algorithm and use that to make a low cost or free-with-registration OCR service* and use this as a test bed to refine UX and customer acquisition strategies in years 1 and 2 while you are digging down into and back out of your boothole?

*With different branding, you don't want to anchor people to a low starting price for your service or have to overcome an impression of low accuracy associated with your brand when your new innovation is on the market.

Kroaler

  • Handlebar Stache
  • *****
  • Posts: 1083
  • Location: Southeast
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #8 on: December 06, 2020, 08:57:40 AM »
Why is it so important to create the S-corp from the beginning if you don't even know if the product will take off? Wouldn't you accomplish the same thing by just paying for all the startup expenses out of personal funds and when you get your first big contract, then create the S-corp and "sell" the product to it so your contracts with your customers can be between them and the S-corp?

I was kind of wonder this. Why not just start a separate bank account and be a  sole proprietor till revenue is over 100k then switch to s-corp or whatever?

cryptobull

  • 5 O'Clock Shadow
  • *
  • Posts: 4
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #9 on: December 06, 2020, 09:01:24 AM »
Why is it so important to create the S-corp from the beginning if you don't even know if the product will take off? Wouldn't you accomplish the same thing by just paying for all the startup expenses out of personal funds and when you get your first big contract, then create the S-corp and "sell" the product to it so your contracts with your customers can be between them and the S-corp?

The reason I was thinking of doing an s-corp from day 1 was to be able to carry forward the losses to be used against future revenue gains achieved by the s-corp.  Can that also be done without an s-corp since the losses pass through?

Also regarding buying shares vs loans, I found this youtube video which goes into details about that: https://youtu.be/N6EcEjTKM8

maizefolk

  • Walrus Stache
  • *******
  • Posts: 5746
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #10 on: December 06, 2020, 09:08:28 AM »
If I'm understanding correctly: lets say to start with the s-corp issues 1000 shares and buy them all at $50 each ($50k total), and now the s-corp has some capital to work with and I own 100% of the shares.  6 months later if the s-corp burns through all the capital by paying contractors (not me) and cloud expenses, then it would need to raise another round and dilute all the shares of the existing shareholders (me).  I would then buy more of the post-diluted shares, again owning 100% of the shares. 

I guess pulling money back out might be trickier though, maybe a stock buyback?  Any stock buyback would probably have to be advantageous for the company though, and not arbitrary, otherwise the IRS would probably frown upon this.  Is this where loans are a bit easier?

I think you probably could do a stock buy back, but it's usually more straightforward to just issue a distribution (LLC electing S-corp) or pay out a dividend (S-corp). For the LLC as long as you're treating all shareholders equally (hard not to when there is only one of them), it should be fine. For the S-corp I think it should be similar but I don't have first hand experience with that entity structure. LLC's can also just make capital calls on the owners without going through the mechanics of issuing new shares. Not sure if S-corps have an equivalent.

sailinlight, I think the reason to want to create a business right from the start is that it'll make it more straightforward for the business expenses (hiring contractors and paying for cloud services) to be tracked and counted as taxable losses. While we really need someone who is an actual expert on taxes to weigh in, that should mean the losses could carry through to cryptobull's personal tax return and could either be carried back to offset income in the years before cryptobull stopped working or carried forward to offset the first chunk of income when the business starts earning money or cryptobull returns to a regular W-2 job. (but I an not an accountant or tax attorney)
« Last Edit: December 06, 2020, 09:21:53 AM by maizefolk »

SeattleCPA

  • Handlebar Stache
  • *****
  • Posts: 1696
  • Age: 61
  • Location: Redmond, WA
    • Evergreen Small Business
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #11 on: December 07, 2020, 10:58:23 AM »
You don't want to be an S corporation before you're paying self-employment taxes on business profits.

That would be an expensive, inefficient way to set things up.

Probably, you want to start as an LLC that's treated as a disregarded entity (so a sole proprietorship). At some point in the future, you would then elect S corporation status.

BTW, we do about 200 S corp returns. I taught S corp tax in a masters program that CPAs and attorneys take.

Ben B

  • 5 O'Clock Shadow
  • *
  • Posts: 10
  • Age: 32
Re: S-Corp SaaS business with 3 year runway, no revenue first 1-2 years
« Reply #12 on: December 26, 2020, 08:43:05 PM »
Why is it so important to create the S-corp from the beginning if you don't even know if the product will take off? Wouldn't you accomplish the same thing by just paying for all the startup expenses out of personal funds and when you get your first big contract, then create the S-corp and "sell" the product to it so your contracts with your customers can be between them and the S-corp?

The reason I was thinking of doing an s-corp from day 1 was to be able to carry forward the losses to be used against future revenue gains achieved by the s-corp.  Can that also be done without an s-corp since the losses pass through?

Also regarding buying shares vs loans, I found this youtube video which goes into details about that: https://youtu.be/N6EcEjTKM8

To echo what others have written above, I've been down this rabbit hole before. and it's usually a waste of time.

So long as your not turning a profit, from a tax perspective the entity type usually won't matter. start as a sole proprietor or an LLC if you insist, get a business bank account and an EIN, and your good to go, you are now a "real" business.

Once things start moving in the right direction, and money starts flowing in, then you can revisit this topic and figure out the most optimal entity structure.

Good luck with your venture and I hope you succeed tremendously