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Research and development (R&D) expenses are crucial for businesses seeking to innovate, enhance their products, and maintain a competitive edge. These costs can include salaries, materials, and overhead expenses related to developing new products, processes, or services.
Understanding the importance of R&D expenses can help businesses strategize for the future and promote long-term growth. With the support of accounting services for small businesses, companies can also make the most of tax breaks associated with R&D expenses.
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How Understanding R&D Expenses Helps with Tax Credits and Funding
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What are R&D Expenses?
Research and development costs are what you spend to build and improve the core of your product. For SaaS startups, that usually means:
Engineers writing code
Designers iterating on UX
Architects solving technical puzzles
Core to SaaS Product Development
These costs aren’t just about experimenting in a lab. In SaaS, R&D is often your most significant operating expense, especially in the early stages. You’re pouring time and money into:
Validating your idea
Achieving product-market fit
Shipping features that differentiate you from the competition
The Significant R&D Investment in SaaS
It’s not cheap. According to EY, high-growth SaaS companies can spend up to 30% of their revenue on R&D. Even as you mature, that figure stays high. Blossom Street Ventures reports that approximately 25% of revenue still goes into R&D at Series B, C, and even through the IPO stage.
What Counts as R&D?
Think: Salaries for product engineers and designers, Cloud infrastructure and tools used for experimentation or development, Prototypes, MVPs, or beta features in testing, work done to solve technical uncertainty. Under GAAP, most of these costs are expensed as incurred, because there’s no guarantee they’ll result in something worthwhile. But in some cases, they can be capitalized and added to your balance sheet, such as when:
Acquiring IP
Building reusable software
Creating tangible assets
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How Are R&D Expenses Accounted For?
Research and development expenses are often treated as immediate costs that reduce your net income for the year. Under U.S. Generally Accepted Accounting Principles (GAAP), companies are required to expense R&D costs in the year they’re incurred. This is a conservative approach that reflects the uncertainty of realizing future benefits from these expenditures.
While investors understand that high R&D costs can hurt short-term profitability, they may also indicate that a company is well-positioned for long-term growth.
Are There Any Exceptions to the Rule?
There are limited situations in which companies can capitalize research and development (R&D) costs rather than expensing them. This can improve financial statements by spreading costs over time, rather than recognizing them all at once. The exceptions include:
Acquisitions of intangible assets, such as technologies or patents.
When R&D results in tangible assets with a measurable useful life, such as prototypes or lab equipment.
Developing internal-use software that will provide ongoing value beyond the original project.
It’s also worth noting that the International Financial Reporting Standards (IFRS) provide more leeway for capitalizing development costs once feasibility is established.
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Why Do Startups Invest in R&D?
Research and development (R&D) is a key part of a company's operations that seeks to acquire knowledge to develop, design, and enhance its:
Products
Services
Technologies
Processes
Along with creating new products and adding features to old ones, investing in research and development connects various parts of a company's strategy and business plan.
According to the latest Business Enterprise Research and Development survey by the National Center for Science and Engineering and the U.S. Census Bureau, businesses spent $32.5 billion to support their R&D activities in 2020.
Investing in Research and Development (R&D)
The Internal Revenue Service's definition of research and development is investigative activities that a person or business chooses to do with the desired result of a discovery that will create an entirely new product, product line, or service. Nevertheless, the activities don't only need to be for discovering new products or services—this is only for tax purposes.
Basic vs. Applied Research
Research refers to any new science or thinking that will result in a new product or new features for an existing product. Research can be categorized into two main types: basic research and applied research. Basic research aims to explore scientific principles from an academic perspective, whereas applied research applies these principles in a real-world context. The development phase refers to the actual application of new science or thinking, allowing a new or increasingly better product or service to begin taking shape.
R&D as the Genesis of Product Development
Research and development are the initial steps in developing a new product, but product development encompasses more than just these two stages. An offshoot of R&D, product development includes the entire product life cycle, from conception to sale, to renovation, and ultimately to retirement.
R&D Offers Productivity, Product Differentiation
Firms gain a competitive advantage by performing in some way that their rivals cannot easily replicate. If R&D efforts lead to an improved type of business process, such as cutting marginal costs or increasing marginal productivity, it becomes easier to outpace competitors.
R&D's Transformative Impact
R&D often leads to the creation of new types of products or services—for example, without research and development, cell phones or other mobile devices would likely never have been invented. The internet, and even how people live today, would be utterly different if businesses had not conducted R&D in the past.
Problem-Solving & Market Innovation
Research results provide businesses with a means to identify issues people face and develop practical solutions to address them. At the same time, development enables companies to find innovative and unique ways to resolve these problems. This leads to many different product and service variations, which give consumers choices and keep the market competitive. Some examples of companies that conduct R&D activities include auto manufacturers, software developers, cutting-edge technology companies, and pharmaceutical firms.
The R&D Tax Credit
In 1981, the IRS began offering tax breaks to companies that spent money on research and development, encouraging them to hire employees. Internal Revenue Service. "About Form 6765, Credit for Increasing Research Activities."
Qualifying companies include startups and other small ventures with qualified research expenses. Such expenses can be used to offset tax liabilities, along with an impressive 20-year carry-forward provision for the credit.
What Expenses Qualify for the R&D Tax Credit?
Here are some expenses that qualify for an R&D tax credit:
Cloud computing costs
Payments made to contractors performing testing or research
Supplies necessary for developing the product, like software licenses
All of these expenses must be made in the US. To learn more about the R&D tax credit, visit the IRS website.
Buyouts and Mergers
Many entrepreneurs and small businesses have generated a substantial amount of money in a short time by selling innovative ideas to established firms with extensive resources. Buyouts are particularly common among online companies, but they can be observed wherever there is a significant incentive to innovate. Research and development can help your ideas or business become more attractive to investors and other companies looking to expand.
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How Understanding R&D Expenses Helps with Tax Credits and Funding
Properly identifying and documenting your R&D spend is the key to unlocking valuable R&D tax credits. The IRS offers a credit for businesses conducting qualified research activities:
Think product development
Prototyping
Software engineering
Technical problem-solving
Qualifying Criteria for R&D Tax Credit Expenses
To claim it, your expenses must meet specific criteria: the research must aim to eliminate technical uncertainty. It should rely on hard sciences (engineering, biology, computer science, etc.). It must involve a process of experimentation. And, critically, it must be done for a permitted purpose (like developing a new product or improving a process). If your accounting isn’t clean, or you’re lumping R&D into general operations, you risk missing out on credits worth thousands, even hundreds of thousands, depending on your spend.
Become Investor-Ready by Understanding R&D Expenses
Investors love startups that spend intelligently on R&D. A well-documented R&D budget shows you're serious about innovation and gives investors a clear view of how you’re deploying capital. It helps answer questions like: How close are you to product-market fit? Are you building defensible IP? Are you spending smartly or burning through cash? The more clearly you can show your R&D efforts, the easier it is to make the case for early-stage funding or follow-on investment.
Open Doors to Grants and Public Funding by Understanding R&D Expenses
Government agencies, particularly in tech-forward economies, often offer grants and subsidies to companies engaged in qualified research and development (R&D). Still, again, eligibility hinges on whether you can accurately track and classify those expenses. Grant reviewers want to see:
Defined milestones tied to R&D stages
Clear budgets for experimental work
Alignment with national or regional innovation goals
Having your R&D spend properly documented makes your application stronger and often helps you qualify for matching funds or pilot programs.
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