CapEx vs OpEx for Technical Leaders in Deeptech and SaaS: A Practical Guide

CapEx vs OpEx: Understanding the Difference for Startups

As a founder of a pre-seed to Series B startup, your focus is on product development and extending your runway. The last thing you want is to get bogged down in accounting terminology. Yet, the question of the difference between capital expenditure and operating expense for startups inevitably comes up, whether from your accountant, board, or a potential investor during due diligence. This isn't just about compliance; misclassifying your spending directly impacts your gross margin, EBITDA, and cash runway projections. Understanding this distinction is crucial for accurate financial storytelling and making sound decisions for managing tech spend, especially when you don't have a full-time CFO. For more, see the hub on finance for generalist operators.

The Core Principle: Matching Costs to Value Creation

At its heart, the distinction between CapEx and OpEx is about timing. The goal is to accurately reflect your company's financial health by matching costs to the period in which they generate value. Misalignment can paint a misleading picture of profitability, making a healthy company look unprofitable or vice versa.

An Operating Expense (OpEx) is a day-to-day cost of doing business. These are the recurring expenses required to keep the lights on, such as team salaries, office rent, marketing spend, or your monthly subscription to a sales tool. These costs are recognized in full on your profit and loss (P&L) statement in the period they are incurred, immediately reducing your reported profitability.

A Capital Expenditure (CapEx), on the other hand, is a significant investment in an asset that will provide value for more than one year. These are major purchases like physical equipment, buildings, or, critically for SaaS and Deeptech companies, the development of internal-use software. Instead of hitting the P&L all at once, the cost is recorded on the balance sheet as an asset. This asset’s cost is then gradually expensed over its useful life. For tangible assets like a server, this process is called depreciation. For intangible assets like software, it's called amortization. This is a key concept for budgeting for technical investments and sound startup financial decision making.

Capitalizing Internal Software Development Costs

For most technology startups, the most significant and confusing area for CapEx vs. OpEx is engineering payroll. The key question is: which parts of your engineering team's work can and should be capitalized? The answer lies in a structured, phase-based approach guided by accounting standards.

For US companies, US Generally Accepted Accounting Principles (US GAAP) standard ASC 350-40 governs this process for internal-use software. In the UK, FRS 102 provides a similar accounting framework. It is also important to remember that these R&D costs may be relevant to HMRC's R&D tax relief scheme.

Both frameworks generally break down software development into three distinct phases.

1. Preliminary Project Stage (OpEx)

This is the initial discovery and research phase. All costs here are treated as an operating expense. Activities in this stage include:

• Brainstorming and ideation
• Evaluating technological feasibility and architecture
• Exploring alternative solutions or vendors
• High-level requirements gathering and documentation

Essentially, any work done before your management team formally commits to building the project is considered OpEx.

2. Application Development Stage (CapEx)

This is the active build phase. Once management has committed to the project and it is probable that the software will be completed and used as intended, you can begin capitalizing specific costs. The reality for most pre-seed to Series B startups is more pragmatic: this is where meticulous time tracking becomes essential. Costs eligible for capitalization typically include:

• Direct payroll and related benefits for engineers, product managers, and QA teams working on coding, designing, and testing new features.
• Fees paid to third-party contractors for their development work.
• Other direct costs associated with creating the new functionality.

The critical distinction is between work that creates significant new functionality (potential CapEx) and work that maintains the existing service (OpEx). Fixing a minor bug is OpEx; building an entirely new reporting module is a candidate for CapEx.

3. Post-Implementation Stage (OpEx)

Once the software is substantially complete and ready for its intended use, the capitalization window closes. All future costs related to the software are expensed as OpEx as they occur. This includes:

• User and employee training
• Ongoing maintenance and support
• Minor bug fixes and patches
• Data conversion and hosting costs

In practice, we see that startups typically capitalize between 20-50% of their engineering payroll during heavy build phases. (Pattern Observation) The percentage is lower for mature products focused on maintenance and higher for early-stage companies building their core platform.

Once the software is launched, you begin to amortize the total capitalized cost. For example, if you capitalized $180,000 of engineering salaries to build a new feature, you would spread that cost over the asset's useful life. A typical useful life for amortizing capitalized software is 3 years. (Example Policy) This results in a monthly amortization expense of $5,000 ($180,000 / 36 months) on your P&L, providing a much smoother impact on profitability than a single $180,000 hit.

Classifying Hardware and Cloud Infrastructure Spend

While software is often the main focus, hardware and infrastructure costs also require clear classification, especially for Deeptech and infrastructure-heavy SaaS companies.

Physical Hardware and Equipment

For physical hardware like laptops or specialized servers for a Deeptech prototype, the rules are more straightforward. These are tangible assets and are classic capital expenditure examples for startups. However, it is not practical to capitalize every keyboard and mouse. This is where a Capitalization Threshold comes in. This is an internal policy that sets a minimum cost for an item to be treated as a capital asset. A common capitalization threshold for single asset purchases is $2,000. (Example Policy) Any purchase below this amount is simply recorded as an operating expense, regardless of its useful life.

For an item that exceeds the threshold, like a $9,000 server, the cost is placed on the balance sheet and depreciated. A typical useful life for depreciating computer equipment (laptops) is 3 years. (Example Policy) For more specialized Deeptech equipment, the useful life may be longer, depending on its expected longevity.

Cloud Infrastructure (AWS, GCP, Azure)

Cloud infrastructure spend is a frequent point of confusion, especially for SaaS startups. The guidance here is clear: Cloud spend (AWS, GCP, Azure) is almost always treated as an operating expense (OpEx). (FinOps Foundation research) The rationale is simple: you are renting capacity, not buying an asset. It functions like a utility, similar to your electricity bill. This directly impacts operating expenses in SaaS and is a critical component of Cost of Goods Sold (COGS), which investors scrutinize. If you are negotiating vendor terms, a framework can help you manage these costs. See our guide on Vendor Negotiation: Financial Framework for relevant tactics.

Putting It Into Practice: A 5-Step Process

Knowing the rules is one thing; implementing a system is another. Lacking a clear process to track and document these costs can create major headaches during an audit or investor due diligence. Here’s a pragmatic approach for expense classification for founders.

1. Create a Formal Policy. Work with your fractional CFO or external accountant to document your approach. Your policy should define your capitalization threshold (e.g., $2,000), the useful life for different asset classes (e.g., 3 years for software and computer equipment), and the criteria for what constitutes a capitalizable software task.
2. Implement Rigorous Time Tracking. This is non-negotiable for software capitalization. Use your existing project management tools like Jira, Clockify, or Tempo. Create distinct project codes or labels to differentiate work. For example, you might use tags like New-Feature-AI-Module (CapEx), Bug-Fix-Login (OpEx), and Refactor-Backend (OpEx).
3. Calculate the Monthly Capitalizable Amount. At the end of each month, your engineering lead can run a report showing the percentage of time spent on CapEx-tagged tasks. If the team spent 35% of its time on new features, you can apply that percentage to the month's fully-loaded engineering payroll (salaries, benefits, and payroll taxes) to get your capitalizable amount. For guidance on building financial cases around people costs, see Headcount Planning: Financial Justification.
4. Record the Journal Entry. Your accountant will then make a journal entry in your accounting software. In QuickBooks or Xero, this involves crediting your payroll expense account (reducing the OpEx on the P&L) and debiting a newly created intangible asset account, like "Capitalized Software," on the balance sheet.
5. Begin Amortization. As soon as the new feature is launched and generating value, the amortization clock starts. Your accountant will set up a schedule in your accounting software to automatically expense a portion of the asset's value each month for its entire useful life, moving the cost from the balance sheet to the P&L over time.

CapEx vs OpEx: Critical Tax Implications

It is important to understand that the rules for financial accounting (GAAP or FRS 102) can differ from the rules for tax purposes. This is a crucial area where you must work with a qualified tax advisor.

For US Companies

In the US, Section 174 of the tax code mandates specific treatment for Research and Experimental (R&E) expenditures, which includes software development. For tax years beginning after 2021, companies must capitalize and amortize these costs over 5 years for domestic R&E. This is a tax requirement and may differ from the 3-year useful life you use for your GAAP financial statements, creating a book-tax difference your tax advisor must manage.

For UK Companies

In the UK, while you will follow FRS 102 for accounting, the detailed time tracking records created for capitalization are immensely valuable. They provide robust evidence for substantiating claims for HMRC's R&D tax relief schemes. The ability to clearly show which projects and how much employee time were dedicated to resolving technological uncertainty is fundamental to a successful R&D tax credit claim.

A Strategic Approach to Expense Classification

Implementing a capitalization policy is not just an accounting exercise; it's a strategic tool. It provides a more accurate view of your company's profitability by matching significant development costs to the periods they deliver value. This leads to more stable and representative gross margin and EBITDA figures, which is fundamental to building a strong fundraising narrative and providing clarity to your board.

Ultimately, the goal is to establish a reasonable, defensible, and consistent process. Start simple. Don't over-engineer it. By correctly distinguishing CapEx from OpEx, you not only ensure compliance but also provide stakeholders with a clearer, more insightful picture of your company's long-term value creation. To continue learning, visit the finance hub for generalist operators.

Frequently Asked Questions

Q: How does capitalizing expenses affect a startup's valuation?
A: Capitalizing expenses moves costs from the P&L to the balance sheet, which increases short-term profitability metrics like EBITDA. Since many startup valuations are based on an EBITDA multiple, a higher EBITDA can potentially lead to a higher valuation. However, investors will scrutinize these policies during due diligence.

Q: Can we capitalize the cost of refactoring or rewriting old code?
A: Generally, refactoring existing code to improve performance without adding new functionality is considered maintenance and treated as OpEx. A complete rewrite of a legacy system that results in a significantly new platform could potentially be capitalized, but this requires careful judgment and documentation.

Q: Do these rules apply to paying external contractors for development work?
A: Yes. The fees paid to external agencies or contractors for development work during the "Application Development Stage" are eligible for capitalization, just like the internal payroll costs. You would capitalize the invoice amounts related directly to building new, long-term assets.

Q: What is a typical 'useful life' for capitalized software?
A: A typical useful life for amortizing capitalized software for financial reporting is 3 years. Some companies may use up to 5 years if they can justify a longer period of value creation. The key is to choose a reasonable and consistent period and document the rationale in your accounting policy.