Neo Tax: Disrupting Hell Week For Accountants and Small Businesses
Long Four Volume #1
Hi all,
Happy Wednesday.
This week I’m excited to bring you the first edition of the Long Four. One of the key values I get from running a tax startup day-to-day is I’m immersed in just about every company looking to start something new in tax. Whether it’s through my investors, friends, or colleagues I’m constantly at the pulse of these companies. Teams and founders pushing the boundaries as it relates to tax is commendable and generally misunderstood in the mainstream tech startup ecosystem.
In June 2020, during the middle of the pandemic, I was on a bachelor's trip to Jackson Hole, Wyoming. I was enjoying my first trip in over six months when I received a message from one of our largest investors. It was about a company called Neo Tax.
I quickly scanned the internet, LinkedIn, and Crunchbase to learn as much as I could about the company. It seemed they were on to something.
Taxes are a pain point for consumers and businesses, and while I am building ModernTax day-to-day there are so many areas where the tax code affects businesses and people’s lives in a negative way compounded with a bad experience. My unique experience includes being an individual taxpayer like 150 million other Americas but also being a startup founder and a business owner trying to do my best to steward the capital that my investors have entrusted me with.
So this week, I am going along with an adjacent tax startup with a mission to help remove the complexity of the small business tax returns process This company is called Neo Tax and the company is starting by putting money back in the pockets of startups and plans to expand into every area of business tax services.
Let’s dive in!
Neo Tax: Your Business Tax Return Should File Itself
While tax day has come and gone, millions of tax returns still sit in the IRS’s que at this present moment dating back to 2020. The IRS itself has a dated and manual process of processing tax returns and although EFILE is quite popular for individuals with the mainstream adoption of tools like TurboTax, many businesses continue to use a rather manual and piecemeal process to file tax returns through accountants, CPAs and tax professionals. Firms still look at tax as an unsexy business compared to other more profitable work like tax planning, bookkeeping, and audit. The technology stack and innovation when it comes to business tax is quite alarmly, for instance over five percent of tax firms in the US still use no software to file business returns.
For businesses, tax returns have always been cumbersome. Even more so for startups. When you are not quite profitable your focus typically is on raising capital, figuring out how you are going to make money, and finding a product-market fit.
Building startups is unlike building traditional small businesses. You hire predominantly technical talent and build innovative products to make people's lives easier. This costs upfront capital and the largest line item is almost always engineering resources. For instance, the average engineer in the Bay area makes $167,187 in base salary.
While startups spend billions in the US on technical talent, also known as research and development costs, historically there hasn’t been a quantifiable way to get any credit for the labor of love and costs that go into building software in the early days. Before you are Amazon, Google, or Apple you have to be a fledgling startup with a few engineers churning away and shipping code that you hope will one day make someone’s life easier.
This drastically changed in 2015 when the PATH Act expanded or renewed several tax credits for businesses. The R&D tax credit was originally enacted in 1981 to stimulate innovation and encourage investment in development in the US but only larger corporations took advantage. In the past few years, startups have been able to capitalize on their largest line item expense by getting tax credits for what they spend on R&D.
While startups can capitalize on R&D tax credits, one thing that has gotten passed over is the actual technology being built to help startups and small businesses capitalize on said credits. While the PATH Act allowed startups to capitalize, the IRS didn’t do startups any favors by making it simple to calculate the credits and in return receive the benefits.
While the ever-evolving landscape of technology and automation has continued to grow, taxes in general, and more specifically how business taxes are submitted to governments, have experienced very little innovation. The question is why?
This week in the Long Four edition we go deep with a company building not only a better way to capture R&D tax credits but a company that is planning to create a fully-automated business tax platform. When this works, Neo Tax can remove tons of complexity from a tax filing process that takes countless hours and costs upwards of $5,000 a year for many small startups; invaluable for those not quite profitable. Plus saving hundreds of thousands a year for large corporations.
Starting a Tax Company
The path that starts with humans plus computers never ends in full automation.
One thing is for sure about Ahmad Ibrahim, he is an all-or-nothing type of founder. In our first meeting for coffee, he was quick to let me know his company only employs one accountant. While other firms building startup tax and accounting software all have in-house accountants and tax preparers — Ahmad has zagged left. He is clear that his company is designed to produce software that automates taxes for businesses, and rudimentary tasks for accounting and tax firms serving those companies.
He got his start in this market by building tax software at a little company based in Mountain View called Intuit as a product manager from 2014 until 2016. He spent those two years grinding away building out a product called QuickBooks Online Accountant which is where he saw the business problem that eventually morphed into Neo Tax three years later. When he pitched the idea back in 2015 internally he was met with skepticism. “This is going to be hard.”
The market of building tax, accounting, and bookkeeping solutions for startups is not novel. We have seen the rise and fall of Scalefactor, there a companies like Bench and BotKeeper that help companies manage their books which has been around since 2010, and there is Canopy Tax which tried to build its tax filing solution that ultimately did not work out but still exists today and primarily sells to accounting and tax firms.
When I ask Ahmad about building tax products for startups and small businesses, he explains that his competitors did not start out saying “Let’s build a CPA firm!” but by default, that is what they have done. Most startups in the tax and accounting sector are just that, glorified CPA firms with engineers. Amhad is not building that with his startup. As of the company’s Series A financing, announced in February, they only employ one accountant or CPA on the team. This team member serves as the brain trust to which they are building their automation engine for tax.
So if Amhad’s goal is to fully automate taxes why has he chosen such an obscure place to start like R&D tax credits? The goal is simple, R&D is a wedge for Neo Tax to not simply acquire customers like others in the space have done. Amhad and his team use R&D tax credits to primarily get access to data which will permit his team to build a model to automate more and more of the tax process for businesses. While dangling free money to early-stage startups has been the go-to market for others, Neo Tax has chosen a more sophisticated approach — they focus more of their time on automation.
In a recent podcast titled Six Levels Down, Michael Lewis highlights a lot of what Ahmad and his team is trying to accomplish with Neo Tax. Lewis highlights the founding story of Athenahealth and how they found the key member of their business by recognizing an overlooked expert toiling in the hospital basement. That person was a medical billing expert that engineers from MIT leveraged to build software for medical billing functions in hospitals. Ahmad’s team is being strategically built with the right dynamics of unearthing all the information needed to automate the business tax process. It also helps that their team is stacked with three PHDs.
What is Neo Tax building?
The entire company’s existence is to automate the tax code. They want to utilize data science and machine learning and apply it to taxes at full stop. This will take some time and it will take accountants getting involved primarily as customers and partners, not as employees within the company.
While hiring countless accountants to pair with engineers is not the Neo Tax way, the human-in-the-loop conundrum with tax and accounting professionals still exists. Currently, the business tax filing process is not automated. The work is done by accountants, CPAs, and tax attorneys so Ahmad and his team are building an accountant’s suite of products in addition to offering solutions directly to startups and small businesses. Everything starts with R&D tax credits. However, from Ahmad’s perspective, anything but a fully-automated business tax filing process is not that interesting.
The product experience
A few weeks ago, I signed our company ModernTax up for Neo Tax and went through the process. My initial onboarding call was with Simon, an onboarding specialist based in Brooklyn. After creating my account and sharing my screen with Simon I was prompted to connect my payroll account. The app leverages a payroll API software product called Finch to connect to my Gusto account, the alternative is Merge. Finch seems to be the leader in this space. For one, Merge runs Google ads when you search ‘Finch payroll’. The advantage of leveraging payroll data is that most accounting firms do not do it, nor do tax firms. Traditional firms barely leverage APIs to access data at all. If I were to switch tax firms or have this service provided by a legacy provider I would still need to source and upload all the information below to get started with a business tax return or tax filing:
articles of incorporation
accounting records
bank statements
credit card statements
detail of asset purchases
depreciation schedules
detail of asset dispositions
vehicle information
With Neo Tax, our company data can be shared securely. Neo Tax can also leverage APIs through bank and credit card statements to find expenses worthy of being included in the tax credit calculation. Firms may connect to Quickbooks, which Neo Tax already does later in their process — but leveraging payroll API products, and products like ModernTax (I couldn’t resist) can make the onboarding experience easier for companies to get started.
After going through the onboarding I received the email below which adds more complexity.
In an ideal world, I would not even need to be included in this process. With Neo Tax, each data source would come together almost magically across a set of third party APIs and at worst my account needs to be looped into access our historical tax records, there would be no gathering of data and/or trying to figure out where all the data is, much less trying to run calculations manually.
Ahmad couldn't give me an exact percentage of the entire business tax process that can be automated right now so I ran my calculations. You could likely automate 50% of the process completely. Neo Tax is doing well by focusing on startups — who generally have simple tax returns and can automate even more than a typical small business with profits. Any business that needs detailed asset purchases, depreciation schedules, detailed asset dispositions, or large fleets of vehicles is likely not a potential Neo Tax customer in the short term.
Four digestible data sources that can be automated
Articles of incorporation and business tax returns: No product automates this verification. We are working on something internally at ModernTax, but there are some limitations to fully automating this process. When a company incorporates, it can be done in many different ways and many different states, so there is no holistic database across all state lines where you can provide some information about a business and definitely get the articles of incorporations. There could be a product here that aggregates these documents from various tools like Clerky, Stripe Atlas, IncFile, law firm portals and the long tail of other sites that manage this process for companies, but it is hard to imagine this being a fully automated process.
Accounting records: Accounting records are already automated and digital — Neo Tax uses an API to connect Quickbooks or Xero and this is a standard feature for startups providing financial services to small businesses and startups.
Bank transaction data: Plaid started in 2012 and continues to dominate where nearly 10,000 companies access bank transaction data. This is again table stakes and already there are multiple vendors here including Plaid, now Stripe, MX, and Finicity.
Credit card statements: These, like bank statements, are fairly standardized with large startups like Brex and Ramp respectively making it easy for accountants and APIs to access credit card statements.
Finishing Up the Product Experience
After I connected my payroll account, Simon then guided me through selecting which employees are product, engineering, or designers. In the case of R&D credits, you only get specific credits for actual work that relates to R&D. Neo has a simple way to classify each employee on payroll with the percentage of time they spent working on eligible activities. This is a large portion of the credit and even a small company can get back five figures with only a few engineers, but it is still a task-oriented requirement. This could be automated long-term, but it can be tricky considering some folks may have a part in the product but not have a product-related role that qualifies for tax credits.
The next step is where I experienced my first setback and that is with connecting my Quickbooks account. This is not a perfect integration across any platforms, so this is currently something out of Neo Tax’s user experience control. As a business owner, I have a few different accounts and I initially connected the wrong account. Unfortunately, there wasn’t an easy way to fix this issue so we had to conclude the onboarding process and Simon needed to report a bug.
After a few days, it was reset and I was able to proceed with another team member to onboard me, Anthony. This was a bit of a snag but I continued with the process and finished after verifying cloud storage and product-building expenses. The below screenshot shows the next step and my account is now in review and will likely be processed in the coming days.
The winning case
Neo Tax has a clear way to make money now and in the future it can make a lot more. As you can see above, they can make $5,893.65 total over the next 12 months as I get my credits deducted from payroll expenses. This is a healthy figure, but there is a time limit on how many years they can monetize the tax credit while companies will file tax returns for the full lifetime of the business.
For instance, speaking with one accountant in my network he advised he has a business client that has been using the same firm to file business and personal taxes since the 1970s. Accounting and tax services have some of the highest LTVs of any other professional service business and Neo Tax needs to tap into that market.
What Ahmad and the team will need to master is how to capture the spending of businesses on professional services related to tax and bookkeeping. They can do this directly with businesses, or by building a suite of tools for accounting and tax firms. Additionally, if they automate the human tasks related to all things business tax and create the “Quickbooks for Tax” their margins can be astronomical.
For those in the accounting industry, there’s a period called Hell Week. They know this as the last week before the tax deadline when businesses are clamoring to get last-minute filings and services. Neo Tax can sit in between the accounting firms and their clients with automated software — and the opportunity is huge with 60,000 accounting firms and two million businesses in the US.
The bear case
The bear case for Neo Tax is around not automating the processes fast enough which could give other more funded players the ability to build mega businesses with accountants and engineers. Pilot is the most funded company in this space. They already have a tax, bookkeeping, and R&D offering under one hood. Neo Tax needs to add the other offerings and automate processes for each which take time and money.
The other side of how Neo can lose is the accounting market is quite hard to sell into. Sure 60,000 accounting firms spend on average $50,000 a year on business tax software, but it is a slow grind to acquire these firms and they are very much hesitant to change. Neo Tax is using partnerships to get businesses clients but there is a long tail of partnerships that are needed to acquire accounting and tax firm partners and clients so there will likely need to be a sales cycle.
On the client acquisition front, it is also important to note the biggest splash in the R&D tax credit space is Mainstreet which used the first product as a wedge to acquire startups directly by advancing the tax credits which included money in startups’ bank accounts. This caught major tailwinds and led to Mainstreet raising a $60 million Series A in March 2021. Mainstreet has slowed down and announced layoffs of over 30% of their staff last week. Neo Tax may have to become more involved on the financing side to get more buy-in as their fees are hefty considering you still need to pay to have your tax return filed at year-end.
Lastly, the complexity of automating the tax code sounds amazing until you consider how often it changes. The IRS is influx and as previously mentioned, there are 15 million returns unprocessed dating back to 2020. If the process changes drastically, and once Neo Tax has spend time and resources automating the current business filing process, they could have to rebuild bits and pieces. It is not like a typical software business where you build it once and you can get repeatable scale. There are no economies of scale, at least not now. There is nuance and complexity which Neo Tax will have to figure out.
Final Call
In the short term, the big opportunity for improvement is in the ease of onboarding. The fewer hours business owners have to spend interacting with their accounting and tax professionals the better. With Neo Tax at its full development, taxes are being filed automatically while companies receive R&D tax credits without ever having to lift a finger. Getting thousands of startups onboarded with the R&D tax product can quickly transition to other tax-related services. Additionally, embedding these products into accounting and tax software can create tailwinds and a huge market opportunity. When I spoke with Jay Ganatra, co-founder and managing partner at Infinity who led Neo Tax’s Series A round, he was excited about the following:
Building software where no humans are needed in the loop can increase margins substantially in comparison to other models.
The go-to-market strategy is where there is a group of businesses that Neo Tax can be put in front of and be replicated — their first large partnership is with startup business bank, Mercury
Accounting firms use Neo Tax to get more clients which in turn helps improve the product over time.
These three can create massive value and that is exactly how Ahmad thinks about it when I asked how he gets the company to $100 million in revenue. He screams, “Every business has to file their taxes!”. Beyond that Ahmad believes Neo Tax can charge more than competitors while using fewer humans to create a better experience.
This is a Sponsored Long Four and you can read about more of my process here. If you are building a startup or are an accountant you should get to know Ahmad Ibrahim and his Neo Tax team.
I will continue to write about companies that I both use (we are customers of Neo Tax), would invest in, and generally think have a huge outcome potential.