May 2018

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A well chosen board: collective wisdom that will will take you places.

Do You Really Need a Board?

Legally, every company is required to have a board of directors.  It could be just one person (i.e. you), but building a well-functioning board is an opportunity to increase your startup’s chances for success.  The board is responsible for authorizing major decisions like senior executive hiring and compensation, issuing debt and equity (including stock, options) and approving budgets/strategic plans, major expenditures and significant transactions.

Many founders I’ve met are focused on their percentage ownership in the company as the primary measure of control, with 51% often the magic number.  But the reality is that very few decisions require a shareholder vote – generally, raising money or selling the company.  As noted above, far more decisions (including those that require a shareholder vote) require board approval, making your board at least as, if not more, important to controlling the fate of the company.

A good board helps you refine your strategy, improves your decision-making and adds stability to your company.  It should also help you recruit senior managers, secure customers and partners and raise capital.  Board members can and should make introductions to relevant parties and sometimes help you close the deal.  Having the right people on your board also increases your credibility with these parties, allowing you to punch above your weight.  You can use positions to attract highly-experienced talent that would otherwise not be interested, available or affordable.

How Do You Build the Board?

The ideal size and composition of your board can and will change over time depending on the stage of the company.  As a general rule of thumb, smaller is better and an odd number is often preferable so there is no potential for a tie vote that is the same as a “no” vote (in practice, this is quite rare, however).  Given the importance, be very thoughtful about who you add to your board.  Each board member should add some unique value or perspective and be able to work effectively with the other board members and the senior management team.

Initially, just you and/or your co-founder is probably sufficient to make sure you can move quickly and get your company set up the way you want.  The CEO should definitely be on the board and lead the meetings.  If the founder is not the CEO, it may be appropriate for him or her to have a seat as well, but beyond that I don’t recommend having anyone else from the management team on the board.  They will pretty much always vote with the CEO and don’t bring much fresh perspective.  The remainder will be made up of investors and independent “outside” directors.

Often, your board will expand or change each time you raise a round of financing.  Investors should hold seats that are roughly proportional with their ownership of the company.  For example, if an investor (or group/series of investors) owns 20% of your company, then one seat on a five-person board is appropriate.  In order to maintain this relationship, early investors may need to give up their seats to later investors.  Smart investors bring a lot of value to your board given that they have broad experience with similar companies and business models as well as relationships with industry players and potential follow-on investors.  That said, the marginal value of adding additional investors to your board goes down quickly and investor-dominated boards are not ideal.

Your outside directors are a tremendous opportunity to add talent and guidance to the company.  Given the math below, it makes sense for the early outsiders to be people you know and trust so that you can rely on them to not only help guide the company but to be aligned with your vision should there be critical early decisions to be made.  That said, resist the urge to appoint them based solely on the reliability of their vote and instead pick people who bring real industry knowledge and contacts to the table.  As the company grows, you will likely add outsiders who lack a personal connection, but if you choose individuals with wisdom and integrity, you can be assured they will act in the best interests of the company and its shareholders (including you).  This may not always be in your best interests as a manager, but this needs to be OK as your goal should be to maximize the value of your equity not to protect your compensation or perks.

See below for the ideal board based on each stage:

Resist the urge to expand your board beyond seven people until you are much larger or publicly-traded as it makes scheduling and decision-making more difficult.  One way to accomplish this goal is by appointing “Board Observers” who have the right to attend meetings and receive information but don’t have a formal board seat/vote and/or by allowing people (e.g. the larger management team) to attend meetings by invitation.

How Do You Compensate BoD Members?

In an early-stage company, it is generally not necessary to compensate management, founder or investor board members.  Each of these individuals typically already earn cash compensation based on their management roles and own a meaningful equity stake in the company.  Some companies provide a small stipend to their outside directors (often paid on a per-meeting basis) but the primary compensation is usually via participation in the management equity plan.  For an early-stage company, each independent director might receive 0.5-2.0% of the company, which gets diluted over time.  The company should reimburse the directors for their out-of-pocket expenses incurred while attending meetings or otherwise discharging their responsibilities.

The bottom line is that a good board makes you more effective and increases your company’s probability of success.  A bad board not only does the opposite but can make your life miserable.  Be thoughtful about how you assemble your board and seek the advice of experienced mentors and advisors to ensure you do it right.

Now that you’ve built your ideal board, stay tuned for next month’s article on how to manage it…

Photo courtesy of Christopher Michel.

Learn to recognize if you’re ready to move to smarter accounting.

Co-written by DJ Marini, Bobby Davidorf and Ardy Esmaeili

Smarter accounting is simply accounting that helps you stay smart. The stage at which your company is, influences whether you are ready to move to Accrual Accounting, which is a better method for financial reporting and control. This is because accruing reflects the realities of a growing business better than cash accounting and positions your company ahead for the next stage. Public companies, for example, have no choice, they are required to use the accrual basis for accounting.

First let’s define what such an accounting-sounding term means. Accrual Accounting is an accounting method that records revenues and expenses when they are incurred, regardless of when cash is exchanged. The big advantage of an accrual system is that it can provide better information for management decision-making. The disadvantage is additional accounting costs and a diminished ability to show less expense and more profit just because you pay vendors late (which is actually a good habit to avoid!)

Sooner or later, your startup will reach a stage in which using an accrual basis for accounting can help you grow smarter. In this article, we explore five signs that can point you to the fact that it may be time to shift to this method of accounting for revenues and expenses.

Five signs that indicate your startup is ready for accrual accounting

In the ideal world, all companies should choose accruing from day one, as it is a method that makes you more disciplined and gives you a more accurate and realistic financial view of your business. But startups never start in an ideal world, and many begin by using the cash method and eventually change. These are the five signs to be aware so you know when you’re ready.

1. Time

Most small companies begin by having a vast majority of their transactions on a cash basis. There can be significant clean up work to match income and expenses to the proper period, and when the company is too small, this is a cost that may not be justifiable. It used to be that you would record all your bills/payments (made via check) and invoices/receipts (received also via check) and then at the end of the month reconcile to your bank account. With the proliferation of cloud accounting systems, which integrate with bank and credit card data, the model has flipped to one where transactions are initially posted to the accounting system based on the bank and credit card records, and then the source documents are often used in small companies without an accounting process to adjust the cash-based entries.

Almost all startups move to an accrual basis once they start getting prepayments from customers for services, including online services, they provide. This is what eventually happens in many current tech business models, and when this is so, accrual is the right solution: it lets you use the money received without paying taxes on it, and recognize income (revenue) when the obligation (i.e. service delivery) is completed.

2. Stable and predictable cash flows

A common barrier for accrual is that unstable cash flows force companies to use new cash to pay for old expenses. We’ve all been there: you finance your operations by delaying payments to suppliers until you have the cash. In a way, this is the intuitive and often times necessary way to operate for small companies. However, doing this while accounting on a cash basis can diminish the usefulness of you financial statements, because it does not reflect the true state of your business.

A common problem is you let payables build up over many months while trying to raise money, then you raise money and pay off a bunch of old expenses. But when you want to budget for the future with your new cash, you don’t have a good historical record of the timing of what was expensed, because a big portion of the expenses were lumped into the month when the money came in.

If you have lived through the example above, now that you have money in the bank and have experienced the struggle first-hand creating projections without a meaningful historical record, it may be a good time to move to an accrual basis. With cash flows now more stable and predictable, you can move to accrual accounting and get in a position to better understand your business going forward.

3. A venture round

For a potential investor to understand the nature and the realities of your business through your financial statements, it will be necessary to move from a cash to an accrual accounting system. This is because cash accounting makes for imbalanced accounting, and therefore may distort your true cash flow and the nature of your expenses. If you’re venture-backed or planning to be, it is always smarter to be on accrual basis or to move to it quickly once a round is on the horizon.

Eventually, your VCs will require this change, either right after money comes in, or, if your cash method distorts reality beyond their comfort zone, they will demand it before the round. This can mean one thing every CEO dreads: slowing an investment round while your accountants change your accounting system. Sometimes this takes even longer, as once accruing is on, modeling and forecasting will need to be re-adjusted based on the new numbers. If venture money is on your near horizon, do not miss this sign and move to Accrual Accounting before they ask you to.

4. Financial audits on the horizon

The fourth sign that indicates you may be ready to move to Accrual Accounting is if your company is or will be subject to financial audits. These are quite common when outside investors come in and want a clean slate in terms of understanding all business liabilities (for example, to ensure their money goes to growing rather than paying past debts). Additionally, when there is potential M&A activity, accrual accounting will make your life easier by reducing the friction of any transaction for your company, and often is a requirement for large acquirers.

In the United States, GAAP (Generally Accepted Accounting Principles) is the standard for preparing and reporting financials statements and thus, it is required by outsiders who need to understand your business. When an audit is performed, a company’s revenue and expense recognition has to reconcile with GAAP, which means accrual accounting method needs to be applied.

5. You need serious modeling and financial management

The final sign that indicates you’re ready for Accrual Accounting is your own need for useful financial statements that enable your company to do accurate modeling and sound management. When your team is ready to manage the business using financial statements that reflect the reality and the true financial health of the company, an Accrual Accounting method trumps a cash method as it provides an accurate view of the drivers of cost and revenue.

Unfortunately, it is quite common for small companies that use cash accounting method to run out of cash before they even realize it, adding a level stress and uncertainty that could have been easily avoided. Accrual Accounting can give you and your team a real picture of your resources and of your financial responsibilities through time, enabling you to plan with the confidence that the numbers reflect reality. It also allows businesses to manage and plan their financial activities and future in real time instead of “after the fact”.

You will be there no matter what

Eventually, all companies move from cash to accrual as they grow. A move from cash to accrual should be part of the strategic advice you get when your company is ready for a CFO. Before that, an approach where the accrual basis is used partially – it can be done, just ask us! – can be a way to avoid the full costs of the effort, get started on this method of accounting, and attain a better position for sound financial planning, faster investment and accurate modeling for the long-run.

Photo courtesy of Christopher Michel.