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Make sure your office space comes with no painful future costs.

Photo courtesy of Christopher Michel.

I recently visited with Gabe Chao, Managing Director of Cornish and Carey Newmark. Gabe is former 13-year real estate attorney who represented some of the largest companies in the world, nowadays he specializes in working with startups on their real estate needs. Prior to Burkland Associates when I worked at Autodesk, the company’s real estate needs were part of my role, so Gabe and I discovered we had many shared experiences when it comes to helping startups with strategic advice.

A year or so ago, Gabe wrote an insightful article giving sound advice to startups when it comes to real estate decisions. Many times, these decisions feel as minor decisions with no long-term implications, when in fact, sometimes they can profoundly affect future choices for your business. I found his article useful and relevant for the type of startups with whom Burkland Associates works.

Specifically, Gabe focuses on five things to consider when management teams make decisions about office space: exit strategy, alterations, operating expense passthroughs, real estate taxes and flexibility.

Here are these five issues expanded. I hope you find this strategic real estate advice from Gabe useful.

Exit Strategy

Arguably the most important issue for a startup to address is the exit strategy (most often through a sale of the company). During my legal career, of the thousands of term sheets that came across my desk, not once was this issue adequately addressed.  Typically, the issue gets glossed over or left out of the term sheet entirely. This (i) results in many leases not including adequate protections for the tenant, (ii) ends up costing the tenant more in legal fees (even if the attorney understands how to negotiate for these protections, and I have run across many that don’t), and (iii) could result in a landlord holding up a multi-million (or billion) dollar deal).

This is the proverbial tail wagging the dog. I would estimate that 99% of tenants and their representatives don’t consider this issue, and simply having language to throw into a proposal doesn’t solve the problem. Understanding how to request the adequate protection in the term sheet (and ultimately the lease) is most important. In my personal experience, sophisticated owners (especially institutional owners) have never refused this request once they understand the business and legal reasoning.

Alterations

One way that landlords like to “handcuff” tenants to limit tenant leverage during lease renewal negotiations is to include onerous provisions in their leases requiring the tenant to restore their space to a specified condition. Landlords know that if their lease agreements make it extremely cost prohibitive for a tenant to move, even if lower rent alternatives exist, then the tenant’s threat of leaving (the tenant’s only real leverage) is diminished. By understanding how to navigate this issue, I was recently able to help a client save over $1.5 Million immediately by having the landlord agree to remove the tenant’s restoration obligations out of an existing lease during lease renewal negotiations. This was not a potential savings, but quantifiable immediate savings.

Operating Expense Passthroughs

Tenants typically focus on the base rent figures because those figures are easy to compare against other options. However, tenants have additional payment obligations other than simply the base rent, and landlords know how to manipulate those obligations in their form leases. The parties typically wait for lease negotiations to address these issues because (i) brokers typically don’t understand how to deconstruct the standard lease provisions to address these protections for the tenant, and (ii) it takes more time to push for these during the term sheet phase (when brokers simply want to close and move on after identifying the space).

However, by waiting until the lease document phase rather than negotiating during the term sheet phase, the tenant loses leverage and it also will cost the tenant much more for the attorneys to negotiate rather than addressing these issues in the term sheet phase. For any sizable transaction, I negotiate these tenant protections directly into the term sheet to maximize leverage and save the client thousands in legal fees; but most importantly, achieving the OpEx protections ultimately can save a company hundreds of thousands of dollars over the term of the lease.

Real Estate Taxes

In a typical “full service” office lease with a base tax year, landlords can achieve a windfall and “double dip” from the tenant if the landlord successfully appeals real estate taxes during the base tax year. Landlord enjoys the tax reimbursement, but with a lower tax base year (and tenant paying the increase in taxes above the base tax year amount), it would be the tenant who ends up paying significantly more over the term of the lease. Most brokers don’t know how to address this issue in the term sheet.

I have seen some attempt to address this issue, but when pressed for an explanation from the landlord during negotiations, cannot articulate the rationale and end up looking silly trying to ask for this (and end up not getting it for the tenant). I not only understand how to address this issue, but have even had a client’s real estate attorney (a partner at one of the largest law firms in the world) ask me to actually draft the protective language during lease negotiations because she felt I had a better understanding.

Flexibility

A main concern for a startup is business uncertainty. The company does not know where it will be in 6 years, let alone 6 months, but landlords are trying to lock in tenants for a longer term while the market experiences historically high rental rates. Brokers rarely try to push for a shorter term or consider other alternatives because brokers get compensated more for longer terms and more square footage. Sadly, this is a pervasive practice in the industry. I help clients exhaust efforts for more flexible lease terms, even if it means lower compensation in the short term. For example, in one recent transaction, my client’s previous broker advised that anything shorter than a 5-year term would be nearly impossible in the current real estate climate. However, I was able to help my tenant client negotiate a short term lease, and also a “rent phase-in” so that the tenant paid rent calculated based on a lower rentable area during the first 18 months of the lease term, which would only later increase and be calculated based on the actual larger square footage to allow the tenant to grow into the space.  This allowed the company to free up valuable capital during its growth phase, rather than having it tied up in rent.

ICOs: A promising innovation, but pitfalls abound. Photo courtesy of Christopher Michel.

Partly because of Burkland’s roots in Silicon Valley and partly because we tend to focus on newer, venture-backed companies, many of the questions we’re asked by founders and CEOs have to do with new ways of doing things. Over the past few years, nothing has captured the imagination of the startup business sector quite like bitcoin and blockchain as a whole. Entrepreneurs want to know how they can take advantage of this technology for their companies and their products. As strategic CFOs of these companies, we’re being asked frequently about cryptocurrency in general and initial coin offerings (ICOs) in particular.

Blockchain in two paragraphs

In very simple terms, blockchain originated as a massively distributed online system that validates, clears, settles and records bitcoin transactions. Since inception in 2009, blockchain has evolved to include both private and public systems that can simultaneously secure, chronologically verify, validate and record the movement of any asset from one party to another.

Why the term “blockchain”?  Transactions in the system are pooled together into a group, or block, from which alphanumeric information is gathered and combined with data from the immediately preceding group to form a complex and unique math problem. This problem is then presented to the respective blockchain’s distributed network, which uses its collective computer power to find a solution. Once the math is solved, all the transactions in the block are verified, the block in question is “sealed,” data is taken from it to form the basis of the next block, and the process starts over again – thus creating a linked “chain” of blocks.

Blockchain’s role in money

At first, bitcoin and its blockchain were focused on the use of cryptocurrency as a digital medium of exchange and thus the  potential to replace or compete alongside traditional currencies and the legacy banking networks that support them. But over the past few years, attention has pivoted to the practical applications of blockchain technology. This is because blockchains can securely and permanently record any transaction without the use of third parties. This disintermediation of middlemen adds up to very low transaction costs when clearing and settling transactions, and the technology underpinning digital ledger technology provides the ability to program “smart” contracts that can programmatically execute without the need for either side to trust the other. At scale, these capabilities are going to be particularly useful in a very wide range of industries – finance, real estate, retailing, banking, insurance, logistics, healthcare, etc.. Indeed,  it is very possible that every major corporation in the world will be using this technology (even if their customers don’t know it) in some part of their business within five years.

A common denominator in any blockchain is a token, or coin, that can act as an incentive for the network’s participants to solve for the blocks that keep the whole system humming along. A blockchain’s tokens are the fuel that establishes, verifies and records a chain’s transactions, so no token = no chain. This is where Initial Coin Offerings – ICOs for short – come in.

Blockchain role in raising capital for your startup

Blockchain startups quickly seized that the sale of these tokens – or coins – was a unique way to raise capital. Typically, an ICO involves the online sale of a pre-determined number of tokens for use or utility inside a blockchain ecosystem, usually before it is built. The startup thus raises capital without technically selling equity or incurring debt, and can fund the highly technical work necessary to build, test and deploy their system. These offerings have proven immensely popular, with the post-ICO value of some tokens quickly skyrocketing thousands of percent in secondary trading.

However, there is a catch. ICOs don’t click neatly into legacy securities laws and have blossomed primarily because they have operated outside the bright regulatory lines designed to protect investors, such as registration with the SEC and regulations against general solicitation. ICOs have been pumped mercilessly on social media, and since one can take part in an ICO with the mere swipe of a mobile phone screen, hype has quickly gotten far ahead of substance. Unsurprisingly, regulatory agencies worldwide are now catching up, taking a very close look at whether these tokens are actually securities in the issuing company, and whether their sale to a random unaccredited investor via a social media post is actually an unregistered offering of those securities. For its part, the blockchain community has argued vociferously that most ICOs aren’t equity at all, but just the pre-sale of digital usage rights that can be redeemed later for some level of utility within a blockchain. Both sides have a point.

The incredible appreciation of these tokens in secondary markets on crypto exchanges has heightened the SEC’s interest, as has the colossal amounts of capital being raised via ICO. ICOs have already brought in more than $13 billion YTD across 537 ICOs globally, according to Reuters, nearly double last year’s $7 billion and a far cry from the $1.3 billion in early-stage and seed-round funding from VCs so far this year. As far as capital formation goes, this clearly a whole new ball game.

Blockchain ICOs: A blessing and a curse

From our perch as on-demand CFOs, ICOs remain problematic because they are still in the regulatory grey zone. Beyond blocking access from US-based IP addresses, ICO issuers typically do little or no AML/KYC vetting, and don’t require anything close to accredited investor attestation. Investors in ICOs, meanwhile, have few rights and are typically not provided any company financial information prior or subsequent to the ICO. To top it off, marketing of ICOs remains wholly unregulated, and although the legal community has rapidly adopted capital structures from the Regulation D and crowdfunding worlds, concerns remain that these offerings will ultimately run afoul of SEC regulations concerning how one attracts investors.

And while more mundane, the accounting of successful ICOs remains murky, since the jury is still out on whether the proceeds from an ICO should be taken onto a company’s financial statements as equity, debt, or even deferred revenue from sale of a product. All have thorny issues; equity is out if the SEC deems the token a security, debt is a reach given the way tokens and blockchains work, and booking ICO proceeds as deferred revenue – potentially the most apt description from an accounting point of view – is problematic because secondary appreciation of the tokens could result a tremendous hit to the balance sheet when the future performance obligation created by the tokens is valued at its cash redemption value.

Hold your horses

We’re excited by the innovation in capital formation that ICOs represent. For the moment, though, they come with major implications for companies (and their management teams) not only tactically, i.e. the SEC might want to talk to you, but also strategically should a future round of financing be complicated by the consequences of using a structure few outside of the crypto world fully understand. Tread carefully and thoughtfully when considering an ICO, and don’t hesitate to contact us at Burkland for an unvarnished analysis of the pros and cons of this type of financing for your startup.

Don’t get trapped by your stock plan.

The purposes and benefits of equity incentive plans for private emerging companies are well covered in the literature and on the web. Therefore, in this article I will highlight some of the problems that organizations encounter when trying to optimize equity incentive plans for their employees.

The typical equity incentive plan provides for the granting of stock options to purchase common stock to employees, board members and consultants.  Incentive Stock Options (“ISOs”) may be granted only to employees, and have some favorable tax treatment potential vs. non-qualified stock options, which are granted to board members and consultants (and some times to employees in certain circumstances).  Many plans also provide for restricted stock grants, which allow the grantee to purchase their share allocation upon the grant, but with the company’s right to buy back the shares that have not vested, typically consistent with the stock option vesting schedule.  The benefit of restricted stock is that the holding period for capital gain purposes may begin upon the grant date, rather than when option shares are actually purchased over a vesting period, if the holder so chooses in a filing called a Section 83(b) Election.

Even in a well-constructed equity plan, however, there is the potential for companies to take certain actions which could get the grantees, the organization, or both in a financial pickle.  In my experience the principal issues involve common stock valuation and the use of restricted stock.

Common Stock Valuation

Stock options must be granted at a minimum of fair market value (FMV).  Failure to do so will subject the grantee to an ordinary tax on the difference between the strike price and FMV, plus a 20% penalty. Since a private company’s stock is not readily tradeable on an established securities market, the IRS requires that the FMV of that stock be determined according to a methodology know as a 409A valuation, and that the valuation be documented in a written report.

It is theoretically acceptable for a 409A valuation to be performed internally, and this may be tempting in order to save the cost of an independent appraiser.  However, most tax advisors believe that independent trained and experienced valuation professionals are the only safe option.  Such valuations have become less costly over recent years, and some professionals are offering this service on a monthly subscription basis.  Options should be granted within 12 months of the valuation, and valuations should be performed more frequently if the company has achieved milestones that would increase its value.  A valuation should definitely be completed after any new equity financing.

Use of Restricted Stock

Because of the additional complexity of administering restricted stock, most companies have limited their use to senior executives, although I have seen cases where they were offered to all employees.  The biggest downside to restricted stock is that they are no longer “options”; that is, the full exercise price of the shares must be paid upfront, without knowing the ultimate realizable value of the shares.  To offset the negative cash flow aspect, some companies have either loaned the employee the full purchase price of the shares, or given the employee a bargain purchase price and loaned them the amount of the tax due for the difference between the strike price and FMV.  Neither of these alternatives is advisable.

First, in order for a loan given in connection with a stock grant to not be considered a taxable event, it must be “full recourse”; that is, the loan is due and payable on a known timetable and is due for the full amount of the loan, plus interest, regardless of the value of the stock.  So, if the loan becomes due when the stock value has decreased (and is often illiquid), then the employee is on the hook for the full balance.  The company may be willing to forgive the loan at this point, but the amount of the forgiveness then becomes an ordinary income taxable event.

Another workaround would be for the company to repurchase the shares from the employee in order to reduce the balance of the loan.  However, since the current FMV of the shares has likely reduced from the original grant price, the loan would not be fully offset, or any premium paid for the shares by the company would subject the employee to an ordinary gain.  Nevertheless, under these circumstances it probably makes sense to repurchase the shares at FMV to minimize the loan balance.

To summarize…

In order to avoid negative tax consequences, or nasty surprises later (which often come to light at a liquidity event or the winding up of the company), my informal advice would be to always grant options at an FMV based on a current, independent 409A valuation, be very careful about the use of restricted stock, and never provide loans to support a restricted stock grant.  Finally, always consult a qualified attorney before implementing an equity incentive plan or considering any of the actions discussed above.  The qualifications you should look for include technical and legal expertise, as well as the real-world experience to understand what could go wrong.

 

Photo credit: Men in Bramhall stocks 1900. Public Domain.

Make sure you understand what lies underneath the data you use to make big decisions.

You’ve heard it many times and in many different contexts: garbage in, garbage out. This universal truth can have serious consequences for CEOs of young companies when it comes to financial reporting. The devil is in the database that provides the data that affects the numbers you rely on to take all kinds of decisions – from sales forecasting to modeling to pricing.

Sound financial planning requires data science to ensure data definition, design and governance support data analysis and ultimately, reporting. A CFO must understand more than their ERP (Enterprise Resource Planning) system such as Quickbooks or NetSuite. They must understand numerous data sources, how they relate to each other and how to reconcile them, because at the end of the day, a spreadsheet as a reporting tool will only be effective with proper data definitions and a solid database design.

Good CFOs start with design

To do proper reporting for bookings, revenue and SaaS metrics, it is critical to first design the data sources. I can’t understate the fact that database design is a critical step of any serious financial planning and analysis (FP&A) that can provide executives the knowledge then need to make decisions about their startup. If the data is poorly structured, incomplete, or inaccurate, the tools for analysis (i.e. a spreadsheet, Looker, SaaSOptics, etc.) will be at best limited in their usefulness; at worst, it will provide wrong information that can lead to poor decisions.

The Devil is in the Data

For example, let’s focus on SaaS bookings – whose reporting  often seems to be controversial within the organization. To design an accurate spreadsheet to reflect sales, your CFO needs to determine, first, what is the definition and data source for a booking. For many startups, the data source is the Salesforce.com opportunity (either maintained there or replicated in an ERP system such as Zuora or SaaSOptics or held in a reporting database such as Redshift). The key here needs to be a total agreement on the database object or table that defines the booking. If you select the Salesforce opportunity, and export to Excel, then you can setup the opportunity to include the data element (field on record) for type with the possible values of (new, expansion, renewal or churn) and then use that data element or column in Excel to filter or build a report or a pivot table.

Another approach for designing the bookings database for SaaS could be to use a more granular level of detail, such as a contract or a subscription. Then, if the team needs to query the contract, they need to determine what is the definition and data source for a contract. In most Salesforce configurations, there is not a contract object – this is where sound design comes handy. Your CFO can create a contract object in a subscription management solution such as Zuora, SaaSOptics, and even on an Excel spreadsheet.

If you are creating reports based on the contracts or subscription, then you will need to ensure that your data table includes the following: a) common reference such as a customer ID, b) unique contracts or subscriptions id, c) subscription data such as start date, end date, item, amount, etc. With this data table, you can apply logic to determine if new, expansion or renewal. For example, if there is a subscription with a customer ID and new prior subscription (use start and end dates) with the same customer ID, then the subscription is new. If the start date is coterminous with the end data of a subscription with the same customer ID, then it is a renewal.

If there is a period with no revenue but revenue in the same period, then the amount of the previous period is churn. It should be obvious that a proper data structure will make the logic easier and you didn’t ask about re-activations (contract ends, there is a lag period, contract begins at a later period….is this churn, new, renewal or none of the above such as re-activation).

CFOs should offer Strategic and Tactical Skills

In a technology startup, CFOs are needed for many strategic efforts such as long-term planning, raising capital, assessing buy- and sell- side acquisitions, and hiring top talent. However, at times, many startup CFO’s must also lead data design and analysis. Often times, it is data and financial insight that helps to ensure success in the strategic efforts.

Photo courtesy of Christopher Michel.

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.

A trove of profitable information may be hiding under your horizon.

Photo courtesy of Christopher Michel.

Are you overlooking a revenue opportunity?

In the past you could identify a location, sink a well and black gold would flow from the ground.  Today, all you need to access these riches is to identify data sources that already exist in your business and drill down into it, or information you could have access to, but have yet to collect.  With a bit of analysis and help, you can create new revenue streams by monetizing your un-tapped data, by thinking of it as “liquid gold,” while creating rules of engagement with your customers so that all this is transparent and safe for everybody.

A lesson from Facebook

Facebook founder Mark Zuckerberg, who hopefully just learned the hard way that data presents huge opportunities provided you use it responsibly, recently described his business before Congress as a “community” (with 2.2 billion members), a vehicle to connect people all over the world.  In reality, Facebook is a data / advertising company whose currency is your information. It collects hundreds and sometimes thousands of data points from its users, aggregating and monetizing them by offering targeted advertising to various companies while maintaining control over them and making a fortune!  Mark’s net worth is currently $66 billion – all built with my information and yours.

You too may be sitting on a wealth of untapped data or the opportunity to collect it.  Most of us don’t like to stray from our core businesses; however, in today’s environment it’s imperative to grow and diversify. Plus, having this additional revenue stream may allow you to give your customers lower prices, just as Facebook can afford to be free as long as it can monetize information collected from their customers.  Mining existing data (customer lists, buying patterns, preferences, etc.) or creating simple mechanisms to capture it (apps, websites, discount and loyalty programs, collection of email addresses that access Wi-Fi at retail locations, etc.), enables you to collect, aggregate and monetize it.

Lose your fear of data

Many companies are reluctant to monetize the information they control for fear of breaching customer confidentiality.  However, if the problems Facebook is facing can teach us a lesson, data collection and data use can be part of a ‘covenant’ with our customers where they get some benefit in exchange for the rights to use their information to generate revenue via ads. This, when done properly, allows a company to maintain control over the data without losing customer trust.

One way to monetize your data is by focusing in your core industry and utilizing it to enhance your sales or offerings to assist industry partners in enhancing their sales, at a price.  Another is to think out-of-the-box and look at other verticals that may be interested in reaching the companies or consumers in your data base. The one thing to remember is that the goal is to facilitate the marketing effort while maintaining control over your data so that your customers’ trust is not weakened by having third parties misuse their information – which has contributed to Facebook’s current trust problems.  Ensuring this takes considerable planning and dedicated resources but enables you to continuously monetize data with confidence.  By following simple rules of engagement on third-party use of your information, each time a vendor needs to initiate a new marketing campaign, you create a new revenue opportunity without compromising it. This is the Facebook model: each bite of the apple generates additional revenue for your company and enables you to offer your customers lower prices or even a free service!

Your CFO can help

Like oil, data can be a blessing or a curse, depending on how careful you are when monetizing it. One of the ways a strategic CFO can help you is by applying some out-of-the-box thinking so that you can identify and collect it in a way that maintains your customers’ trust and monetize it with confidence.

“There’s nothing to fear but fear itself.” – Franklin D. Roosevelt

Photo courtesy of Christopher Michel.

Recently, our team read a fantastic book – Getting Naked, by Patrick Lencioni – that explores the journey from superficiality to deep empathy that amazing human relationships usually take. Amazing consulting relationships, being just one kind of human relationships, also follow this journey, starting as professional engagements and becoming meaningful relationships of loyalty and trust. The book explores why.

It turns out that consulting relationships that stay superficial in the name of looking “professional,” never move a consultant from a vendor to a trusted partner. This is a book that goes deep into the simple but powerful insight that growing a relationship – any relationship – is about becoming vulnerable. For a consultant, this openness results in a better understanding of the “whole,” enabling us to understand their business better by understanding their motivations, their strengths, their weaknesses, in short, their true needs. It is about a humble approach to consulting where you open up completely and show your human side. It is in this zone of humility and openness that loyal and sticky relationships can develop. The book is a call to open up by facing three fears that prevent us from building deep relationships.

The concept is surprisingly unsurprising: professional relationships are human relationships. There is no way around it. Like all lasting human relationships, professional ones also move from the superficial to the deep, as those involved open up to fearlessly expose their humanity with all the good and the bad that comes with it. It is this fearlessness that is the basis for the insight of this great little book.

Lencioni brings home this need for fearlessness that turns into trust and loyalty on both sides by exploring the three specific fears that prevent consultants from becoming trusted partners of their clients.

  1. Fear of losing the business

Like in dating, if you’re afraid of losing your partner, you will behave in a way that actually gets you there. Your relationship will stay superficial because you will avoid the “difficult” conversations that make a relationship more intimate.  In regards to consulting relationships, Lencioni puts it brilliantly: “ironically, though, this fear of losing the business actually hurts our ability to keep and increase the business, because it causes us to avoid dealing with the difficult things that engender greater loyalty and trust with the people we’re trying to serve.” This happens, he explains, because clients can “smell” that fear of losing their business makes us put our interest in keeping it before their interest in being helped.

  1. Fear of being embarrassed

This year marks the 50th anniversary of one of the most acclaimed movies of all time: 2001: A Space Odyssey. In it, pride causes HAL, an AI-enabled computer, to assume it is infallible, pushing it to eliminate all but one of the crew members, derailing the mission it was trying to maintain intact. It is pride, Lencioni writes, that keeps consultants from asking questions that may make them look ignorant or stupid. This leads to the second fatal fear in his book: the fear of being embarrassed. Nobody can look smart 24/7 in a deep relationship, vulnerability, which builds empathy, needs to go through the trial and error of making mistakes, sharing stupid ideas, and facing errors. In my experience, it is how one reacts to errors that shows a client what one is made of. A client will fire a consultant who tries to save face before firing one who owns their mistakes and problem-solves to correct them. As in personal relationships, wanting to be seen as smart is a turnoff. Smart people don’t yearn to be seen as so.

  1. Fear of feeling inferior

This final fear that prevents consulting relationships from taking their journey to loyalty and trust is also based on pride, but on a different kind. Lencioni writes that the “fear of feeling inferior is not about our intellectual pride, but rather about preserving our sense of importance and social standing relative to a client.” Interestingly, he reminds us that the word “service” comes from the same root as “servant,” and outstanding consultants who build loyal relationships overcome their need to feel important by serving, or in the author’s words, doing “whatever a client needs them to do to help them improve, even if that calls for the service provider to be overlooked or temporary looked down on.”

At the end of his insightful book about loyal relationships, Lencioni provides a practical list of actions that outstanding consultants can take to overcome the three fears and build a deeper relationship that grows roots. These practical actions are the following:

To fight your Fear of Losing the Business:

  • Always consult instead of sell
  • Give away the business
  • Tell the kind truth
  • Enter the danger

To fight your Fear of Being Embarrassed:

  • Ask dumb questions
  • Make dumb suggestions
  • Celebrate your mistakes

To fight your Fear of Feeling Inferior

  • Take a bullet for the client
  • Make everything about the client
  • Honor the client’s work
  • Do the dirty work

At the end of the day, Lencioni reminds us “we all have weaknesses, and if we try to cover them up, we’ll probably put ourselves in a situation of having to do more and more of what we aren’t good at.” Nurturing trust and loyalty in a consulting relationship requires us to put down our egos so that we become vulnerable by showing – not hiding – our weaknesses, by showing our humanity to ultimately generate the empathy we need for our relationship to go deep.

Become fearlessly human in your professional life! Realize that you can’t conveniently put your humanity in a drawer in the name of a “professional” relationship, because at the end of the day, all relationships are human.

Craft a sticky story of your company’s journey.

Photo courtesy of Christopher Michel.

Last week I had a Monday morning meeting with the founder of a pre-seed, self-funded company. We had been collaborating for almost a year and he told me that they had their first pitch competition in three days. He wanted to do a review of their pitch with me.

After a quick run through his pitch, I gave him my brutally honest take on it: “None of it was usable”

The deck would have been OK for an investor sit down, but it was not appropriate for a three minute pitch in front of an audience where the goal is not to attract investors but rather to win a competition – or at least to peak interest and to be memorable.  After all, win or not, you want them talking about you afterwards.  A totally different frame of mind is necessary in the prep and the delivery for an event like this.  You do not need to be a Ted Talk master, but you do need to tell an authentic story people will remember and connect with.

Unfortunately, they had already submitted the deck and could not make changes.  I pondered for a moment. The deck had one good slide so I advised them to just focus on that one slide and ignore the rest. As scary as it sounded, a good story focusing on one good visual was much better than a bad story focused on many bad visuals.

Here’s how we re-worked their pitch.

Make you and your story the focus of your pitch.  If your story is powerful when you sit down one-on-one, then it is simply a matter of figuring out how to translate it into one that captivates a large audience. So for my friend (founder), this meant it was time to break him down and build him back up.

We began by asking all sorts of questions….

  • Why did you start the company?
  • Are you really self-funded, what past success lets you do this?
  • Why should I invest in you.  What makes you special?
  • Who are you? What is your story?
  • What is your personal story that drove you to start the company?
  • What about your team, what makes them special?

Now, can you tell all this in no more than three powerful sentences?

Notice that not once did I ask about Sales Growth, Exit Strategy, MRR,  LTV or financial models, setting up the story is all about you and your story. If your story is compelling, the details can follow. It doesn’t work the other way around.

Here are my top 9 pitch tips that can help you weave a sticky story that is authentic.

  1. Watch Youtube videos of winning pitches:  Everything is online these days so watch past winners of this pitch competition and others of similar time criteria.  This was the aha moment with the company I was working with.  It is one thing for me to tell them what to do it is so much more powerful to see what successful peers have done.
  2. Be Memorable / Be Remembered: When 60 founders are pitching in one evening it is all about standing out from the crowd. Do something memorable, shocking but genuine.
  3. Tell your personal story:  Quickly let the audience know how you got here and why this is your passion and you are the one person in the universe that could come up with this product because of your unique background.  Let your personality come through.  Remember at this point they are investing in you as much as your product. Be Authentic, and true to self.
  4. Show, not tell: demonstrate your product:  Figure out a way to show what your product does even if it is software.  You need to have an aha moment with the crowd.  If they don’t get it nothing else matters.
  5. Tell them how big the opportunity is:  Revenue and traction is not necessary at this point.  That the market for your product is huge is mission critical at this point.  Get them excited.
  6. Practice the pitch so much that it seems like you are doing it off the cuff:  The 2 – 3 minute pitch needs to come off as if you are speaking to a friend telling then your companies life story for the first time.  Practice, practice, practice and edit, edit, edit always making the statements shorter, shorter and more concise.
  7. Have less content than time:  If it is a 3 minute pitch have no more than 2 minutes of material.  This way one is never nervous about running over and there is space to let your personality come through and add lib to the audience based on their response to you.
  8. Plan the transitions well: how smoothly one moves from one topic to the next is the mark of a good story teller.  If the transition is logical and seamless it feels more like a story to the audience and not a presentation / pitch.  The more story-like, the more entertaining, the more entertaining the more memorable.
  9. Prepare for Questions: founders often practice, practice, practice the pitch but forget to practice answers to questions.  Come up with a list of the most likely questions and a clear, concise and memorable response.

After considering these pitch tips, it was only a matter of weaving the the story in a sequence that made it progress. Here’s the outline we used:

Happy to report that being the amazing entrepreneur he is, he turned this advice into a pitch competition victory three days later.

We now serve over 100 clients! See who.

 

 

 

Proper financial modeling is critical, but not for the faint of heart.

Work with enough early stage companies, and you’ll inevitably hear reference to a financial model. Depending on the company in question, the model will be either a mysterious topic discussed only in hushed tones, or something casually mentioned on a Friday afternoon as a box to check in the start-up’s sure-to-be rapid ascent to riches. Neither is correct; in my experience, entrepreneurs at early-stage companies almost always approach financial modeling from the wrong angle (if at all), resulting in incorrect expectations and potentially costly decisions down the road.

Here’s a quick list of the five most common misconceptions and mistakes that early-stage management teams make when it comes to modeling.

  1. Yes, you need to do a model…and a good one. It is staggering how many young companies try to raise capital around a business plan containing only the most basic of financial projections. It is not enough to list revenues, expenses, and net profits – you have to build out a model that accurately shows the moving parts of the business you want to build. No matter how astute an entrepreneur may be in his or her field, superficial financial projections scream amateur, and won’t help the conversation.
  2. No, the model’s estimates are not cast in stone. It’s a model, after all, not a guarantee. Many entrepreneurs are justifiably wary about overpromising, but being too conservative isn’t great either – better to actually build out what you reasonably hope will happen, and back it up with logical assumptions and arguments. Institutional investors know that reality and projections will differ, and a good model can be adjusted to reflect what is actually going on as your company makes progress. That’s what models are for – they are living documents.
  3. It’s the Journey, not the Destination. Any idiot can type numbers into a spreadsheet, so don’t think fancy formulas and complicated pivot tables will impress anyone. What matters much more is the level of detailed thought you have put into how all the moving parts of the business fit together under different scenarios. Investors will generally discount your projections anyway; what they really care about is whether you have actually done the work to think through all the expected revenues and expenses in the business over the model’s time horizon, and what assumptions you’ve made to ramp them. Important: Everything is connected, so don’t model, say, 5x sales growth without thinking carefully about what it means for the rest of the business. What will it cost? At what point to do you need to add staff? And what happens when you do? Does rent go up? How about insurance? All elements of the business have to reflect what you are predicting, not just sales, clients, users, etc.
  4. Models Are Not Fire-and-Forget. A proper business model is built in a way that allows key elements of the company’s economics to be adjusted going forward. This provides a mechanism for management to not only adjust core metrics to reflect real-world experience, but also a sandbox in which different scenarios and combinations can be tested to measure what happens to your company. Many entrepreneurs make a model during a fundraising round and never look at it again; this is like installing a GPS app on your phone and never turning it on. Use the model as a tool to better inform how and when you will be impacted by various developments, and what you can do to react. Done properly, they’re particularly good at predicting when cash will run low (which helps manage fundraising activities well in advance of a pinch) and can be a tremendous resource for learning which inputs and assumptions ultimately drive the business. Operationally, this helps you focus your time and energy – and that of your senior personnel – on the areas that ultimately have the biggest impact on the business.
  5. One Size Fits All. Don’t fall into the trap of building different versions of the model to suit the different conversations you’re having, display a certain pre-conceived result, or garner a higher valuation. It’s just not a good idea. You’re crafting the question to suit the answer, which leads to merely plugging in numbers into excel (remember the idiot mentioned in #3?). Build a model that is a legit depiction of what you think might happen if all goes well – no more, no less.

Proper financial modeling is not for the faint of heart, and it’s one of the areas in which Burkland’s on-demand CFOs excel. It requires an interesting mix of accounting knowledge and good, old-fashioned operating experience to do well, which means modeling is often the very last thing an entrepreneur wants to tackle. But it’s critical to not only understanding and managing the inner workings of your company at a granular level, but also to raising outside capital, and most importantly, to understand all the moving parts that affect your own business. Take the time to do the modeling right; your company, your investors and you will be thankful you did.

Photo courtesy of Christopher Michel.

We now serve over 100 clients! See who.