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.
Learn to recognize if you’re ready to move to smarter accounting.
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.
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.
“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.
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.
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.
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:
To fight your Fear of Being Embarrassed:
To fight your Fear of Feeling Inferior
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.