Burkland’s Fintech Practice Leads Steven Lord and Smit Shukla share eight accounting gaps and issues to watch out for in the early days of scaling a startup.
Startups are inherently complicated and messy organizations in the beginning, often correctly focusing first on what the company does instead of the administration of the company doing it. However, at a certain point every growing startup (or their board) eventually takes a focused look at finance with an eye towards improving accuracy, timeliness and depth of both tactical-level accounting and strategic-level forecasting. Invariably, this process reveals issues, gaps, inefficiencies and bad habits that need to be rectified in order to get the books squared away and financial processes at the company built and primed for scale and speed.
In our work as fractional CFO and accounting resources for startups, we’ve probably seen every possible permutation of those gaps and issues, particularly on the accounting side. They’re rarely intentional; instead, finance was just not a main focus of the founding team concerned more with technical product development and market fit than mundane accounting questions. Yet when it comes time to raise capital or report financial results to investors, the books are the foundation on which everything else rests. When we get that call, our new clients typically share a group of accounting problems that need to be tackled first, before strategic planning, forecasting or KPI reporting can be improved.
1. Legal Formation
Start-up founders’ top priority is to get the business activity set up and solidify the processes and business idea. Entity and bank account setup usually doesn’t make it to the list. However, it is important to keep independence between the founder and the entity, to avoid penetrating the corporate veil and submit duly-required registration filings; the critical first step is to legally form a company and obtain a corporate bank account.
Are your associates contractors or W2 employees, or both? Are they classified correctly, and have you registered in all the states in which your employees live? Do you have the correct documentation for all of them, and do your payroll reports reconcile with your accounting? Should you use PEO? These are key questions to answer *before* a problem comes up with people’s compensation – few things take the wind out of a startup team faster than a botched payroll. Likewise, few things can be more problematic, distracting or expensive to fix than incorrect classifications and state payroll registrations. Getting this cadence right early, including synching payroll with your accounting system, will avert big problems down the road.
3. Unfiled Tax Returns
Surprisingly, many startups do not file timely or complete tax returns, or have mistakes in prior returns that need rectifying. There is no value in waiting to clear these issues up, as they tend to become worse and/or more expensive to fix the longer you wait. Fractional finance companies with dedicated tax teams, like Burkland, can review prior state and federal returns for compliance and make sure the company is on track to file on time.
4. Cash vs. Accrual
Smaller companies usually start their books on a cash basis, which means money in and out is booked in the month it occurs, regardless of when the invoice was sent or received or the service delivered. However, once it’s larger, the company will have to switch to accrual accounting, which essentially pins money in or out to the period in which it was invoiced or the service provided. Accrual accounting gives a much more accurate view of financial position, but can be confusing for early-stage founders trying to manage their spend to a bank balance. Converting to accrual can be an expensive and time-consuming project once the company is growing quickly or generating substantial revenue, so convert to accrual as early as you can.
5. Chart of Accounts (COA)
Speaking of allocations in your accounting system, an inaccurate or incomplete chart of accounts is a common issue with early-stage startups. Think of your COA as a roadmap for your company’s financial framework. It sets the various line items that your business will need to accurately report financial activity historically and going forward. The vast majority of first-time founders will go with a template in Quickbooks without much thought to customizing those accounts for the business they are building, yet an accurate COA is like a fingerprint – each one is unique. Take the time to understand how your financial statements will be created and what you want to see on them, so your COA is already as granular as possible when the company is exponentially larger – you’ll save time and money down the road.
6. Equity Unreconciled
Most early-stage companies rely on external capital to finance their operations. This capital can come in the form of equity, convertible notes, SAFEs, etc., and all need to be accounted for properly on the company’s balance sheet. It routinely amazes us how many different ways a startup can misclassify equity and debt infusions – as revenue, as loans, as unallocated capital, you name it. Getting your company’s capitalization table reconciled against the money you’ve received is a critical step to take early, as soon as the money comes in. Hint: Many startups rely on their attorney for this issue, but that’s only half the solution. A proper accounting of the capital on the balance sheet is not a legal remit; it’s a financial one.
7. Accounts Payable
Many startups pay their bills and expense reimbursements ad hoc without any type of formal payment system (like Bill.com, Expensify, etc.), which can lead to a confusing combination of payment sources, payment timing, or worse – missed deadlines and overdue bills. Moreover, corporate cards and the advent of virtual debit cards like Divvy can mean a company’s expenses are entirely allocated to “American Express” or “Company Visa” in your accounting system. A lack of proper expense payment procedures, systems, and coding inside your Quickbooks or Xero instance not only generates unnecessary stress and chaos internally, but has the potential to derail vendor and employee relationships along the way.
Many startups don’t dig into their gross margins, yet understanding and defining their cost of goods sold, or COGS, is integral to accurate accounting of the business. Particularly for SaaS and other tech businesses, COGS can be tricky to determine correctly and consistently, yet the company’s gross margin (revenue – COGS) is a key metric in which virtually every investor will be interested as you scale. Instead of viewing it as an afterthought, get COGS defined for your business and tracked on your financial statements sooner rather than later so, as with other elements on this list, you don’t have to go back and recreate the wheel down the road.
For startup founders, finance is justifiably not at the top of the list when just getting going. But that’s not to say it shouldn’t be on the radar relatively quickly after formation. Our advice is to begin getting your finance function squared away at the earlier of 1) putting capital, external or your own, into the business, or 2) hiring people or paying contractors to work on your startup. By caring about these typical accounting issues earlier rather than later, you’ll save time, money, and aggravation fixing them later.