Recently we’ve been receiving some questions from startups about the key accounting and financial items they should consider ahead of their first institutional fundraising round. The below chart summarizes the main considerations.
Set up a standard chart of accounts (CoA)
An organized chart of accounts (CoA) is important in establishing a consistent structure for your historical financial reporting. While there are no specific guidelines on what accounts or level of detail to use, convention is to develop reasonable amount of accounts that enable owners to take a close look at their business without creating accounts that will only be used once. Setting of a correct Sales & COGS section is especially important in establishing an accurate gross margin for a business. For a SaaS company, COGS will usually include expenses incurred to service existing customers (web hosting & storage, customer service) but should omit costs associated with product development or acquiring new customers such as sales commissions.
For operating expenses, key sections to separate out are expenses like business travel (air, car, train, lodging) as well as expenses related to entertainment and meals. For many startups, personnel costs make up the majority of expenses and should be contained under a separate parent account that includes line items for wages, taxes, processing costs, and contractor expenses.
Switch to accrual accounting
In the beginning, many early-stage companies use cash accounting to record both revenue and expenses. When approaching an institutional seed round, it is important to switch to accrual accounting so that outside investors can clearly see the period in which revenue and expenses are incurred. Accrual based accounting matches these periods which provides a much clearer look at operations and smooths out the ebbs and flows of the cash collection cycle. This means booking Sales against Accounts Receivable instead of recording a sale when cash is collected as well as recording prepaid expenses for multi-month expenses like insurance. While moving to accrual accounting does require an additional operational lift, before the first instructional check comes in is a common time to make this switch and will provide investors with additional insight into the financial operations of your business.
Set up a formal payroll / HR service
One additional step that should be taken before an institutional fundraising round is the formalization of the payroll / HR process. If one is not already in place, adding an online payroll provider such as Gusto or ConnectPay will help streamline payroll operations for both full-time employees and contractors. Investors like to see this process formalized as it not only helps for scaling, but also reduces the amount of informal payments on the books via services such as Venmo or Quickpay. Expenses like these are nebulous and often can be hard to categorize when a company goes back to standardize accounting ahead of a diligence around. Best practice is to avoid these types of transactions by formalizing the payroll and reimbursements process.
Finance Diligence Considerations
Sync historical statements with projections
In addition to clear and organized financial accounting, a company preparing for its first institutional funding round should also have a functioning diligence model that includes grounded-in-reality historical and financial projections. This signals a strong financial foundation to investors and highlights a level of realistic thought that was given to important areas like hiring, OpEx, and productive development costs. Additionally, a diligence model will smooth the transition into cash management once the business completes its capital raise (serving as a major cost / time saver to management once completed). Overall, a strong model linked to actual operating results will always be looked at more favorably than a pie-in-the-sky or top down financial model.
Create a bottoms-up view of sales projections
One of the most important pieces of a model is the revenue component. This is because changes in revenue projections will largely impact a company’s cash runway and its timeline for maintaining its current operations before another capital raise. We have found that the best revenue projections are bottoms up and derived from actual deals contained within the CRM pipeline. Using a CRM helps to fix these projections to a realistic level based on known or expected deal flow. Longer-term projections can be driven by the hiring plan and the number of expected sales people multiplied by an expected production value that has been tested against the results in the CRM.
Create a detailed hiring plan
Putting together a detailed hiring plan helps both business owners and stakeholders in different ways. By putting pen to paper on a hiring plan, it forces a CEO to think deeply about the next 5-10 hires they plan to make. It also demonstrates to stakeholders that there is a comprehensive plan in place around scaling the business over the next 12-18 month runway post raise, and because people resources usually represent where you have most control over your costs. This provides insight into how and when the biggest portion of your capital raise and OpEx will be spent. The most comprehensive hiring plans also take into account the variable costs associated with hires such as software, hardware, and ancillary costs that are often forgotten or omitted.
Vendor-based non-salary OpEx
Outside of the hiring plan, a detailed financial model should also contain OpEx drilled down to the vendor level to provide detail into the ongoing overhead costs associated with running and scaling the business. Usually ongoing costs can be taken directly from current vendors in the accounting software and scaled up to meet hiring needs and business expansion. Items like office rent, software tools, and payroll processing costs all increase as more employees come on board and are easy to overlook without careful attention to detail of the outer months of a financial operating model. Again, detailed attention here highlights to an investor or potential board member a deep understanding of costs and how they change during the growth phase after a round of funding.
Cash Management and Cash Runway Prediction
Once the fundraising round is closed, cash runway will be the most important metric to any business owner as it provides a snapshot in the amount of time left (at current projected run rate) before additional capital needs to be injected into the business. However, it is important to recognize that this number is not static and in fact will change each month due to hiring, business growth, or strategy shifts. One important feature of an accurate cash runway is that it prevents over scaling of a business, because it shows how the effect of scaling can result in cash depletion in later months. This helps business owners to course correct or scale less quickly than they would otherwise. Maximum transparency around cash management is necessary so that investors can see the health, timeline table, and future capital requirements needed for ongoing operations.