What is accounting and why does my startup need it?
Most small businesses need to understand their own financial position primarily in terms of how much they can spend (whether now or in the near future) and how much money they’ll generate as a result. High-growth startup founders tend to think about their finances in much the same way: cash-on-hand is much more significant to the day-to-day reality of an early-stage company than revenue yet to be collected. What isn’t obvious to most first-time startup founders is that once they secure professional investment, the founder will be just one of a number of stakeholders in their company’s finances—and all the rest will expect the company’s financials to conform to professional accounting standards.
Because high-growth startup founders intend to rapidly grow their valuations and either work with increasingly sophisticated investors or go public, they have to meet the expectations of parties and partners who are used to dealing with much more sophisticated players. Investors and banks both expect startup companies to treat their finances the way large companies do, which in the United States means organizing and reporting their financials according to professional accounting standards required by the US Securities and Exchange Commission (SEC). Specifically, these standards conform to the professional accounting practices outlined in Generally Accepted Accounting Principles (GAAP), a standard developed and maintained by the independent, nonprofit Financial Accounting Standards Board.
Crucially, these standards are based on professional judgment, experience, and a deep understanding of the principles at play. Most corporate accountants go through years of schooling and secure multiple professional certifications. Unless a startup founder is a trained accountant herself, it would be very difficult for her to satisfy these expectations without hiring an accountant. And because the work to reconcile the company’s financial history to these standards must cover the company’s entire history since incorporation, the cost of hiring an accountant rapidly increases the longer the company is in operation. Gust Launch recommends founders of high-growth startups hire accountants as soon as they are able rather than sacrificing tens of thousands of dollars when they first take professional investment to retroactively organize their finances at a premium.
GAAP & accrual-based accounting
The primary difference between GAAP and most startup founders’ understanding of their own cash flow situation is that GAAP requires a company to match their costs of operation in any one span of time to the revenue generated by those costs in the same period. This practice is called accrual-based accounting.
On a basic level, investors and banks prefer that startups use accrual-based accounting primarily because it’s an industry standard: SEC regulations currently require publicly traded companies to conform to GAAP, which means that the language and practice of investment assume that all private investments play by the same rules. Because the SEC requires GAAP accounting, investors and banks want private companies to use the same standards so that they can compare each company’s financial health and performance to the vital signs of other companies in the market.
More practically, these players prefer accrual-based accounting because it most accurately represents the financial health of the company—companies generally spend money on things that will benefit them long-term and also secure promises of payment (like subscriptions) that don’t necessarily turn into cash all at once, or that have implications for ongoing costs after the customer has paid. Accrual-based accounting helps companies associate these future costs and future revenues according to when the cost of doing business results in money coming in.
As an example, a company’s cash intake in March correlates obviously to the amount of cash the company could spend in March, but if the company owes a lot of money in April, then having the money in March doesn’t mean it’s a good idea to spend it. Similarly, if a company pays a provider all at once for a contract that lasts twelve months, but the contract drives the company’s ability to generate sales throughout that whole period, it usually makes more financial-reporting sense to spread the expense out across the year than to record it as a cost all at once. Accrual accounting highlights these relationships between cash, expense, revenue, and liability, rather than assuming that expense and income are most meaningful to the company’s financial position at the moment the payment occurs.
Financial history, reconciliation, and accounting costs
The key difference between accrual-based accounting and cash-based accounting is that with accrual-based accounting a company’s financial history represents the relationship between expense and revenue over its entire life. Because the matching of cost to benefit needs to be consistent from period to period, any GAAP-compliant accounting history starts from the moment the company began doing business: typically, its date of incorporation. The history of the business’s financials is contained in its “books,” and these books correspond to set time periods (typically months, quarters, and years).
Since high-growth startups eventually need to present their financials according to GAAP and these financials must cover the entire history of the startup, the difficulty of reconciling finances to GAAP-compliant standards grows the longer the company waits to hire an accountant. This reconciliation process quickly becomes expensive, especially if the company has not kept good track of their expenses and income.
Surprisingly often, these costs reach tens of thousands of dollars even within the company’s initial phase—and because most investors and creditors expect the company’s financials to comply with GAAP standards, the first influx of sophisticated capital is usually the latest point at which the company will need to comply. To put the impact of delaying accounting in perspective: if an investor group or venture fund expects to put $250,000 into the startup but knows that $25,000 will need to immediately go to an accountant to redo the company’s books, then they also know that their investment will provide 10% less runway—which makes the investment a tougher sell.
To avoid reconciliation costs, we recommend that startup founders work with an accountant as soon as they can.