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Understanding why startups need accounting, what are some of the common mistakes, and how to avoid them
As a new entrepreneur, you are probably working endlessly on developing your product, preparing investment pitches, finding a technical co-founder, and chasing suppliers or customers. Accounting may not be a task of foremost importance on your mind.
You may not need a full-time accountant from the very first day, but as your business grows, things get more complicated and you may be out of your depth when it comes to handling your startup’s financial accounting. A proper accounting system offers a coherent way to evaluate and track your business’ financial health, and allows investors to clearly determine your sustainability and profit potential.
We asked myStartUpCFO‘s Co-founder and CEO Sandeep Shroff and Associate Manager Nikhar Jajodia about their opinion. MyStartUpCFO caters to the business accounting-related needs of startups.
Q. Why do startups need accounting?
Jajodia: Accounting may sound like a task which only businesses care about, but when we think about it, everyone already does accounting. A kid with $5 in his pocket, a couple out on grocery shopping, or an individual on the payroll. Accounting is essentially tracking where your money comes from and where it goes.
Startups are no different. Without tracking their bank transactions, their vendor bills, etc, they might lose track of where exactly the money is going. Additionally, there are infrequent events like paying a vendor twice, missing your taxes, forgetting to cancel a subscription, and so on… which are best kept in control if you have an accounting system in place.
This analysis can really add value to a company as they know how long their current cash balance will last. This is extremely important to know so that a company can plan its financial future.
Q. What is the importance of accounting for startups when they are seeking investment?
Shroff: Before investors give money to any startup, they want to know how the money will get used, over how much time the money will get used, and what the company will achieve in that period.
For an early stage startup, let’s say you’re going to raise US$1 million. You will say that you will have a product out in the market, and 10 customers by the end of Year 1. So, there is an issue of how much money, when it will be used and what are the goals you will achieve with the money. If you don’t do your accounting, you don’t know if you are on track with your goals or not.
First, you need a budget, which again is an accounting job. In the budget, you will make an estimate that you need four engineers to work for eight months to build your product, and one salesman to sell it. The salesman will take six months to sell ten deals.
Everything has to be quantified and attached to a monetary value. For example, if one engineer costs you $X, four engineers will cost you $4X. Over eight months, they will cost you $32X. Similarly, you have to find the cost of sales.
All this will lay out how much money you need to achieve your goal. And, once you have explained why you need the money to a potential investor, when they give you the money, you will have to track whether you are spending according to your plan or not.
Q. Some startups delay accounting until they start generating revenue. When should startups start accounting?
Jajodia: In my opinion, a dollar is a dollar regardless of whose dollar it is. Doesn’t matter if you’re spending your money, the government’s money [e.g. through grants], investor money, or money generated via sales. Keeping track of expenses and revenues from day one not only cultivates a great habit of knowing your numbers, but also helps you cut down on a few unwanted expenses in the early stages, such as free trials that turn into paid ones, temporary upgrades you forgot to disable, bank charges your bank promised to not charge you, among others.
Having said this, we as Finance and Accounting (F&A) guys are firm believers in keeping costs low, hence, for an early-stage startup, it is advised to do at least basic accounting in the first few months and not worry a lot about creating complex dashboards.
Q. What are the common accounting mistakes startups make?
Shroff: If you ask me, the biggest accounting mistake that startups make is not doing any accounting at all, and thinking they have a good handle on their expenses by doing everything in their heads!
Jajodia: Most companies fly blind in the beginning. Not the best way to reach any destination other than crashing!
The other common mistakes include not knowing compliance requirements and deadlines. While some of these misses might just be a nuisance, others can attract heavy penalties and become an unnecessary distraction for management. For instance, it’s true that if you’re not making profits you ideally won’t have to pay taxes, but that doesn’t mean that you don’t have to file your tax return.
Excessive optimism is a perennial mistake all startups make – overestimating your revenue and bookings and then spending accordingly. The trouble is that revenue falls way short of target and expenses do not.
Q. How can those mistakes be avoided?
Jajodia: Hire a competent accountant! Given that accounting, or rather finance and accounting, is a set of highly specialized functions, it is better to hire an accounting firm that can bring a full-spectrum skill set to the table.
As founders/CEOs, management should focus on doing what they do best – run the company, grow revenue, hire smart people, etc. Leave company back-office operations to professionals.
Q: Do early-stage startups need CFOs? If yes, why?
Jajodia: Full time CFO? Perhaps not. Part time CFO? Most likely for that occasional strategy session to keep the company on track.
Startups are new buds in a world full of bankers, vendors, insurers, and investors. These institutions can be backed up by years of finance and accounting experience behind them. Signing agreements or understanding term sheets are the kinds of activities that may bore most of us, but in the back of our minds, we are aware that there are probably some terms and conditions in those agreements that may cause trouble down the years.
This is where a CFO brings their years of experience and know-how to translate a complicated agreement into layman language that companies and CEOs may find easier to understand.
Apart from that, a lot of startups have first-time CEOs who are very good at their core operations, but may not bring financial expertise to the table. Such gaps are filled by an external CFO who can always help with activities like contract negotiations, funding rounds, investor introductions, and negotiations, ensuring your expenses are within the budget, and cutting down your costs when the day calls for it.
Q: Should startups outsource for accounting needs?
Jajodia: Not necessarily. Depends on what skills are available inside the company and what the in-house folks deem the best use of their time.
Outsourcing is helpful for startups because when you’re running a startup, most hands are already occupied with non-accounting work. We always recommend companies spend time selling their product/perfecting their product or doing anything that helps with the vision and mission of the company.
It is wise to let an experienced accountant take care of the day to day accounting. Hiring an internal accounting person can be one alternative, but that is a lot of fixed costs for a startup.
The most efficient and cost-effective decision can be to outsource the service to a specialist first, one who brings the full set of skills to the table to support the company from its infancy to its young adulthood. They obviously will cost a bit, but in return, you get a lot of benefits such as tax expertise and cost-saving compared to a full-time person.
Header Image by Oleg Magni on Pexels