Accounting, a Necessary Evil
We all know that accounting is a necessary evil, likening it to going to the dentist regularly or having renter’s insurance. Yet for those many entrepreneurs out there who have not been through a capital raise or M&A transaction, or even those who have yet to have any substantive conversations with buyers or investors, I can tell you your preparation here will save you tremendous brain damage down the line, as well as giving you an unique perspective on your financial performance outside just cash in/cash out and the net.
GAAP (Generally Accepted Accounting Principles)
The buyer and investor communities operate on GAAP (Generally Accepted Accounting Principles), which is an accounting standard, used by public and private companies alike, auditors, as well as adopted by the institutional investor community. Young growing companies have a challenge to adhere to these standards as more often than not, one of the owners will do the accounting not knowing or caring about accrual, or a third-party CPA will be used, however their focus is on year end taxes which are done on a cash basis, with the objective being to reduce tax, and not show a high profit. Thus 9 times out of 10, lower mid-market growth companies are running their books on a cash basis, however buyers/investors will want to see this on an accrual basis (the key component of GAAP).
Valuation and Diligence Complications of Cash-Based Statements
So, what happens is, buyers/investors aka the $$ people, will review the cash-based statements and be able to have a sense of the performance, yet a big stipulation remains on how will the financials shake out upon converting from cash to accrual. Where this is problematic is if the company only has cash statements when a deal is proposed, which is based off EBITDA or revenue, yet during diligence when a QOE is performed (quality of earnings), and any changes to revenue or EBITDA as a result of cash to accrual, may proportionately affect the valuation. This is especially prevalent when customers pre-pay for services/software a year in advance or for multi-year periods.
The Waiting Game
Having been through this situation many times, it’s not a great feeling where we (the advisor and the entrepreneur) are left helpless waiting for the results, and knowing the financials are likely to change, thus the valuation will change based on the variances.
Your Financials, Through the Lens of the Investor
Rather, why not attack it in advance by either performing the cash to accrual conversion prior to going to market (speaking with $$$), or be proactive and getting this done irrespective of when you believe a transaction may occur, as opportunities pop up very quickly (Google decided to aggressively go after YouTube in 10 days) thus it’s more pragmatic to be prepared. Not to mention, why not be able to view your financials and assess value, through the same lens as the investors?
What You Can Do About It Now!
I suggest outsourcing accounting entirely to those who specialize in this domain, much like we outsource other functions similarly, be it HR, IT, etc… for a modest monthly fee groups such as Early Growth Financial Services, or CFO Now will manage your accounting, and they specialize in early stage growth technology businesses, often with recurring revenue, pre-payments, etc.. where they know the importance of accrual financials, and recognize the importance of properly categorizing revenue and expenses by type. When they come on, they typically will redo the financials going back a few years, and get you going on a monthly basis going forward, providing monthly statements within 15 days of close. They also provide access to the accounting file and software, so if you want access or to collaborate.
Accounting Sucks, but It’s Important
I know accounting is a pain, yet it doesn’t have to be if approached the right way.