The ROI Cost of Neglect: Why Early-Stage Companies Need Good Accounting
Article

The ROI Cost of Neglect: Why Early-Stage Companies Need Good Accounting

by John Kogan
June 24, 2021

Portfolio companies often ignore their back office early in their life cycle. This neglect can lead to large accounting messes that are expensive to clean up and can delay or endanger fundraising and M&A transactions, dramatically reducing outcomes for investors and CEOs.

Why the Books Are a Mess

As a consulting CFO to private companies, I am frequently brought in due to two key needs: 1) the CEO realizes that more capital is urgently needed and that raising capital requires a plan and a financial forecast; and 2) the financials are not in shape for due diligence in an upcoming funding or sale transaction.

In most instances, it is readily apparent that the books are a mess to some degree. Founders uniformly focus on stretching a dollar while achieving product and revenue milestones, and often leave the back office almost entirely neglected.

A typical scenario is a single bookkeeper, possibly part-time, possibly in a globally remote locale, who is weak in their understanding of controls, processes and general ledger accounting. It is easy to get someone to agree to pay bills and maybe even reconcile the bank account, but accounting to understand operating results is another thing entirely.

Areas that are commonly mishandled include revenue and cost accrual, accounting for revenue by distribution channel or product line, accounting for cost of sales separately from operating costs (in order to understand gross margins), costs by channel or product line, and inventory. (Simple exercises such as setting up a chart of accounts that correctly reflects the business do not take a lot of time and are not costly, they simply require experience and expertise that many bookkeepers do not have.)

To make matters worse, the failure to implement basic processes early on, when transaction volume is light, makes it exponentially more difficult to produce relevant operating results later. As time passes, you accumulate a multitude of confusing, inconsistent and incorrect entries, with uncertainty around which transactions were recorded when and what improperly documented entries represent.

This means that from the outset, I am hampered in my ability to produce a forecast, particularly a meaningful near-term forecast. Frequently, a major accounting “clean-up” is necessary before the company can have a clear view of its margins and thus a credible forecast. Such clean-ups are costly in more ways than one.

How Neglect Hurts Long-Term Value

The consulting fees for clean-up projects often run to the tens or even hundreds of thousands of dollars, consuming all prior “saved” dollars and more — but that is not the worst of the economic damage. The delay caused by the need for clean-up can be significant. The consequences of poor visibility and delayed deal due diligence can range from the CEO’s inability to make informed decisions on hiring and other expenditures to catastrophic loss of deal value or entire deal failure.

Founders often have a deep understanding of their business and carry the critical variables around in their head, until suddenly they can’t. “I’m flying blind” becomes their constant refrain for painful months while accountants scramble to figure out what happened and to triage the damage and attempt repairs. Companies frequently issue preliminary, corrected financials, only to find additional problems requiring restatements.

This makes managing operations very difficult. One-off decisions are made without insight to the whole picture, including a meaningful forecast. In a sale transaction, delays and restatements can cause valuation depression due to lost credibility, deal fatigue and the risk of worse-than-expected performance during overly prolonged due diligence.

Other downside risks of accounting neglect include:

  • Personal liability of officers due to payroll taxes being mishandled
  • Incorrect tax returns that have to be amended, incurring both accounting fees and interest and penalties
  • Unhappy customers, vendors and employees when errors arise repeatedly or can’t be rectified quickly
  • Career damage to the CEO or other executives that led uncontrolled growth
  • Audits by state labor boards triggered by compliance failures
  • Distraction to executives and staff pressured to produce evidence regarding years of activities, usually as operational needs are at an all-time high
Forensic accounting is time consuming and like remodeling an old house, you never know what you will find until you start tearing down the walls. Often the scope of work for the clean-up crew expands repeatedly as new errors and omissions are uncovered. Estimates of the time to complete the correction work are inherently fraught, and the availability of the person or team hired to fix things may become an issue.

 

Getting Finance Help Early Pays Off in the Long Run

The loss of millions of dollars in value is highly predictable. For most companies, an up-front investment in the part-time services of skilled financial professionals, as opposed to anyone with a bit of clerical bookkeeping experience, is not significant in comparison to the costs avoided.

Quality guidance in setting up the financial house is something investors need to demand of their CEOs and CEOs must demand of themselves and their finance organization. Without the discipline of reporting to the board and knowing the package will get more than a cursory review, proper financial reporting processes rarely get to the top of the busy CEO’s list.

A skilled part-time accountant, controller or CFO will help the company ensure:

  • Processes to correctly record transactions are put into place early on.
  • The chart of accounts properly segregates the components of operating results to provide meaningful information, including gross and contribution margins.
  • Accrual versus cash accounting is correct. (I commonly see a mishmash of accounts that agree as to the total ins and outs of the bank account but lack application of transactions to the actual period in which they occurred, versus when the bill was paid or cash collected, obscuring operating results with wildly fluctuating margins month over month.)
  • There is a view to the ultimate goals of the organization and the steps needed to get there, including the ability to readily extract reporting that allows for forecasting, capital raises and strong exits.

 

What a Part-Time Finance Team Typically Costs

Depending on the size of the business, the cost of such part-time services can range from a few thousand dollars a month for pre-revenue or early-stage businesses burning a lot of cash, to up to $20,000+ for a team that may include several professionals on both the accounting and financial planning and analysis sides of finance. They may supplement or replace the inexpensive bookkeeper — and they can advise you as to how good the bookkeeper is and whether you can or should continue to use them.

Even at $20k per month or $240k per year, you are still paying less than you would for one full-time CFO with benefits and equity, and you are getting all the skills you need, from accountant and analyst to controller and CFO, without paying for the pieces you don’t need. This type of framework works best for companies making up to tens of millions in revenue, but not enough profit to stomach the cost of a full-time in-house team, which could cost upwards of a million dollars annually.

Optimizing Long-Term Value and ROI

To the visionary founder, back-office administration is dull and rarely urgent. Nonetheless, it is critical to optimizing long-term value and investor/founder ROI. Short consultations at the outset of record keeping, a bit of guidance for that bookkeeper, moving to “real” accounting as you get into real revenue, and translating the vision of the entity to a written forecast pay large dividends in managing growth and allowing for smooth, successful exits.

To learn more about building a back-office team that optimizes ROI, contact our experts.

Stay In Touch

Sign up to stay up-to-date with the latest accounting regulations, best practices, industry news and technology insights to run your business.

Author
John Kogan
Director
Resources
Related News and Insights
Transform Your Back Office Into a Value Driver
Article
In this video series, Armanino's experts address some of the pain points faced by business leaders today.

May 27, 2021
Back-Office FAQs: Tips for Business Leaders
Article
Too often, business leaders spend more time on back-office processes than on value creation.

May 26, 2021
How to Streamline Your Back Office Operations
Webinar
Are you spending more time managing your back office service providers and less on more important goals?

April 1, 2021 | 02:00 PM - 03:00 PM PT