What Governments can Learn from Startups

What Governments Can Learn from Startups

Every few years the electorate votes the ruling party out of office — often in favour of a new, reinvigorated opposition party. Effectively we vote in a ‘startup government’ led by a few individuals with political experience, marketing savvy and the support of political opportunists with deep pockets, or at least committed ‘followers’ who ‘like’ a particular party.

The parallels with startup culture are clear except for one thing:

Canadian governments control organizations that employ about 18% of all working Canadians. The percentage of public sector employees seems consistent across the country — at least in BC and Ontario.

All of which means that every few years we can expect to be governed by a team of relatively inexperienced cabinet ministers. It is almost frightening to consider that these individuals will take charge of a set of different organizations that collectively represent a huge percent of the workforce — as large and as diverse as only the largest multinational corporations.

Can these (hopefully) well-intentioned individuals effectively adapt and take control of such a large and complex set of organizations?

It is almost inevitable that new governments rely extensively on senior management in the public sector to draft public policy.

While this may be understandable, it also represents a significant challenge to any new government.

The Art of the Pivot

When we replace governments we don’t replace the civil service. While many of the functions of the civil service are critical, they are incredibly resistant to change. We should look to startup culture to help re-invent the business of government.

Of course there is deep expertise within each organizational component of Government. But, simply because the bureaucracy — and public sector unions — have managed to put a stranglehold on virtually every public sector organization, that does not mean that we must allow them to dictate the way in which government services are delivered.

New governments need to identify groups of creative people with a fundamental understanding of the various business units — both within the regulators and the regulated — and task them with disrupting the status quo by building prototypes of new business models. In other words we need to consider the ‘Minimum Viable Process’ for achieving our organizational goals.

We don’t need to look very far for processes in Canada that need to be disrupted. Consider:

  1. The Phoenix Payroll System
  2. Support for Disabled Veterans
  3. The CRA’s Voluntary Disclosure Program
  4. Shared Services Canada
  5. Sexual assault in the military and the RCMP
  6. The Missing and Murdered Inquiry — and Indian and Northern Affairs Canada generally
  7. Bankruptcy Laws (think of Sears Canada)
  8. Tackling climate change

However the government’s resources are limited and they need to prioritize. Unfortunately there isn’t all that much bench strength or creativity among our members of parliament. Our partisan approach to politics and our ‘first past the post’ electoral system isn’t very fertile ground for creativity. Instead it is all about conformity to ‘family values’ , improving the lot of ‘working people’ (aka ‘making the rich pay’) or helping ‘the middle class and those who want to join it’ (aka ‘ trying to appeal to everybody’).

All of the power appears to be centred in the PMO (Prime Minister’s Office). This was true under Stephen Harper — and is just as true under Justin Trudeau with his ‘sunny ways’. Individual members are expected to toe the party line. Our political system actively works to stifle creativity.

The horrible truth is that our governments don’t have the right DNA to act as disruptors. What’s more — we do need predictability in Government — so while disruption must occur, it must be controlled.

HOW TO PIVOT THE CRA

Like a great many Canadians I have opinions about how we could do things better. But realistically my expertise lies within our tax system. I am one of the 40.25% of professional accountants that works in “professional, scientific and technical services” (most of whom practice as public accountants).

The CRA is administering the most complex set of legislation in the country. It relies on individuals and corporations assessing themselves. This is generally referred to as a ‘self-assessment system’.

The majority of complex returns are prepared by professional accountants. For their part the CRA hires and/or trains accountants to administer the Income Tax Act (and the Excise Tax Act).

According to Industry Canada 11.01% of accountants work in public administration and 40.25% work in “professional, scientific and technical services”. (Of course not all of these work in CRA or in public practice — however the CRA is the largest federal employer of accountants.) My point is that if we can encourage better compliance the administrative costs — paid for by the government — goes down.

The question is:

How do we take what is supposed to be a ‘self-assessment’ system and improve both compliance and efficiency? 

POSSIBLE INITIATIVES

  1. Encourage public accountants to provide ‘better’ tax filings in exchange for reduced audit levels on a firm-by-firm basis (contingent on the quality of filings). Try to reduce the number and extent of audits by improving the quality of original filings.
  2. Increased penalties for egregious behaviour on the part of public accountants (consider the recent offshore fiasco in which practitioners weren’t sanctioned)
  3. Use professional discipline of the CPAs for inadequate work (as part of the toolbox for sanctioning practitioners)
  4. Charge a fee for Professional Development courses as a part of their mandatory annual professional development of CPA members (why not monetize training instead of just paying for it)
  5. Rather than attacking benefits enjoyed by businesses — make similar benefits available (eg. income splitting) to ordinary employees.
  6. Rather than attacking benefits enjoyed by civil servants — allow other taxpayers to simply deduct medical expenses (at least up to a certain level of income).
  7. Reduce the number of public sector employees administering the Income Tax Act by beginning a pilot program allowing public practice firms to review income tax returns for a fee — much like lawyers provide legal aid (CPA firms are already capable of auditing large international firms — why not tax returns)

While I am sure that some public sector employees possess the necessary creativity for this kind of re-positioning work, they necessarily have different perspectives than private sector workers.

For example a public sector worker is almost guaranteed a job for life. This differs markedly from unionized workers in the private sector, where collective bargaining often revolves around ‘job security’. In fact unionization rates have fallen precipitously since at least 1981. According to Statistics Canada about 42% of workers were unionized in 1981. By 2012 that number had declined to 29.9%.

Too often public sector unions stifle any kind of initiative that may reduce jobs or job security. Unfortunately it may be difficult to involve them in streamlining business processes, if that view dominates their perspective.

According to Statistics Canada’s Labour Force Survey: 1999, 2007 and 2012, the percentage of public sector workers that were unionized was 71.4% in 2012 (up 0.6% from 1999). By contrast the percentage of private sector workers that was unionized was 16.4% (down 2% from 1999).

Public sector workers almost invariably have defined benefit pension plans. At retirement these plans — which are untaxed during their working years — typically have a present value of between $500,000 and $1.5 million. Except for the legendary ‘one percent’ virtually no other group of workers has anything like the ‘cradle-to-grave’ security of our public sector workers.

Another key difference between public sector workers is that they generally work for regulatory bodies. Those of us in the private sector tend to be regulated as opposed to regulating others. Clearly this causes a difference in the perspective between the regulators and the regulated. In particular I think of the Finance Department and the Canada Revenue Agency and the difference between their perspective and that of accounting professionals in the private sector.

Much has been said about the recent furore around proposals to address issues around “tax fairness” and the use of private corporations to confer an unfair advantage on that same legendary ‘one percent’. In my view this resulted in a rookie mistake by an otherwise competent Finance Minister. In short he relied on the regulators that worked for him.

Predictably the regulator attempted to defeat their rivals in the regulated sector. What’s more they discounted both the costs of compliance (which they routinely do, since they don’t bear these costs), and the value of their own job security and ‘gold-plated’ benefits, which they would rather keep quiet about.

A better approach would have been to create a dialogue between the regulator and the regulated. We need to improve regulations in a much more collaborative way. Neither perspective should be expected to produce a workable system without significant input from the other.

Some years ago, while still in the private sector, our current Finance Minister is purported to have said the following at a private sector conference on pensions:

”Who believes that the average Canadian, without a defined benefit plan, and without the demonstrated capacity to save enough to support their retirement, will, over the long term agree to fund public sector pensions at a level that they can only dream about attaining themselves?”

– Bill Morneau — 2013 (according to an article in the National Post)

Given the current government’s success with so-called ‘progressives’ in the last election, it can be easily understood why this issue wasn’t addressed in their recent foray into ‘tax fairness’. It comes down to math:

In the last 2 elections the winning party earned strong majorities with 39.5% and 39.6% respectively of the votes. If workers in public sector unions account for between 18% and 19% of the working population, it wouldn’t be wise to target their incredibly rich pension plans in any discussion of tax fairness. This is particularly true for a party that is courting progressive voters.

To be clear, I too consider myself a ‘progressive’ voter. However I believe in basing policy on evidence, whether scientific or statistical. When it comes to fairness I am most concerned with the over 60% of working Canadians that don’t have the kind of job security, or defined benefit pension plans enjoyed by most public sector employees.

A Brief History of Bookkeeping

In 1494 an Italian mathematician by the name of Luca Pacioli published “Summa de arithmetica, geometria, proportioni et proportionalità” (Venice 1494), a textbook for use in the schools of Northern Italy. It was a synthesis of the mathematical knowledge of his time and contained the first printed work on algebra written in the vernacular (i.e. the spoken language of the day). It is also notable for including the first published description of the method of bookkeeping that Venetian merchants used during the Italian Renaissance, known as the double-entry accounting system. The system he published included most of the accounting cycle as we know it today. He described the use of journals and ledgers, and warned that a person should not go to sleep at night until the debits equaled the credits. His ledger had accounts for assets (including receivables and inventories), liabilities, capital, income, and expenses — the account categories that are reported on an organization’s balance sheet and income statement, respectively. He demonstrated year-end closing entries and proposed that a trial balance be used to prove a balanced ledger. He is widely considered the “Father of Accounting”. Also, his treatise touches on a wide range of related topics from accounting ethics to cost accounting.”

It has often struck me that a system described so eloquently more than 500 years ago, could somehow be reproduced in software and used by publishers to create an annuity. However that is precisely what software publishers like Intuit Inc. and The Sage Group, plc have done with their popular accounting software.

The fundamentals of accounting theory are basically unchanged since Pacioli’s day. In spite of this, by simply updating tax tables and changing the format of data files, the publishers force small companies – and their accountants – to upgrade their accounting software every year.

As a public accountant this is particularly irksome since most of us use audit software – called Caseware™ – and only purchase low-end desktop accounting software to accommodate our clients. What’s more, the bookkeeping done by our smaller clients is most often done very poorly. In fact it is often so badly done that I am frequently better off to export the bank account from within the accounting software to a spreadsheet, and use that as the framework for a more accurate set of books.

Thankfully the current crop of online accounting software allows companies to “invite” their accountant to collaborate and access their accounting data online – without purchasing a license.

It is a tribute to his genius that the bookkeeping algorithm described by Pacioli is as simple as it is. There are really only 2 very simple equations that form a part of the algorithm:

2 Underlying Equations:

  1. For each transaction the sum of debit parts is equal to the sum of credit parts
  2. The sum of assets is equal to the sum of liabilities plus the sum of equities (aka “the balance sheet equation”)

Professional Advice Isn’t Scalable

Terms like “Pivot”, “Lean Startup”, “Minimum Viable Product”, “Product / Market Fit”, “Gazelles“, “Unicorns” and “Scale Up” are ubiquitous.

However that doesn’t mean that these concepts are key to each and every small business. In fact all of the writers, investors and academics that use these terms, seem intent on building a new, uniform kind of startup culture.

If every business was the same, they wouldn’t need professional advice, we’d just need to send everyone to one of a handful of startup boot camps.

As professionals, most CPAs know that each business is unique and that advice must be tailored to meet a client’s individual needs.

So What Is A Startup?

From the perspective of a company like Google or from a venture capitalist’s point of view, a startup is a company that was formed within the last 4 or 5 years and has grown to 20 – and sometimes as many as 50 employees.

I guess that is understandable, since what most practitioners think of as a startup wouldn’t register on the radar of most venture capitalists.

In British Columbia where I practice, every year BC Stats publishes a study called ‘Small Business Profile‘. Every year the studies show that only around 5% of companies have more than 20 employees. In fact companies with 50 or more employees are considered large companies (in BC at least) – which might seem to turn conventional wisdom on it’s head. In that respect BC differs from Canada, which has the cut-off for medium-sized businesses at 100 employees.

 

Note that “non-employer” businesses include 2.7 million self-employed Canadians – so that this table contains less that one third of all businesses in Canada in 2014.

So while a VC may think of a 6 year old company with 25 employees as a startup, the rest of us know better. A startup is really a company at the seed stage with a couple of founders and 4 or 5 employees at most. The difference between a seed stage company and one that is ready for a Series B round of financing, is as striking as the difference between a high school student and an infant.

Professionals need to nurture companies at a seed stage and avoid over-feeding (i.e. providing too many services).

For professionals, servicing startups is kind of like taking care of goldfish – feed them too much and you’ll kill them.

Startups need the right services at the right time – and their needs change very quickly.

Vancouver and Toronto-Waterloo Both Make Top 20 In 2017 Startup Genome Report

According to Startup Genome  2 of the top 20 startup ecosystems in the world are located in Canada.

Vancouver (No. 15)
The Vancouver startup ecosystem is currently comprised of 800-1,100 startups and shining success stories. In the early days Slack’s founder estimated the market for the software to be $100 million, which they exceeded in just three years—and have now become the fastest growing business software of all time.

Broadband.tv is now the third largest video streaming site in the world after Facebook and Google.

The dating app Plenty of Fish sold to Match.com for $575 million.

Bitstew exited in 2016 for $157 million – accounting for the largest exit in Canada last year, while TIO Logic exited for $233 million within the first few months of 2017

 

Toronto-Waterloo (No. 16)

The Toronto-Waterloo Corridor stretches from Toronto, Canada’s largest city and financial center to the Waterloo Region, which boasts the second highest density of startups in the world and is the headquarters of some of Canada’s largest tech companies.

These two startup ecosystems have been considered separately in past rankings. However, over the past year, there have been strong signals that the region is increasingly behaving as one ecosystem. Overall, an estimated 2,100-2,700 startups thrive thanks in part to world-class engineering talent, strong entrepreneurial culture, an affordable rental market, and a global base of customers.

 

Alberta Introduces New 30% Venture Capital Credit

On January 16, 2017 the Alberta Government has introduced a new Alberta Investors Tax Credit, providing a tax credit for investments in private, early stage companies in Alberta (Dentons).

Under the terms of the legislation, the province provides tax credits of 30% calculated on the gross amount of the investment. For individuals the tax credit is refundable, so individual investors will get a tax refund if their Alberta tax liability is less than $30,000. For corporate investors, the tax credit is deducted from tax otherwise payable.

A quick read of the review by Dentons indicates that it was copied almost word for word from BC’s Small Business Venture Capital Act. It seems that both provinces cap the tax credits each year at about $30 million, so businesses need to register early to avoid disappointment.

In BC, if companies arrange for offerings that are eligible, they need to quickly file Share Purchase Reports to ensure that their investors receive the tax credit. So waiting until the end of the calendar year isn’t advisable.

 

 

 

Open Letter to The Minister of Innovation, Science and Economic Development

I understand that your Minister of Science launched a review of innovation policy on June 13th of this year, and that you are now responsible for that review.

As a CPA and income tax practitioner my clients will be very much affected by changes to Canada’s existing policies designed to encourage innovation. I am a member of an ad hoc CATA “LinkedIn Group”. As such I am aware of lobbying efforts being made by CATA to your Ministry.

I feel that I must point out to you that CATA does not represent the vast majority of my clients and that while their lobbying efforts have some merit, you should not believe that they necessarily represent the best interests of the entire community.

They are presenting your Ministry with a complex suite of recommendations and seeking validation from members using online petitions. As you would expect, their petitions overly simplify the situation, making it much easier for busy executives to “just say yes”.

I have reproduced their most recent online questionnaire below:

I cannot in all conscience respond to this survey. It appears that my only option is to reply “Yes”. Any attempt at a “nuanced” response, will presumably be ignored, since they have already determined what their proposals are.

SO WHO IS CATA and WHO DO THEY REPRESENT?

The small, early stage companies that I typically represent are very seldom members. Large CPA firms are well represented. In fact, CATA’s key spokesperson is Dr. Russ Roberts, a former partner at Deloitte, LLP.

So while CATA’s views are certainly worthy of consideration, they do not represent my clients or their needs. I therefore urge you to tread carefully when conducting your review.

SHOULD OUR START-UP OUTSOURCE THE BOOKKEEPING?

Start-ups often ask:

Which Online Bookkeeping Software Should We Choose?

Comparison of Accounting Packages – Implication that one of these is right for you to do your own bookkeeping

The future of all software – including bookkeeping software – is online. This allows for much better information sharing and connectivity with distributed teams. With better connectivity and distributed teams, outsourcing many activities becomes possible.

If you outsource your bookkeeping function, it doesn’t make sense to choose the bookkeeping software. You won’t be using the software, probably don’t understand how to use it, and shouldn’t inflict it on someone else who already knows how he or she wants to go about doing the job.

SO THE QUESTION IS REALLY:

SHOULD OUR COMPANY OUTSOURCE THE BOOKKEEPING?

Every startup has limited resources – and a helluva lot to do. With so many critical things to do, startups need to focus on core functions like ‘getting out of the building’ and developing a ‘minimum viable product’.

IS BOOKKEEPING ONE OF THOSE CRITICAL CORE FUNCTIONS?

The short answer is “No”!

Bookkeeping isn’t a core function, but recordkeeping and banking are both core functions. Unfortunately many entrepreneurs consider recordkeeping and banking part of the bookkeeping function. This leads to 1 of 2 very common mistakes:

  1. Understanding that banking and recordkeeping are critical, core functions they set about trying to do the bookkeeping themselves – and typically spend too much time doing a very poor job.
  2. They outsource everything to the bookkeeper, including the recordkeeping and banking functions. In so doing they put the assets of the company at risk and can make the job of the bookkeeper almost impossible – where records weren’t properly kept from the outset.

BANKING IS A CORE FUNCTION

Don’t get someone else to do your banking for you. You are already taking lots of risk starting a small business. Don’t pointlessly add to your risk by giving someone else access to your bank accounts.

RECORDKEEPING IS A CORE FUNCTION

You’re probably already using online banking. Online banking functions automatically generate records. It is a simple matter to ‘keep’ records as you generate them. You can even go online after the fact and download banking records. But don’t wait too long. Your bank will probably archive the records after a few months. Once that happens, it becomes time-consuming, expensive and difficult (or impossible) to retrieve them.

When you deposit customer cheques to your bank account, you won’t be able to tell by looking at the bank statement whose cheque was deposited. Six months after the fact you’ll be left a confusing mess. If you deposit customer cheques it makes sense to use a deposit book – and keep details as to what cheques were deposited.

Similarly when you write cheques it makes sense to order cheques with a stub attached (and fill it out when you write the cheque). Otherwise take a picture of it with your phone and email it to yourself.

When you buy something online, print a copy of the invoice or receipt to a PDF file and store it where it can readily be found later.

If your recordkeeping system consists of “just ask me and I’ll get it for you”, you’re forcing the bookkeeper to document the missing records, inform you what he or she needs and then wait until you get around to getting the relevant records. This approach is very common – and hopelessly inefficient.

Fake News and Fake Expertise:

Misinformation in a “Post-Truth” World

We’ve all seen the proliferation of lists and comparisons designed to grab our attention on the internet:

 
3 Things Every Entrepreneur Needs to do this Holiday Season (Forbes.com)

Someone in the communications department makes a short 3,5 or 7-step list of things to do and points to a blog post on their website. The notion is that if you can reduce planning and decision-making to a simple list of to do items, the strategic planning required for your business or personal life, can be simplified.

The value of the advice is implied by the placement of well-known corporate logos on the website. This would seem to imply that the advice has been ‘blessed’ by all of the large companies whose logos grace the website.

fake-news

 

http://grasshopper.com/ is an online service that “lets you run your business using your cell phones!

They offer a resources section on their website that provides comparisons of popular online services designed for startups. Let’s take a look at their evaluation of Business Income Tax Software.

tax-software-comparison

Take a quick read of the article and I’m sure it will become quickly apparent that it took more time to build the accompanying graphics than it did to write the content.

After more than 30 years as a tax accountant and a tax auditor, I’ve learned that the most important thing to do when asking questions of a small business owner, is to ask the right questions.

So how would a tax professional start in determining a business’ need for tax software?

1.       Determine what jurisdiction the business operates out of. Almost all online resources assume that the business is US-based. This is true because they are operating from the centre of the universe – and noone else matters.

2.       Determine the nature of the business. Is the company operating a small retail store or a contractor providing painting and drywalling services? Is it a Canadian technology startup creating digital electrical metering systems?

3.       Determine what kind of entity business is. There are a variety of different types of entity. Grasshopper.com sells to small, home-based businesses.  So they’ve written this guide for their customers. The US Small Business Administration distinguishes between 6 different types of business organization:

US Small Business Administration

a.       Sole Proprietorship

b.       Limited Liability Company (LLC)

c.        Cooperative

d.       Corporation

e.       Partnership

f.         “S” Corporation

It’s pretty clear to us at least that “Grasshopper isn’t a tax expert” – but they write a very attractive post!

New “Refundable” Tax Credits for Startups in US.

The US introduced a new “refundable” tax credit for startups. Commencing in 2017, companies will be able to apply up to $250,000 to offset payroll withholdings on behalf employees.

According to Miller & Chevalier, CPAs:

For purposes of the credit, a “qualified small business” is an employer with gross receipts of less than $5 million in the current taxable year and no more than five taxable years with gross receipts.  Qualified small businesses may claim the R&D payroll tax credit in tax years beginning after December 31, 2015.

 

business-incentives-us-statesIt appears that the applicable amount of the federal credit is capped at $250,000 per year – for a maximum of 5 years. The effective amount of the benefit federally appears to be about 10% of qualifying wages (“QREs”) – compared with 54.25% in Canada. If QREs exceed $1 million Canadian, the percent will start to decline. State incentives for R&D include job credits, R&D tax credits and a variety of investment credits.

Hopefully Canada’s Federal Government will take this into account in their review of supports for the knowledge-based industry ecosystem.

IFRS or ASPE for Canadian Startups?

As CPAs we are bound by the pronouncements of the Chartered Professional Accountants of BC. CPA firms that provide what are known as “assurance services” are required to have their clients adopt 1 of 2 competing financial reporting regimes:

  1. Accounting Standards for Private Enterprises (“ASPE”)
  2. International Financial Reporting Standards (“IFRS”)

According to a brochure put out by PwC LLP in 2011 – ASPE or IFRS?  – 

Private enterprises should consider ASPE as the best
alternative if they have:
• No plans to access public equity markets
• No plans to access public debt markets
• Signifcant domestic competitors, customers and suppliers that
are private
• Current reporting that is relatively simple with minimal accounting
complexities
• Minimal reliance on benchmarking and comparative analysis
• No immediate transition plans; goal is to maintain business within
family or private individuals
• Minimal or no external equity investors who may have different
views of the enterprise’s future
• A mentality of ‘simpler the better’
• Minimal accounting resources to spend on training, education
and compliance
• An intention to stay within a familiar principles-based
conceptual≈framework
• Prepare fnancial information principally for owners, lenders and
tax compliance

Private enterprises should consider IFRS as the best
alternative if they have:
• Signifcant competitors, suppliers or customers in jurisdictions that
already adopted IFRS
• Plans to issue equity for growth or expansion through an Initial
Public Offering
• External fnancing and the enterprise’s intentions are to provide a
consistent platform for bankers and credit analysts
• Sophisticated users of fnancial statements
• Plans to expand operations globally
• Complex operations dealing with fnancial instruments or
tradeable instruments
• Signifcant partnership with foreign companies, investors or public
companies
• An intention to hold themselves to public company standards
• Competing against public companies for access to credit
• A transition plan that includes a possible sale to a private equity
investor or public company
• A foreign parent company or foreign subsidiaries who already
report in accordance with IFRS
• Plans to access capital or debt markets outside of Canada
• Plans to maintain fnancial reporting on the same basis as their
public company competitors to help with benchmarking

So Which Framework Should Your Company Choose?

For most of the 98% of BC companies that have fewer than 50 employees (and many of the ~7,500 “large” private companies as well), assurance services are seen to be too expensive. Hence most CPAs prepare “non-assurance” compilations for the majority of their clients (aka “Notice To Reader” financial statements). When we compile financial statements for our clients, we’re expected to refrain from implying that the statements were prepared in accordance with Canadian GAAP (either ASPE or IFRS).

So until your company is prepared to pay the price for assurance services, you’ll not actually be using either standard. In fact you might be better to embrace a completely different non-GAAP framework.

US TINY “GAAP”

In 2013 the American Institute of Certified Public Accountants (“AICPA”) introduced a Financial Reporting Framework for Small and Medium-Sized Entities. Much of it was based upon Canadian GAAP which was more principles-based than US GAAP. Presumably the new framework was in response to complex financial reporting requirements mandated in 2002 by Congress and the SEC in response to earlier financial scandals (Enron and Worldcom).

The “FRF for SMEs” accounting framework draws upon a blend of traditional accounting principles and accrual income tax methods of accounting. It utilizes historical cost as its primary measurement basis. In addition, it provides management with a suitable degree of optionality when choosing accounting policies to better meet the needs of the end users of the fnancial statements. The framework eschews prescriptive, detailed standards and voluminous disclosure requirements. Being a more intuitive and understandable framework for small business owners and the users of their financial statements, the framework lays out principles that encourage the use of professional judgment in the particular circumstances of a transaction or event.

While the AICPA is quick to point out that the framework is not GAAP in the US, it seems likely that it will eventually take hold there as a kind of “tiny GAAP”.

WHAT REPORTING FRAMEWORK SHOULD STARTUPS USE?

The trouble with startups is that most aren’t yet businesses. They are more likely to be in the process of defining their core business. Before you know exactly what you are, choosing a financial reporting framework based upon PwC’s decision tree (above) is a bit premature.

Since a startup is expected to spend at least 4 to 7 years in the wilderness without preparing audited (or reviewed) GAAP financials, whatever option is eventually chosen will require a re-statement. This will invariably be needed to comply with whatever flavour of GAAP is selected.

However the chances are that most startups won’t produce an exit for its founders by way of an IPO. Faced with the precipitous decline in the number of US pubco listings since 1996, an article published in Bloomberg View mused:

Are small closely held companies looking for an exit via acquisition or merger rather than an initial public offering?

If an acquisition is the far mare likely route, startups must consider whether their acquirer will be US-based. In fact it also quite likely that some investors will be US-based as well. In any event using the AICPA’s FRF for SMEs won’t be much of an impediment for most startups. It’s not that you will likely provide fully compliant financials in any event. However, you should probably avoid financial statement presentation that is clearly at odds with that framework.

 

 

 

 

 

 

3 Key Financial Sticking Points for Growth Companies

Companies that are seeking private equity from angel investors or angel groups should understand that they will need to withstand some degree of financial due diligence. Depending on the sophistication of the investors, the degree of rigour applied can vary a great deal. Regardless, it is best to clean up your financial information and assumptions to get rid of the rough edges before you present them to potential arm’s length investors.

At a recent meeting of Keiretsu in Vancouver, BC – I had a chance to review financial information provided by 6 companies presenting information to the group. Each of these had significant rough edges in their financial presentations – most of which can be categorized in one of 3 ways:

  1. EXCESSIVELY HIGH VALUATIONS
  2. FINANCIALS THAT DON’T CONFORM TO GAAP
  3. UNREALISTIC REVENUE PROJECTIONS

In fact most exhibited at least 2 key sticking points in their presentations, any one of which would give prospective investors pause during due diligence.

EXCESSIVE VALUATIONS

Examples:

In their first year of operations, one company expected to spend  $400,000 in development costs with no revenue. They are looking at a pre-money valuation of $3.5 million before the end of the year.

In their second year of operations with projected revenue of about $700K and a monthly burn rate of $250K, the company is looking for a pre-money valuation of $10 Million.

In their second year of operations the company experienced a fourfold decrease in revenue and a $1 million loss – compared to a break even year in their first year. They explain their $7 million pre-money valuation based upon a “pivot” in the second year.

The company experienced a $250K loss in the first 3 quarters of the current year. They are now projecting a $250K profit for the entire year and based upon that they are looking for a pre-money valuation $12 million. This is down from $15 million post-money valuation from an earlier round.

 

FINANCIALS THAT DON’T CONFORM TO GAAP

Examples:

Company showing a negative inventory of $65,000. This presumably arose when the bookkeeper made an entry to correct cost of sales. Effectively it is impossible to have negative inventory. That probably represents revenue, a liability, or simply a posting error. The thing is, when you’re presenting to investors, get your CPA to ensure that they make sense before you distribute them.

Company with half of their $800K of assets represented by  other assets – which remains identical from one year to the next. Given the nature of the business, the assets were probably development costs. Since the company is in a loss position – and has never been profitable – they would not meet the standard for capitalization under generally accepted accounting principles(“GAAP”).

 

UNSUBSTANTIATED EXPONENTIAL GROWTH

Since angel investors are looking for exponential growth, it is pretty much expected that investee companies will project exponential growth. However it strains credibility if you project 200 times revenue growth in a single year. Most of the rest of the companies in my sample used 10 times growth at least once in their projections – which is almost certainly way too optimistic.

While most presentations by startups feature some or all of these 3 key financial sticking points, angels themselves have developed interesting “back-of-the-napkin” approaches to deal with some of these problems:

MILLION DOLLAR DOG FOOD RULE

“No deal is worth more than a million dollars unless some dogs are paying to eat the dog food!” (i.e. unless there are customers)

DOUBLE HAIRCUT METHOD

This method assumes that most founders will overstate revenue in year 5 by at least 75%. That means halving the revenue projection twice in year 5. It also assumes the same level of capital as required in the original forecast.

TWICE AND A HALF RULE

Assumes that twice the amount of capital will be required to achieve half of projected revenue in year 5.

 

The Cost of Going (and Being) Public

Recently I spoke to one of the founders of a medical device company who was looking to go public in order to fund the development and regulatory approvals for their new products. Assuming that the company accurately projects their capital needs at $4 million I thought it would be a useful exercise to look at the impact of the decision to go public on the company’s burn rate.

To begin with I looked at a study published by PwC in 2014 –

 

According to PwC estimates:

How much can the costs of going public add up to?

Underwriter costs for an IPO – up to 10% of the proceeds.

Legal, audit and accounting costs – from $200K to $500K for a smaller offering

Marketing and road show costs ?

Miscellaneous costs (eg. printing costs, filing and transfer agent fees)?

What’s more many of these additional costs are ongoing.

 

 

Based on this analysis at least half of the cost is directly attributable to going public too early in the life of the company.  Given that this is a medical device company, the cost of foregone SR&ED refunds could easily exceed the IPO and maintenance costs.

Ideally going public should be seen as a possible exit for Series A or Series B investors instead of a strategy for raising money for a development stage company.