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.

How Good is Business Advice?

A few years ago I watched as a young colleague with an MBA took it upon himself to advise the proprietor of a crepe stand about operations and business strategy – in exchange for a free crepe. As a former journeyman chef I was amused by the exchange. It was clear to me that my colleague’s advice was vastly overpriced.

Last week I served on an advisory panel for early stage companies at Innovation Island on Vancouver Island.

One of the participants seemed to be struggling with too much advice. The presenter had stopped working “in the business” in favour of working “on the business”. When I heard that I couldn’t help thinking that someone lifted that line verbatim from an introductory management consulting textbook.

In the past year or so the company had successfully sold their services to at least 3 large government organizations – which isn’t trivial for a small startup on northern Vancouver Island.

However the presenter seemed to think that selling services isn’t scalable – and that the company wasn’t a good fit for a seed round. I had to ask myself who got to them. It seemed to me pretty likely that one angel investor couldn’t see the potential – and they took it to heart. Based upon one man’s opinion they had decided their only option was to bootstrap the business themselves.

Some years ago I read an opinion piece by an intellectual property lawyer. He recommended that a startup developing IP should keep it close to the chest until they secured investment. He didn’t like the idea of using the IP in services in order to prove out the technology. Maybe that works for an IP lawyer who gets paid when the IP is protected – but it sounds like bad advice to me. How does a startup know whether their IP is worth protecting until they established that it’s useful?

How do you know that a minimum viable product is viable unless a customer has tried it out?

If an angel investor doesn’t want to invest in your company, it doesn’t mean that you don’t have something. It could simply be that the particular angel investor doesn’t understand it and can’t see it. If instead you hear the same refrain from a number of investors – maybe you should take it seriously.

If you’re getting advice, you really have to consider the source.

 

Asset Sale vs Share Sale

Technology companies – in fact most small businesses – often have difficulty taking advantage of the recently enriched lifetime capital gains deduction. When first introduced the capital gains deduction was targeted the first $500,000 of capital gains on family farms and qualified small business corporation shares (“QSBCs”). Since then the lifetime capital gains limit has been increased to $806,800 for QSBCs and $1 million for family farms.

However it is always difficult for sellers to sell shares. Buyers prefer to buy assets for 2 reasons:

  1. The cost of shares is not deductible by the buyer against income – while most assets are at least partially deductible
  2. Shares of small business corporations are much more complex beasts to acquire and may include undisclosed  liabilities or other “surprises” that buyers are understandably nervous about acquiring

Buyers and their legal representatives will typically discount the purchase price if the vendor insists on selling shares. In some cases buyers simply won’t consider acquiring shares.

Many small, private corporations have at least a few skeletons in their closets. Closely-held companies often operate a little too close to the line and sophisticated buyers will often engage professionals to uncover at least some of these.

As a former senior manager with PwC LLP in Vancouver I was seconded to a due diligence team looking at the potential acquisition of a technology company. As it happened, the target company was one of a number of companies owned by the same entrepreneur. The entrepreneur had separate accounting firms handling each of his companies.

The problem was that he never informed his accountants of the existence of the other companies. Each year he filed for refundable SR&ED tax credits with one of his companies. Presumably his accountants were unaware of the existence of these other companies, since they were not disclosed on the tax returns as “associated” corporations.

Because of the amount of taxable income of the associated group, the corporation would not have been entitled to high-rate refundable tax credits. Thus any purchaser could be on the hook for undisclosed tax liabilities – and penalties – in the millions of dollars.

Of course it isn’t only undisclosed tax liabilities that could surface after an acquisition. There could be problems with employees, former employees, customers or suppliers. With small corporations eligible for the lifetime capital gains exemption, financial statements are often merely compiled with little or no assurance from the public accountants drafting the statements.

For that reason most accounting and legal professionals will advise buyers of QSBCs to purchase assets – or to discount the purchase price and conduct significant due diligence before determining that price.

CAPITAL DIVIDENDS AS AN ALTERNATIVE STRATEGY

Technology entrepreneurs looking to sell their companies should understand that the value of their companies is most often determined by the value of their IP.

Eligible capital property of a business is intangible capital property, such as goodwill and other “nothings”, the cost of which neither qualifies for capital cost allowance nor is fully deductible as a current expense in the year of its acquisition.

Selling intellectual property developed by a technology company results in a gain on disposition of eligible capital property. These types of gains are similar to capital gains – in that only 1/2 of the gain is taxable. The remaining un-taxed half  can be distributed tax-free to shareholders via an amount paid out of the capital dividend account (“CDA”).

So rather than selling shares – typically at a discount – the entrepreneur keeps the company and sells the IP within the company. So the sale price is higher, the sale is only partially taxable and may even be shielded by non-capital losses, SR&ED ITCs or SR&ED expenditure pools within the company. When the proceeds are distributed, the company can elect to pay dividends from the CDA account.

While this works well for technology companies that have IP, it can also work for any corporation selling goodwill as well. Of course buyers will typically attempt to structure their purchase so that proceeds are allocated more to tangible assets which can be depreciated more quickly.

 

 

VCC Tax Credit Is Not “Government Assistance”

British Columbia’s Small Business Venture Capital Act provides a 30% tax credit to eligible investors in corporations involved in a “prescribed business activity” within BC. For individuals the tax credit is fully refundable and isn’t considered taxable under paragraph 12(1)(x) of the Income Tax Act:

SUBSECTION 12)(1) – INCOME INCLUSIONS

(x) Inducement, reimbursement, etc. — any particular

amount (other than a prescribed amount) received by the tax –

payer in the year, in the course of earning in come from a busi –

ness or property, from

(i) a person or partnership (in this paragraph referred to as the

“payer”) who pays the particular amount

(A) in the course of earning in come from a business or prop –

erty,

(B) in order to achieve a benefit or advantage for the payer or

for persons with whom the payer does not deal at arm’s

length, or

(C) in circumstances where it is reasonable to conclude that

the payer would not have paid the amount but for the receipt

by the payer of amounts from a payer, government, munici –

pality or public authority described in this sub paragraph or

in sub paragraph (ii), or

(ii) a government, municipality or other public authority,

where the particular amount can reasonably be considered to

have been received

(iii) as an inducement, whether as a grant, subsidy, forgivable

loan, deduction from tax, allowance or any other form of in –

ducement, or

(iv) as a refund, reimbursement, contribution or allowance or

as assistance, whether as a grant, subsidy, forgivable loan, de –

duction from tax, allowance or any other form of assistance, in

respect of

(A) an amount included in, or deducted as, the cost of prop –

erty, or

(B) an outlay or expense,

to the extent that the particular amount

(v) was not otherwise included in computing the taxpayer’s in –

come, or deducted in computing, for the purposes of this Act,

any balance of undeducted outlays, expenses or other

amounts, for the year or a preceding taxation year,

(v.1) is not an amount received by the tax payer in respect of a

restrictive covenant, as de fined by sub sec tion 56.4(1), that was

in cluded, under subsection 56.4(2), in computing the income

of a person related to the taxpayer,

(vi) except as provided by subsection 127(11.1), (11.5) or

(11.6), does not reduce, for the purpose of an assessment made

or that may be made under this Act, the cost or capital cost of

the property or the amount of the outlay or expense, as the case

may be,

(vii) does not reduce, under subsection (2.2) or 13(7.4) or

paragraph 53(2)(s), the cost or capital cost of the property or

the amount of the outlay or expense, as the case may be, and

(viii) may not reasonably be considered to be a payment made

in respect of the acquisition by the payer or the public author –

ity of an interest in the taxpayer, an interest in, or for civil law a

right in, the taxpayer’s business or an interest in, or for civil

law a real right in, the taxpayer’s property;

The key wording here is:

(other than a prescribed amount)

VCC tax credits are prescribed by Regulation 7300 of the Income Tax Act to be “prescribed amounts” for the purposes of paragraph 12(1)(x). Not only do recipients not have to include the tax credit in income, they don’t have to reduce the Adjusted Cost Base of the underlying shares after receiving the tax credit (Regulation 6700)

This is a good deal for investors – to extent that investments in such companies can ever be considered “good” for investors. It also means that friends and family can invest in eligible shares and obtain a full deduction for the share when transferring to a self-directed RRSP.

Self-Employed Contractor or Employee?

Whether you are an individual looking for a broader range of tax deductions than employees are ordinarily entitled to, or an employer looking for a more flexible working arrangement with your “employees”, you need to understand the rules around employment.

The employer-employee relationships is dealt with by a number of different legislative regimes. These include:

  1. The Income Tax Act (Canada)
  2. The Canada Pension Plan
  3. The Employment Insurance Act
  4. The BC Employment Standards Act

It is important to understand that simply wanting to qualify for enhanced tax deductions as an independent contractor isn’t enough. Similarly employers can’t avoid the obligations of an employer merely by stating that a person providing services is self-employed.

Tax authorities – as well as other regulators – will look to the specifics of the relationship itself and make their own determination. This is true whether or not both parties intended to avoid the characterization of the relationship as an employment contract.

If you wish to establish a relationship that isn’t an employer-employee relationship, you should understand the position of the CRA with respect to this issue.

The CRA publication:

Employee or Self-Employed?

RC4110(E) Rev. 14

explains how this issue is perceived by both the CRA and the courts.

It is possible for the employer and the employee/contractor to contract out of the employee relationship, but it must be done thoughtfully and should be in writing. Regardless of whether or not the contract is in writing, the terms must clearly avoid the appearance of a “master-servant relationship”, or the courts (and the CRA) will look through the contract and assess accordingly.

If an employer pressures an employee to agree to a position as an independent contractor, the government may side with the employee if the self-employed contractor seeks employment insurance and severance when he or she is dismissed.

In a situation like this the employer could be required to pay severance and be subject to an assessment for a shortfall in CPP and EI withholdings.

The website TaxTips.ca has a decent explanation of many of the issues: TaxTips.ca

If an “employee” forms a corporation to provide services to his or her employer,  the corporation may be considered as a Personal Services Business – which would have significant implications. These are potentially more onerous than what an individual would face if he is deemed to be an employee without the complication of a corporation.

The case of Walter Pielasa and his wife, Susan (758997 Alberta Ltd. v. The Queen – 2004 TCC 755) illustrates some of the problems that an “incorporated employee” can face if his corporation is found to be a personal services business.

IMPLICATIONS TO A CORPORATION OF CLASSIFICATION AS A ‘PERSONAL SERVICES BUSINESS’

LIMITS TO ALLOWABLE DEDUCTIONS

Paragraph 18(1)(p) of the Income Tax Act restricts the deduction of expenses of a personal services business of a corporation to the following allowable deductions:

  1. the salary, wages or other remuneration paid in the year to an incorporated employee of the corporation
  2. the cost of any benefit or allowance provided to an incorporated employee
  3. any amount expended in connection with the selling of property or the negotiating of contracts by the corporation, as long as the amount would have been deductible if it had been expended by the incorporated employee under a contract of employment that required the employee to pay the amount, and
  4. legal expenses incurred by the corporation in collecting amounts owing to it on account of services rendered

The above amounts are only deductible by a personal services business if they would be deductible by a business other than a personal services business.

LOSS OF THE SMALL BUSINESS DEDUCTION

A personal services business is not eligible for the small business deduction, and thus pays tax at full corporate tax rates.

————————-

While these outcomes would significant for any incorporated employee and could be devastating to employers, there are other potentially significant disadvantages in those cases where the employer is successful in structuring contracts to meet the definition of ‘independent contractor’. I’ll discuss these in a future post.

 

The Evolution of the Business Plan

Management science used to tell us that we needed to plan carefully and intelligently for any new business venture, document our assumptions clearly – and then execute.
As a professional accountant I’ve always been leery of projections – or as we like to refer to them “FOFI” (i.e. future-oriented financial information). The thing is, accountants built their reputation for honesty on the accurate reporting of historical information. What’s more we’re pretty good at that.

Steve Blank – the well-respected academic and entrepreneur out of California said it very eloquently:

No business plan survives first contact with customers

 

The thing about projections is that, especially in the case of a new business, they’re almost always wrong. For a startup trying to commercialize a new technology in a new market space, projections are almost always wildly over-optimistic.

In fact most investors in early stage companies discount projections heavily – or more likely just ignore them.

But in spite of the fact that they are inaccurate – and most experienced investors discount or ignore them – my clients still need to prepare them. So what is the answer?

From my perspective at least, the answer is STRATPAD™.

Originally developed for the iPad – StratPad is a web-based business planning tool that most entrepreneurs can learn to use in the course of a one day workshop. Which means it costs lest than having your CPA or your management consultant write it for you – and more important, keeps the entrepreneur at the centre of the process. Since is a business plan is really a living document, management needs to keep it up-to-date, or at least re-visit it on a regular basis. If you outsource your business plan that means you always have to outsource your plan….

And you’ll never own it!

 

Importance of Startups in Job Creation

As a part of their “The Startup Revolution” series, the Compass Blog published “The Rise of the Startup“. It makes for fascinating reading.

In particular they point to a study by the Kauffman Foundating in 2010. That study revealed that – over the past 28 years – startups were responsible for all net new jobs in the United States. In 21 of those 28 years, startups was the only class of business to create net new jobs.

According to their blog there are 4 key reasons for the rise of the startup:

  1. startups can be built for thousands, rather than millions of dollars
  2. emergence of new types of investors:  angels, accelerators and micro-VCs
  3. entrepreneurship developing its own management science
  4. speed of consumer adoption of new technology

Of course the Kauffman study shows that startups have been important in job creation for at least 28 years. If that’s true then those 4 factors may not explain the rise of startups, but rather how our economy is adapting to their importance.

Silicon Valley

 

 

Local Startup Sues Incubator in Dispute Over IP

Pixsel Sues Invoke Labs for Allegedly Stealing Code to Create a Competitor

This story got coverage in the main stream press today.

Perhaps it is a good thing that the local CBC station is beginning to cover the startup / high tech scene. Certainly this sector is becoming a major source of new economic activity. Before we rush to take sides, it is important that we keep things in perspective. Firms involved in incubating startups have their own economic interests. Sometimes economic self interest pushes people – and organizations are just people working together – to cross the line.

At the same time, startup companies are an important source of creativity and energy – but most fail. It is all too common for people who fail to find someone else to blame.

Unless Pixsel or Invoke Labs (both?) can successfully commercialize their IP and create wealth and economic activity locally, we may never hear of this again. In the mean time we can celebrate the fact that activity in the local startup scene is starting to get our attention.

 

6 Alternatives for Online Invoicing

Do a GOOGLE search for “Online Invoicing Systems” and you’ll come up with an enormous list:

About 1,810,000 results (0.33 seconds)

 2 Types of Online Invoicing Packages

The truth is there are a large number of alternatives to choose from. So many in fact, that you’d be hard-pressed to evaluate very many of them. However there are really only 2 types of online invoicing packages that a start up should be looking at:

  1. Standalone Invoicing Systems

  2. Online Accounting Systems

I’ll look at 2 popular standalone systems and 4 different online accounting systems.  They were chosen based on their relative importance in the marketplace and my estimate of their “staying power”. In other words I don’t think it makes sense to evaluate an alternative that is reasonably likely to disappear. I did this in part by researching the companies on CRUNCHBASE. Of course most of these companies do a pretty good job of letting members of the accounting profession know about them and, as a result I am quite familiar with a variety of offerings from each of these publishers…

Traditional Paper-based Invoicing System…

Billing Traditional

Using An Online Invoicing System…

Billing Online

Accounting vs Invoicing

The billing and collections processes are an essential part of any accounting system. Arguably they are the most important parts. The decision to implement some sort of invoicing system, must happen very early on – when you send out your first invoice.

For most startups the bookkeeping can be done after the fact, however if your business is going to survive you’ll have to bill early and often – assuming you have customers. That means building an invoicing system right out of the gate. The good news is that it is much easier to evaluate an invoicing system than it is to evaluate an accounting system.  Comparatively, an invoicing system can be quite simple. If you’re evaluating a standalone system, you don’t really need to know anything much about accounting.

Remember that as a small business owner, you’re likely to be one of the primary users of the invoicing software. When it comes to using accounting systems, you’re much more likely to get someone else to do the bookkeeping for you.

If you haven’t yet made a decision regarding your accounting system, it isn’t really very risky to select a standalone invoicing system. Ultimately you can continue to use the invoicing system alongside your accounting system indefinitely, or simply transition later to using the invoicing features of whichever online accounting system you decide on. In fact you could even elect to try out Wave Accounting (see below) for its invoicing functions alone, since there is no cost for using the system.

Standalone Invoicing Systems

Freshbooks (Toronto , ON)

Freshbooks

 

According to Crunchbase, Freshbooks received $30 Million Series A on July 23, 2014.

I have used their application for my own accounting practice since 2012. It is very easy to use and I highly recommend it – particularly for small, service-based businesses. Of course as an accountant, I don’t have to pay to use their system. If I did I might be tempted to test PayPal.

 

 

PayPal (San Jose, CA)

PayPalCalifornia-based PayPal was acquired by EBay in 2002 and is a market leader in the online payments space.

Until recently I wasn’t aware that they offered an online invoicing solution for small business. If I had, I might have evaluated it for my own practice. Given that they don’t currently appear to charge a fee (other than transaction-based fees), they would probably be worth your while to take for a test drive. Note that PayPal offers a solution for web-based businesses that sell products online.

 

 

 

 

Online Accounting Systems

Generally I would recommend that you select a bookkeeper or an accountant first, rather than an accounting package. Any of the packages discussed below will fill the accounting needs of a small start up. However in the wrong hands, any accounting system can be messed up. While many of my colleagues will disparage one or another system, from my perspective this is generally related to their own familiarity with a particular package instead of the particular flaws in the system itself.

On the other hand if you were to evaluate a free system – eg. Wave Accounting – primarily for its invoicing functions, you could easily either start using it later on for all of your accounting needs or transition to another system.

Wave Accounting (Toronto, ON)

WaveAccording to Crunchbase, Toronto-based Wave accounting has raised $24.6 Million in 4 Rounds from 6 Investors, and has 2 million users worldwide. While the number of users is impressive, it is the only online accounting package that is completely free to use.

 

For my part I use it both for accounting and invoicing in Sutton Innovation Inc (a tax comsultancy practice). My partners in the practice have remote access to the data and I outsource the bookkeeping to a colleague in the Philippines.

So while I personally use it most often for invoicing and tracking receivables, it is a full-featured accounting package and I can easily supervise the bookkeeping and perform year-end accounting adjustments.

Xero (Wellington, NZ)

Xero
Founded in 2006, Xero went public in 2012. According to Crunchbase it has some 370,000 users worldwide – including one of my larger clients. Unlike Wave, Xero actually charges a fee to users – hence the lower number of users.

 

 

 

 

Quickbooks Online (Mountain View, CA)

QBOPublished by Intuit, QuickBooks Online (along with Sage One below) is one of the oldest and most established brands for financial and accounting software. Personally I use it – in conjunction with Freshbooks – for my accounting practice. In addition I use their Profile tax preparation software and can certainly recommend the company and its products.

 

 

Sage Online (Newcastle Upon Tyne, UK)

Sage

While Quickbooks is strongest in the US, Sage is stronger in British Commonwealth countries and in Africa. Over the years Sage has acquired Simply Accounting and MYOB – both of which I have used in the past. I have not tested their online software – it was just recently launched.

 

However, given the reputation of the firm, it clearly warrants a look if you are evaluating online accounting software.

 

While I believe that these probably represent the best options for start ups looking for online invoicing solutions, if you don’t think these 6 options give you enough choice feel free to check out the 27 Free Alternatives listed by Mashable (self-described as “a leading source for news, information & resources for the Connected Generation”).

27 Free Alternatives – Mashable

Young Entrepreneurs More Likely to Fail

In spite of Silicon Valley’s apparent fixation on youth – see How Tech Investors are Failing on Due Diligence – a recent academic study has shown that older entrepreneurs are less likely to fail.5 Year Survival by Age

The study spanned 5 years and looked at founders in 5 different age groups by decade (20s – 30s – 40s – 50s – 60s).

Given that the study covers 5 years – about half of the people in their 40s would be in their 50s by the time the study ended.

Note that entrepreneurs in their 30s are marginally more likely to exit by way of M&A transaction than their older colleagues.