Entrepreneurs - A Little Accounting Knowledge Can Make a *Big* Difference
A number of years back, I was approached by a company in that needed some help finding a strategic partner. The company, based in Asia, was doing pretty well. They had some partnerships with some top brands, a solid customer list, and revenues were growing nicely. What they needed was a US-based strategic partner with money to invest and the ability to push their products into that market.
Within a few months, I found them such a partner, based in the US, and worked with the company's bankers to create a good deal for the Asian firm. The term sheet we negotiated achieved the company's goals, and once we had it signed, we flew back home, ready to start preparing the due diligence package. And that's when the fun started.
The first thing we discovered, upon opening up the accounts for analysis, was a hole in the balance sheet. The "sweat equity", the unpaid work done by the company's founders since the company's inception, had not been reflected in the "Accrued Salary and Expenses" line in the Liabilities section of the Balance Sheet, or anywhere else.
Most of the company's senior management team had been working on half salary (and sometimes less) for years, since the company's formation. And, though the team had already been allocated some common stock based on their cash contributions upon founding the company, this oversight meant the team was in danger of losing significant additional value in the upcoming negotiation.
The second thing we discovered was that the company's financials had been quite literally "prepared by hand" - the person creating the spreadsheets - a much older gentleman - had literally entered every sales and vendor invoice and cost item manually and hand-calculated every output in Excel over the past two years.
Pre-trip, we had assumed he had used Excel's "Paste Special" function to remove the formulas (more proof of why assumption can be the mother of all screw-ups). He hadn't. When we showed him the "Sum All" function, he was amazed.
The third thing we discovered was that the sales projections for the next three years had been prepared the same way - using pencil and paper. There was no easy way to adjust for the probability of a bad quarter (or a great quarter), and no way to adjust any of the expenses short of re-calculating the entire spreadsheet. Adding a new opportunity involved a complete re-calculation of every worksheet. There was no tie-in with the Cost of Goods Sold worksheet, other than another hand-calculation.
With three days before the team arrived from the US, there was only one way to tackle these issues - fire the accountant, create an accurate Profit and Loss statement, including a set of historical accounts and projections, using the existing accounts and sales data, and create a revised Balance Sheet that accurately reflected the salary accrual strategy that management had been following.
We knew we'd have some explaining to do re the revised balance sheet, but we were comfortable the investor would understand our reasoning there. The revised Profit and Loss statements, Cash Flow, and Projections were our larger concerns, and needed to be addressed before their arrival, so due diligence could be completed to their satisfaction, and the funding closed.
For the accounting requirements, rather than stay with Excel, we chose to go with QuickBooks - an excellent and proven accounting system for companies fo small to medium size. For future projections, we used one of my financial models (a precursor to the models available for download on this site).
The evening before our guests arrived, thanks to these two sets of tools, four very tired entrepreneurs, and two tired consultants, we had every sales invoice loaded, every expense in place, and everything else dollar-perfect and ready for their analysis.
The good news? Despite the pencil and paper approach, the accounts turned out to be perfect with respect to the historical inputs, and the projections sheet was such a hit, the investors asked if they could share it with their financial group back at HQ. The even better news? Three weeks later, the deal - a US$10 million first-round funding - closed, at the full value agreed in the term sheet.
1. Be prepared. Had we not undertaken to revise the accounts of this company to be in line with international (GAAP) standards, there is a risk the investor may have looked at the accounts and made an adverse judgement about the quality of the company, based on the quality of the information being presented - which might have endangered the funding
2. Don't assume - know. Never assume that a spreadsheet was created by someone who knows what they're doing - they may have been created by hand-copying in numbers from a circa-1972 Casio calculator (!) - check every cell, every formula, and step back and look at the big picture - don't assume anything - ask to see the assumptions beneath every projection
3. Account for all possible options. Don't create projections that can't be dynamically adjusted to account for all possible events - positive or negative - a non-dynamic set of projections that fails to articulate a multitude of possible strategic options can sometimes signify a management team bent on executing a single strategy, come Hell or high water - Hell and high water can be avoided by articulating different sales and operating strategies in a dynamic financial plan - and when it comes to financing, though many VCs will use their own tools to conduct analysis during due diligence, having a dynamic approach to execution may shorten the time needed for due diligence
4. Include your founder value at full weight. Entrepreneurs, if you can only be bothered to learn a handful of accounting principles, learn this one: learn how to accrue your salary to the Balance Sheet, so you can be repaid what is owed later or have something of value you can convert into equity at the right time. Acknowledge the fact that you're working for half-salary (or less) using your accounts - - if you don't do this, you risk losing the value of your contribition*
*The importance of accruing salary pre-funding is especially true if there is any risk of losing control of your company, or its accounts (i.e., if you're re-assigned to Special Projects, fired, or otherwise leave the business before this value can be realized). Should that happen, the best defense you have against ending up with nothing to show for your efforts is an audited set of accounts - a set that includes your founder contribution at full value.
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