Tech Startups and Accounting – A detailed analysis (complete details)
Tech Startups and Accounting: Successful entrepreneurs are good strategists. They have foresight to spot future trends. They have insights to commercialize and execute ideas. But most entrepreneurs might have little or no exposure to system of accounting their business transactions. Growing number of technology startups are ideated by technical specialists with expertise in their area of interest. The big questions are – is there a serious need for them to know the importance of accounting at the start-up stage? Does lack of accounting exposure affect the way business decisions are made in a newly established innovative venture? How can knowledge of accounting make difference to the management of start-ups?
Tech Startups and Accounting
Technopreneurs (technology driven entrepreneurs or simple techies) stay tuned to the technical side of their business. Fund raising and capital investment decisions taken by young entrepreneurs with limited exposure to accounting systems might lead to disastrous consequences for the entity. There is often little or no information available in public domain about the role played by external experts in such decision making process. Therefore though the entrepreneur(s) might employ or appoint agencies to look into accounting data, this in itself may affect decision making process. It is a good idea for a technopreneur to become his or her own accountant and look at numbers with more confidence.
When the business is in its early stage, record keeping to measure accrual profit is barely a priority. All that Startups are looking for at this stage is ‘Cash’. But as the business grows and fund raising goes into its second or third round, the need for comprehensive record-keeping sets in. Often accounting is confused with book-keeping or journalizing. Well, gone are the good old days when as a small player you could get away with simple income and expenses kind of transactions. Today’s modern enterprises need much more robust and comprehensive records. As the company is privately held, these records are not for filing of statutory papers but for decision making.
Let us take a simple example of calculating the total cost of a product which is sold by an e-commerce company through its portal. Apparently the cost is simple a summation of ‘cost of buying the product’ plus ‘cost of logistics incurred to buy the product.’ There can be many other important elements of total cost which the firm might not take into account and therefore end-up miscalculating the total cost. Several overheads which are incurred at firm level also need to be allocated and apportioned to products without which the actual difference between its selling price and total cost cannot be correctly estimated. Well, does this really matter for the business? Indeed, a lot. The ecommerce industry operates on thin margins. Each player struggles to grab the share of the hyper competitive market. Any misunderstanding or misinformation will lead you towards irreversible mistakes and losses.
Proper accounting helps in scenario planning and budgeting. Forecast of cash inflows and cash outflows is essential for keeping the firm financially fit and healthy. Investors not only expect good returns from their investment but also want the business to create a scalable model for opportunities present in the market. What this means is that investors are willing to absorb shocks of initial losses if they are convinced about the ‘on track’ performance by the startup. This ‘keeping things on track’ is possible only when the founders know all the vital signs. This gives investors’ confidence about effectiveness of actions which propose to use their invested funds.
So what are the vital signs? Which information should new businesses value? The answers vary across different forms of new enterprises but the underlying phenomena of utility for forward looking insights remains constant. In a typical information and internet technology driven model the most valuable information happens to be a Unit Level (popularly known as Unit Economics). For a brick and mortar, capital intensive and asset heavy model the economic logic unit level does not necessary hold good. Because in an asset heavy model there is a timing difference between cash outflows (which happen at a point of time) and cash inflows (which happen over a period of time). This is what is generally discusses as Capital Budgeting problem. Due to timing difference traditional businesses like producing goods (rather than services) used Net Present Value and Internal Rate of Return as their primary diagnostic measure before deciding to invest into project.
Well, even a tech startup needs NPV calculations to begin with but it cannot moderate its operations simply by looking at NPV or IRR numbers. Then what is the primary metric for technopreneurs? They use something simpler called as BEP or Break-Even. Break-Even Point is a point in business life-cycle where the firm’s revenues equal its total costs. It is a point where the firm has recovered all its fixed costs. Technically it is a ratio of Fixed Costs to Unit Contribution Margin. Unit Contribution is the difference between Selling Price and Variable Expenses. Anything sold after Break-Even generates profit. Faster the recovery of fixed costs, closer the firm gets to BEP. For many companies it takes long gestation periods to Break-Even as the Unit Contribution Margins are wafer thin in today’s hyper-competitive scenario. A good knowledge of these basic accounting tenets go a long way in making tech startups wiser in their commitment to fixed costs.
What makes successful startups different from others is the ability of its founders to think in a holistic fashion. When faced with challenges these are people who get into details by putting themselves into the shoes of their customers. And for that they rely on data and not merely instincts. In a volatile world instinct can help only temporarily. For long-term edge new businesses must enhance their ability to generate and use critical data for leveraging their other resources. A good accounting and control system pays-off both by helping sound decision making as well as cross referencing information for future use. So, don’t wait for any statutory demand as it might be too late for you to bring your house back in order.