Accounting Advice for Founders

Accounting Advice for Founders

Notes derived from a guest lecture by Danny Wallace, Partner at PwC’s Silicon Valley practice. For informational purposes only. Errors and omissions are my own.

Collect sales tax from early on

Since the South Dakota v. Wayfair supreme court case, businesses without a physical presence in a state but with more than 200 transactions or $100,000 in-state sales should pay sales taxes in the state. Many startups did not collect sales tax at all, a mistake that will defer IPO and M&A deals. Fixing the sales tax issue is expensive for 2 reasons:

  • You need to pay sales tax in arrears.
  • Starting to charge sales tax will hurt your growth numbers and hence valuation.

Sales tax is an issue that comes up on every M&A deal. By all means, the company needs to get registered for sales tax and should seek professional advice.

Classify operating expenses cleverly, reduce G&A

Operating expenses are not created equal. We prefer R&D (research and development), and maybe S&M (sales and marketing), over G&A (general and administrative). Take advantage of the reporting flexibility of expense classification. For example, rent in the Bay Area is high, and some startups put rent under G&A, but we could allocate the rent to different items. Suppose you have one floor for G&A, one floor for R&D, and one floor for S&M, then we can only report a third of the rent under G&A.

Also, there are opportunities to capitalize the R&D expenses so they do not hit the income statement and go straight to the balance sheet and depreciate over time.

Do 409a valuation every year and proper tax withholding

You must do a 409a valuation at least once a year, which will qualify for a safe harbor for the next 12 months. Otherwise, the IRS may challenge the tax status of the stock rewards to employees, and in turn, employees may sue the company for failure to perform 409a valuation properly.

Grant the stock rewards at the fair market value, or there will be tax consequences.

The company needs to issue 1099’s to the contractors. If the company does not, IRS will treat the contractors as employees. As the business expands globally, you also need to consider international taxes and work with professionals to design a global tax strategy.

Watch out for internal fraud

Especially in the seed and early stages, startups are plagued with internal fraud and misappropriation of the company’s assets. Two-thirds of all US-based small businesses fall victim to employee theft. Common schemes include expensing trips that never took place, claiming personal expenses as business ones, and falsifying sales for commissions.

Fraud is common at this stage because companies often have no formal processes in place, and operators are too busy with getting the business off the ground. The companies should minimize the number of corporate credit cards and require approvals for all purchases and transfers above a certain threshold. At the same time, strengthen the hiring process with reference checks and background checks. Set up a whistleblower hotline.

Always verify communication with a second means

External fraud is also prevalent, with the most common one being phishing emails for wire transfer. Examples of spoofed emails are the CEO asking emergency wire transfer for a confidential deal, or a vendor requesting for updating bank information. Or the hackers may fake a login page to get your internal systems credentials, risking your intellectual property and employee data. Spoofing could also be in physical mails.

You should always verify the intent with a second means, such as calling the alleged sender directly and set up multi-factor authentication.

Think twice before publishing key metrics, protect data integrity

Besides items from financial statements, a company may choose to publish key metrics specific to the business, such as monthly active users, number of paying customers, net retention rate, number of completed trips, etc. You need to clearly define and consistently measure the key metrics. Once you publish such metrics, you need to continue doing so going forward. Data integrity and history are crucial. Investors will sue for any misrepresentation of the metrics. Similar to how you should prevent internal fraud, make sure you have internal control in place.

Own your revenue model: ratable or non-ratable, net or gross

There is a trade-off between the ratable and non-ratable revenue models. Ratable means proportional. Ratable models recognize service revenue over time as services are provided. The revenue schedule is defined in the contract elements. Ratable models are more predictable and offer more visibility into the company. For example, SaaS companies with mouthy subscriptions can provide great guidance to investors with a high degree of confidence. However, ratable models are less tweakable. For example, at the end of the quarter, if you risk missing the forecast numbers, you cannot just send salespeople out to get deals done on the last day of the quarter. Even if you do so, you recognize only one day of revenue.

Another dimension of the revenue model is gross vs net, especially for marketplace and platform businesses. For example, Uber follows the net revenue model. If Uber collects $10 from a rider, pays the driver $8, pockets $2, Uber will recognize $2 revenue instead of $10, and $0 COGS instead of $8, because its terms and conditions say it is a platform company connecting drivers and riders.