GAAP for Start-Ups
October 26, 2021
By Ulesha Kulkarni
As a tech entrepreneur, you are most likely focused on developing your product, hiring the right team, establishing and growing sales and managing cash flow. In addition to these critical areas, creating the proper accounting policies early and developing a discipline to adhere to them is equally important. The ability to communicate the financial picture of your company using a framework used by most other businesses provides increased credibility to investors, enables you to effectively monitor your business’s progress and builds a solid foundation on which to grow your business.
The following are a few key reasons why following Generally Accepted Accounting Principles (GAAP) is preferable to using other accounting methods:
Raising Capital from Investors
If you're looking to raise venture capital or take out a business loan, your financial reports should follow GAAP. Venture capitalists, in evaluating your company for investment, will want to build investment models and compare key performance metrics to benchmarks. Providing them GAAP-basis financials provides instant credibility and demonstrates you are conveying your financial information in a way that they can easily understand and compare to others. Also, most venture lenders will require GAAP-basis financial statements to fulfil the underwriting requirements mandated by their financial institutions.
In addition, once you close on your venture loan or take your first institutional round of financing, these institutions often require regular financial reports and even audits. Building your financials based on GAAP from the beginning makes this new requirement much easier to comply with.
Understanding and Managing Business Performance
GAAP-compliant financial statements provide a consistent basis on which to measure the performance of your company. They demonstrate that revenue from period-to-period is recorded on a consistent basis and related costs are presented in the period in which they are incurred. This allows meaningful analysis around statistics like annual recurring revenue (ARR) and customer acquisition cost (CAC), as a couple of examples, because the information from which they are derived has been prepared on a consistent basis. Key performance indicators (KPIs) like these, when calculated from GAAP-basis financial records, provide insight into the performance and efficiency of your company. From revenue to pricing, GAAP financial statements will give you a clear picture into what’s working and what’s not.
Reliable Forecasts and Comparability
Basing your forecasting on financials that are consistent demonstrates the reliability of those forecasts. Because of this consistency, using the GAAP system can also make it easier for your start-up to compare its performance to other businesses in your industry.
Foundation for Exit Strategy
Whether you decide the ultimate exit is a sale to another company or listing your stock on a public exchange, GAAP compliance is a requirement. Companies looking to acquire your company will typically undertake a process to evaluate your quality of earnings. This process will encompass evaluating whether your financial statements comply with GAAP. When deviations are found, they adjust your financial results and, if significant, may adjust the amount they are offering for your business. Being prepared with GAAP financials minimizes the risk of surprises during this process and lowers the risk of adverse adjustments to purchase price. Going public also requires GAAP-basis audited financial statements for at least two years. The process can be lengthy and costly. Ensuring that your books and records are already prepared in accordance with GAAP lessens the expense of completing the required audits and can help expedite the process.
Easing Tax Compliance
As your company grows it will be required to prepare its tax returns on an accrual basis. Many of the requirements for tax follow GAAP accrual and recognition conventions. Keeping your records on a GAAP basis from the start means you will be ready to use required information in the tax returns when tax season comes.
The following are some GAAP requirements unique to technology companies:
In addition to accounting for accounts payable, accruals and fixed assets on an accrual basis, the following areas are unique to a technology company.
Capitalization of Certain Development Costs
GAAP requires the capitalization of software development costs for those companies building a software platform internally, which it will then provide access to via the Internet (software as a service or SAAS), and for companies that license their software to customers (on-premise). The points at which capitalization starts differs for each as can the composition of costs to be capitalized.
GAAP requires the fair value of stock options, restricted stock awards or units and other stock-based awards to be recognized as compensation expenses in a company’s income statement. GAAP treats these awards the same as cash paid to an employee and requires their amount to be included in the total amount paid to an employee or consultant. Measuring these expenses requires judgment in estimating the fair value of the stock and other assumptions and for stock options requires the use of an option pricing model like the Black-Scholes Merton model.
Revenue recognition for technology companies also can require judgement. Often the technology company’s product or service is comprised of several separate components that may be delivered at different times or over different periods. Allocating the amount received from the customer for the distinct performance obligations under the contract can require significant and careful judgement. In addition, the product or service being sold may include intangible products such as the license of software or digital content. Unique rules apply to each for recognizing revenue. Finally, start-ups are often selling their products and services to much larger, more well-established and capitalized companies. The desire to gain sales traction in a product or service and especially the desire to get customers with significant brand recognition, often results in start-up companies providing significant up-front and year one discounts, or tiered volume-based discounts. These characteristics also provide complexities in applying the revenue recognition under GAAP.
Thinking through these areas early, and engaging with experts in these areas, enables you to create a strong financial reporting foundation. A strong foundation will provide the vehicle to scale your business and allow you to access capital more effectively.
If you want your start-up to be a successful one, you must treat GAAP as a ‘must-have’ rather than a ‘nice-to-have!’