Define A Financial Structure Early

If you’re looking to exit your company, building the financial structure for your business will be important. It will be the most important piece of the equation in any future conversations. Unicorns need not apply.

It is the most under appreciated. They will get you to the promise land, but then they will also fall back into the abyss. There are only a few groups of people that really care about your financials.

These groups though carry a lot of weight, and will drive much of the conversions through your transaction or exit:

  • Investors
  • Acquirers
  • Government

As you go about building your business, you will care about key financial elements. Things like, the cash coming in and out. Where the cash is going and how it’s being allocated. What you won’t do is get immersed in the minutia of the accounting process.

I encourage you to do the opposite. Take the time to build out your financial framework early. It’ll pay dividends in the future. There is no worse task than having to go backwards in time, and when you’re going through the due diligence process all your dirty little secrets will be discovered.

The experience outlined below is best applicable to businesses that have been built with financial sustainability in mind. 

Define Your Financial Structure

When you’re starting, there are two accounting methods you want to be familiar with: Cash Basis and Accrual Basis.

  • Cash Basis Accounting: you record cash as it’s collected, and expenses as they are expended.
  • Accrued Basis Accounting: you defer revenue and accrue expenses as services are being performed.

When you’re getting started you’ll undoubtedly get started under the Cash Based model. This is ok until you reach $5M a year in revenue, after that you won’t have much of a choice. Check with your CPA to get more details.

For the first couple of years, we were on a Cash Based accounting model. When we switched to a Accrued Based model, it was a bit of a cluster as we tried to get our heads around the process.

Cash Based Accounting Model:

  • Customer Purchases $120 / year service in May
  • Company records $120 of revenue in May
  • Company spends $10k in sponsorship in May, for an event in July.
  • Company records $10k in expenses in May.

Accrued Based Accounting Model:

  • Customer Purchases $120 / year service in May
  • Company records $10 of revenue in May. $110 of revenue is deferred.
  • Company spends $10k in sponsorship in May, for an event in July.
  • Company defers the $10k expenses until July, captured in the Balance sheet as a prepaid.

There are a number of systems out there to help you with the process. I encourage you to use Quickbooks Online. It’s built for accountants, but it’s invaluable to get immersed in the terminology early. If you’re serious about exiting, it’ll rear its ugly head eventually.

I always wanted to try but it’s built for smaller businesses, and only supports cash models.

Financial Documents

There will be three financial documents you want to have readily available: Balance Sheet, Income Statement (Profit & Loss – P&L) and Cash Flow Statement.

  • Balance Sheet: The most important thing to remember here is the following equation: Assets = Liability + Equities
  • Income Statement (P&L): This provides you a high level view of your income and expenses. How much came in, how much went out (and where).
  • Cash Flow Statement: This shows where all your cash is flowing, breaking it into activities like operational activities, investments, etc…

Do your homework. Understand each document. You don’t have to be able to create each one, but you should be able to read and understand them.

Become familiar with the term Bookings and GAAP.

Bookings has a strong correlation with your Cash Based accounting model. It shows you every dollar you brought in during a specific period. GAAP however, aligns with the Accrual Based accounting model, and corresponds to the General Accepted Accounting Principles (GAAP).

I love Bookings. It’s simple. It’s defined by cash. It’s the true operational metric that defines performance for any business.

  • Do we have enough cash to cover payroll?
  • Do we have enough cash to pay our bills?
  • Are we running in the red?
  • How much operational cash is flowing?

You don’t require an accounting degree to start your business. You do require a basic understanding, and an ability to ask questions. What you’ll learn is that while you have a lot of freedoms when running your business, your financial structure is one of them.

Ensuring you have things structured correctly early will save you headaches further down the line.

Financials Will Determine your Value

Whether you’re raising capital for or exiting your company. Your financial structure will determine your success, specifically around what your company (product) is worth (i.e., valuation). When speaking to investors be careful to clearly define the financial model you’ll be using.

Tip: Bookings will be your go to model when communicating your financial state externally. Depending on who you’re negotiating with, they’ll want to fall-back on GAAP. Set the tone for the model you’ll use early, and often, to help avoid confusion.

Your product will get you to the right table, get the right people talking about it, but unless you’re an Instagram and can afford a conversation with Mark Zuck, you’ll likely follow the same road as most everyone before you.

Your expected journey: A business unit will identify the need, and become your stakeholder. The corporate development person will reach out. The business unit stakeholder will push the story internally, while the corporate development person will work broker the deal.

Regardless of the process, the true valuation will come from your financial structure.

Leave a Comment