There is no magic potion for building a successful business, just as there is no secret formula for anything else in life. However, a few secrets of the trade might assist you in getting there. It's not simple to come up with a unique business strategy. However, with the proper structure and approach, there is a far higher possibility of avoiding any embarrassing pitfalls. That is to say, pitfalls would hurl the whole business into a state of collapse. Taxes, bookkeeping, accountancy, and financial planning are among the most loathed aspects of building a successful business. Several early-stage companies fail due to insufficient financial planning and prioritizing or a lack of expertise on the issue. Founder Institute explores how to improve the best methods for handling finances of early-stage firms, highlighting the severe mistakes to avoid, and more in the 5th edition of their "Mastering Startup Operations" series. Adam Spector, COO of AbstractOps, and his team (Alex Roytenberg and Betty Kayton) sat down with Ryan Micheletti from Founder Institute to discuss various startup operations in early-stage businesses.
Note: Following are excerpts from the original interview. Here is the link to the video of the full interview.
Adam, do you want to do a quick intro on yourself and maybe introduce the panel?
Adam Spector: Thank you so much. It's always a pleasure to be here. It's great for me to do these sessions on “Mastering Operations” because one of the key goals that I have as a founder and investor is helping this overall ecosystem to expand and increase. I genuinely believe that the more startups there are in the world, the better the world is. The businesses we are starting and our progress are a natural value addition. So hopefully, these sessions are precious for the people on this call to improve their businesses and how they run them. I'm the co-founder and COO of AbstractOps. We're a startup ourselves, with a core focus on automating a lot of the back-office work - the kind of back-office admin work that startups have to do to build their business. We want to take that off your plate to get going and focus on what you do best, which is hopefully building out that great product and then getting customers for that product. I would also like to introduce Betty Caden, one of our advisors at abstract ops. She is one of the fantastic CFO leaders in Silicon Valley. She's a longtime leader, she's advised several different companies. She also happened to be the fourth employee and the first CFO of Dropbox. So, she has seen it all. I’d also like to introduce Alex Rotenberg, who happens to be AbstractOps’ accountant and bookkeeper. He's a CPA with over 20 years of experience and has a firm that works with a vast number of startups, making sure that your books are taken care of so you can once again get back to focusing on what you do best.
In general, startups and many of the startups on this call might be self-funded. Then you probably get family funding. Then comes the angel, followed by the venture. But the critical thing about money in a startup is what matters is your overall burn rate. How much money is coming in, or how much money do you have in the bank minus the overall costs? Over time you take those two things: cash in hand plus cash coming in, subtracted from your expenses. That equals the amount of time you have to survive. That's the most basic level of financial planning that I think every startup should do. It's simple. Put it into a spreadsheet and plan how much time you have to live. We'll talk more about planning overall, but understanding burn rates is critical. You may want to do your bookkeeping monthly. You want your books to be in place because if you understand your books, which consist of your expenses and many transactional costs, that will help you predict your overall expenses. Finally, accounting is a little bit more about taxes and insights into your general business.
I'm a three-time founder. I've invested in 40 plus different startups. As a founder, one of the critical things that I highly recommend people do is - make sure you create a plan. Make sure you understand the work you're trying to do, the expenses you have, your cash in hand, and figure out what that plan looks like and the project. Think along the lines of: “Hey, like what do I think revenues are going to look like six months from now, or 12 months from now?” “What if I launch a different product line?” Those are some of the critical things you want to put into your plan. Include hiring as well. Maybe include some essential margins as well. Are you going to have 80% SAS margins? Are you going to have 20% services margins? Those are things you should be asking yourself and trying to put into a basic plan. However, as Dwight Eisenhower said - “Plans are nothing, but planning is everything.” The best-laid plans go out the window the moment you step into battle. And that's what happens with startups.
Even at AbstractOps (where we think we are pretty decent about planning) in six months to a year, I will be shocked if we are precisely on target with our plan because things change quickly in a startup. But what's important is to try to plan things out so that you know what to do in the future and where that's taking you as a business. A critical element is to at least attempt to have some level of a plan because that's the story. The goal is the story that you tell to your team., it's the story that you tell yourself, it's the story that you tell your investors, and hopefully, you achieve it. I’ll now turn it over to Betty for the financial statements.
Betty Kayton: I just want to add one last comment about the plan. Just like Adam said, you never end up doing exactly what the plan says, but the idea is, ask yourself all the questions. “What happens if this goes on and what happens if that happens?” “How about this?” You get a huge amount of mileage from answering the questions, asking them, and thinking about what could go wrong and what you could do differently. I love planning, even though Adam said it never turns out the way you expect it to. So, let's talk about financial statements. I'm going to put a little bit of international that isn't in the deck as we're coming along.
So, there are three classic financial statements. Everybody calls the P&L (which stands for profit and loss). The P&L is the document that shows your innies and your outies. It shows your revenue and expenses and how much you’ve made at the end of the day. So if you take in a hundred, your profit/revenue is a hundred. You have expenses of 80, a hundred minus eighty is twenty, so that's your profit.
The next one is a balance sheet. A balance sheet says, “What are your assets and what are your liabilities?” If you have $2000 in the bank, that's an asset. If you've got $500 of inventory, purchases are $1500. Your liabilities show how much money you owe everybody. So the balance sheet just says, “Do your assets exceed your liabilities?” You always hope they do because you don't want to be bankrupt. So you always want to make sure you've got cash in the bank. So if you know today that you're going to run out of money in July, you need to take the time now to start planning so that you don't run out of money in July.
The third one is the cash flow statement, and this is the one that's the most important when you're a startup. Yeah. The income statement is indeed going to audit your finances. If you're going to go public, you care about a balance sheet. But as of today, for a startup, what you want is the cash flow statement. How much money left your bank account this month, and how much came in this month? If it's got a plus at the bottom, That's great! Most startups, though, lose money initially - especially for the first one or two years. As long as you don't lose more than you expected or planned for, you're okay. “Gee, we thought we were going to lose $20,000 this month; we only lost $18,000. Isn't that great? We only lost $18,000 this month!” It sounds crazy, but it means you're running ahead of the plan. You'll hear me say a million times: “Cash is king.” If you've got cash, you have time to figure out what's going on, figure out what to fix, and figure out how to take care of it. If you don't have cash, you're really out of luck.
Adam Spector: I’ll just add something to that point from the startup founder perspective. The way to get cash is not just by your income but also by fundraising. This is where you might have money in the bank to start with to help provide that coverage as you're building your product until you start receiving actual revenues. That's where venture money can help make sure you have the cash because cash is king. It enables you to build your product and get it into the market to start making that money. Your venture provides that cash cushion since you're losing all this money upfront.
Betty Kayton: This is what a financial chart might look like. This accounts for five years, but you're a startup. You're probably only going to do 3-5 months. You're probably not going to go out this far, but the idea is that you're looking at what your key indicators are. As you get going, you're going to care about how many customers you have. You're going to care about bookings and backlog. Revenue is what came in, and the cost of sales is what it costs to generate the revenue. So let's say you're a software company. The ‘17’ shown on ‘Cost of sales’ is what you might pay Amazon Web Services or Azure to do your hosting. So, you got 83 to start. You had to give 17 right off the bat to AWS. That leaves you 67. And now you've got to look at your operating expenses, and that's going to be payroll and rent. You're going to pay for other software services. You might use Dropbox and pay them some money. And then you're going to earn some money, i.e., net income. There's a line below that is called EBITDA. What is that? That's a number that investors like to see. You’ll notice that it’s pretty close in the case of this sample company to the net income. EBITDA stands for “Earnings before Interest, Taxes, Depreciation, and Amortization.” It’s the stuff that matters. If you take the net income and add back the interest, and that doesn't count taxes or depreciation, it's a better judge of the business to look at the EBITDA line. So, your bookkeeper generally gives you the EBITDA. It doesn't matter much in the first year, but it starts to matter as you get to the second or third year.
Headcount is significant. In most companies, 75%-80% of your cost is for people. Whether they're employees or consultants, or advisors, that's generally where your price goes. Also, you don't like firing people. So, if you need to move out of a building or you stop paying for salesforce.com or whatever you're using, that's not so bad. But you don't want to fire people. It's a good idea to keep track of that. And then comes cash because cash is king. So keep an eye on your cash balance, and as we can see in the picture above, it is in the negative. What is it without a new investment? Well, this company better go out and raise a million bucks because we're going to be negative $800,000 a couple of years out, so we better have a fundraising plan. So that's the ins and outs of the financial chart. This is still pretty much the same worldwide. This is a very United States-centric chart.
Adam Spector: I'll just add one other point. When I talk with companies about fundraising or they want to pitch me for investment, anyone who's projecting for four to five years into the future, I completely ignore what they have there because that's all going to be thrown out. It's good to have those plans, but in some ways, having granularity monthly might be even more valuable with the same sort of information.
Betty Kayton: Okay, let’s now get to accounting 101. This isn’t going to matter a lot to a lot of you because this is relevant only if you've already raised your first $300,000-$500,000, and you're moving on beyond that. So for those of you that haven't raised a lot of money, don't sweat it, but be aware of it so that it's not a surprise as you get bigger and bigger. The most important thing here, which is worldwide, is the concept of cash versus accrual basis. So let's give an example. Let's pretend that you're paying the rent, and let's say you have to pay a thousand dollars in rent every month. If you look at a column for each financial statement, it goes a thousand every month. Great. But let's say you don't have the money for one month, and you don't pay the rent this month. So you have a thousand, a thousand, then a zero because you skipped it, and then $2000 because you paid two months at the same time. So you have $1000, $1000, $1000, $0, $2000, $1000, $1000, $1000. If you're looking at it and trying to analyze your expenses, you go, “Wow, our expenses doubled this month.” No, that's just timing. So cash basis says, you look at how much you spent, which is $1000, $1000, $1000, $0, $2000, $1000, $1000, $1000. In an accrual-based system, you smooth that all out. What you do is look at when you should have paid for it, as opposed to when you did pay for it. So if you take that same chart, and you look at it on an accrual basis, it's going to be $1000, $1000, $1000, $1000, $1000, $1000, $1000, $1000. It gets smoothed out. I'm assuming most of you folks are going to use QuickBooks. QuickBooks has a button on it. You just click on the button that says cash basis, and it gives them to you, and you could click on a different button on QuickBooks that gives you accrual basis. Even though you only enter the stuff once, you just click on the right button, and you'd get a different view of it. So it's just a great idea to understand that the accrual basis lets you look at what should have happened instead of what did, and it makes it a lot easier to understand what happened. Let's say you stopped paying bills for a month. Well, it didn't mean your expenses stopped. It just means you kicked them down the road. You're going to pay them next month.
Betty, is there a better option for startups at an early stage? Do they do cash or accrual, or does it not matter?
Betty Kayton: My recommendation is if you have good accountants like Adam's team, you do accrual from the beginning. The reason is it takes maybe an extra 5% more time to do it right, But then when you're going out, and you're trying to explain it to investors down the road, you have the data there. You can look at it. You're doing accrual, but remember, you just click on the button in QuickBooks, and you can still look at it on a cash basis. So if you do accrual, you get to do both. Sorry, you're out of luck if you only do cash. You don't have the data for the accrual. And as you get bigger, by the time you've raised 3 million bucks, you've got to be on accrual basis. They're going to demand it. So if you can afford it and do the 10% extra work, it might cost you a couple of hundred bucks to go over to accrual to start with, but then you never have to go back and redo and rework anything.
So let's go down to big purchases. Let's say I go out and I buy a hundred-dollar laptop. I'm going to record it as an office supply expense. But let's say I have to buy a $20,000 machine. I need a 3D printer. I need a $20,000 3D printer. Well, I'm not going to expense that all in one month, even though I wrote a check and I paid the whole 20,000 bucks upfront. The accounting rules say that “Look, this thing's going to last you a long time. It's going to last you two or three years”. You take the cost of the 3d printer, and you divide it by 36 months. So when you report it on your financial statements, even though the whole $20,000 in cash went out the door, it's $20,000 divided by 36 every month, and that's called depreciation. So you show it each month as a level expense. For tax purposes, you don't get to deduct the whole amount in some countries. In some countries, you also have to spread that over time when you do your tax return. So there's a big difference between a bit of expense and a significant expense. And most people pick in the United States $2,500 as the cutoff point for that.
There's a thing called GAAP, Generally Accepted Accounting Principles. This is US-only. Every country in the world does it differently. The US does GAAP. So, if you're planning on going public on the United States Stock Exchange, you will follow the US-GAAP. The rest of the world does IFRS, International Financial Reporting Standards. So IFRS has everybody on the phone except the US guys, and each country has its own rules about revenue recognition. And this is a big deal. So let's just say for a second that we’re going to pick Dropbox. We signed a contract with Dropbox, and we're going to pay $1,200 for Dropbox for a year.
$1200 divided by 12 is a hundred bucks a month. So it's a hundred dollars a month, but I'm paying it all upfront. I'm writing a check right now for 1200 bucks. So GAAP says, “Wait a second. You don't get that whole $1200 credit right away because you have to produce all that software. You have to for the next entire year. You've gotta be alive, not go bankrupt, keep your software up, and support them right on right now”. So here's what we're doing on the GAAP. It's going to be a revenue of a hundred a month, a hundred, a hundred, a hundred, 12 times, even though I got the cash, the whole 1200 bucks upfront. So we talked about how to finance your startup. Well, would you instead build them $1200 upfront and get the full money now? Or would you rather make them 12 different bills each month, a hundred at a time? That's 12 times as much work. You have to do 12 times as many invoices. And it takes a whole year to get the money. So where you can bill them all upfront, get the cash upfront if you can let the customers finance you. They don't want stock options. They don't want to be interested. They don't want a piece of the company. If you can, get your customers to do that. So GAAP is a big deal for revenue in the software business, and then there are all kinds of other goofy rules.
For example, GAAP says you have to record a cost on your financial statements for stock options. However, when you give somebody a stock option, it doesn't cost you anything. You just hand them a piece of paper. It's dilutive, meaning you give up some of your equity, but it doesn't cost anything. But US-GAAP says you have to record it. So, if you're going to make actual GAAP financial statements, you need an excellent accountant. Most companies pretty much ignore GAAP for the first year or two until they start raising some money. They say, “Look, we're going to keep good books, but we're not going to be GAAP-compliant,” or for foreigners, “We're not going to be IFRS-compliant. We'll do a good job. We're just not going to follow all the stupid rules. We'll only follow the good rules”.
Somebody asked a quick question about what happens if your equipment goes terrible. Remember that 3d printer that we bought that would last 36 months? It breaks in month 9. We have to throw it out. It's gone. You then have to go in and say, “Oops, 36 months minus nine, there's 27 left. The remainder will hit your income statement the day you throw the machine out. Because you can't say, you’re going to appreciate it. If it's not here anymore, it's gone.
So, this slide is a little complicated. I think you may find it interesting if you're primarily in the software business. Remember we said we just signed a contract with Dropbox, and we're going to sign a 12-month warranty, and it's for a hundred dollars a month? So on the left slide, you see the word ‘Bookings (New Orders).’ We just had a booking. A hundred times 12 is 1200. We have a signed contract, and it says $1,200. That 1200 goes into this bucket. So, you now have a backlog of $1,200 because you've received an order and you haven't billed it. Now let's look at the next green arrow going to the right.
We just billed a hundred dollars this month. We put in 1200, but we only billed the first month, $100. There are 1100 left in the backlog. And so a hundred at the time, it goes over to the right side, into the second bucket, and that hundred comes over there, and then you get to book revenue. So the idea of a backlog is it's an order that you haven't billed yet. I'm going to change this quickly, and then we'll move on to something else. We're going to say, “We just booked the whole $1,200, like we did last time”. But this time, we have an awesome person like Adam and Alex running the company, and they said, “We're going to bill the whole $1200, right up front the same day it’s signed”. So $1200 goes into the bucket, and guess what? $1200 comes out of the bucket. We billed the entire $1200, and it moved over to the right side. And we'd get billings. The billing is 1200 bucks, but we only get $100. Even though we got the cash upfront, we have it all here. We only get credit a hundred at a time. So in the right bucket, we're going to get 12 coming in and one at a time coming out. And that's called deferred revenue, and deferred revenue just means we sent the bill, but we haven't done the work yet. So, in theory, if the company goes bankrupt or closes down, you have to refund the money. So this is the liability. So if you billed 1200 upfront, only delivered two months, and the company closes up, you're supposed to give them back the thousand dollars because they paid you for work you didn’t do.
Let’s move on to KPIs (Key Performance Indicators), and they're different for every business. There's no one-size-fits-all where everybody's all the same. A KPI is basically what can you look at on 1-2 pages that contain 10-15 numbers that say, “Am I doing well?” It's like a red light, green light, and orange light. Are they doing wrong or not? Every customer is different. I think for software, we'd say, “How many customers and how many of them are active?” Maybe a thousand customers signed up, but nobody logged in last month. Well, if they're not active, they're probably going to cancel next month. Why would they keep paying you $10 a month if they're not using it? Remember that bucket - bookings, billings, backlog, and revenue. That's the last set of buckets. And then, if we're in the software business, “What's our recurring revenue? How much is next month going to be? What is the churn rate?” So let's take an example. Let's say this month; we have $10,000 in revenue. And next month we have $10,000 in revenue, and you go, “God, that's great. Isn't it the same? It's wonderful. It was 10. It's still 10”. And I'm going to go, “Wait a minute. Not necessarily”. Let's pretend that you had ten last month and six of them canceled. There is only four leftover, and six brand new guys just showed up, so it’s ten. Well, that's not a very good company if 60% of your customers cancel and you have to go out every month and scrounge for new guys to fill up the cancellations. So it's not enough just to look at your revenue. You also have to look at how that all turned up the churn rate.
Let’s move on to Headcount. “Are we hiring too fast? Are we hiring too slow? How much cash?” and the most critical question, which is, “When are we going to run out of cash?” And that's the essential part. About R&D expenses, for those of you in the United States, there are some very special rules about keeping track of your research expenses and filing for the government to pay you cash for the refund. So even if you pay no tax, the government will write you a check in some cases, for research, for hiring certain vital people, and for being in specific locations, as an enterprise credit. So make sure you talk to your tax advisor and your professionals to learn which ones you're eligible for. And a lot of other countries other than the US have similar programs. They're usually called innovation bonuses or innovation credits, or research credits. So anyway, that gives you some idea. Alex can keep going on the rest of these.
Alex Roytenberg: Good evening everybody. So we'll get started with the accounting and bookkeeping side of things and then move on to the taxes. So when you're looking at or thinking about bookkeeping, there are a couple of things that people think about: “Am I starting too early? Or am I starting too late?” So the way that we look at it is, “Hey, if you start too early, the worst-case scenario is that you're going to end up paying for QuickBooks roughly one or two months earlier than you need to.” The issue that we're seeing with people who wait too long is that getting the information from certain banks becomes a complexity once it's after 90 days from that transaction transpiring. It ends up being more work for you, the founder, and the accounting team to get that information into the system. So, what ends up happening is that the accountants might end up charging you additional money for the extra time, but they ended up spending. So instead of it being an automated feed directly from the bank into the accounting system, it ends up being manually punched in. Some founders would say, “Hey, I can do it myself. I don't need to hire an accountant yet. We only have 10 or 15 transactions a month. We'll be okay”. The issue here is that if the transactions aren't done correctly, the accountants will have to redo work. So you've just spent time on a task that you're not perhaps at most optimal to do.
Adam Spector: At AbstractOps, we have a lot of customers who don't have accountants or bookkeepers, and this is something that comes up over and over again, where they were trying to do it themselves, or they just weren't doing anything. It becomes a massive hassle for them to clean it all up. They have to pay way more. They have to spend at least as much money as they would have paid early on just to have a bookkeeper or accountant working with them to start with. Highly recommend that you don't try to do it yourself unless you went to school to be a bookkeeper or accountant and have that knowledge. This isn't an area that's worth using your time. You have way bigger fish to fry, such as getting your product out the door and getting customers, than trying to manage the 15 different transactions you have. It might seem like a small amount, but why are you spending time trying to become an expert when getting a low-cost bookkeeper might only be $100 or $150 a month for the lower end? It's a typical expense for the amount of time it might take you to do it wrong anyway, probably.
Alex Roytenberg: We've seen quite a few times and what we've had to do is take the existing QuickBooks instance that some people have, or different software, and dump it and create it from scratch. Going from scratch is sometimes more accessible and less of an issue than trying to correct something in existence that’s just not working. We want to discuss the other big thing to make sure that you bifurcate between your bank account and your business bank account. If you are setting up a business, what you don't want to do is you don't want to use your checking account to receive funds from clients, investors, or anybody else. You also don't want to use your checking account to make payments for vendors, suppliers, contractors, or employees. The significant risk behind that is a couple of factors. If you have a commingling of funds, what is possible is that your corporate veil or the reason you set up an LLC or corporation for protection against liabilities might go away. Also, the other significant factor is that you may end up improperly recording transactions. Transactions that should have been recorded on the company's books and records as an expense might end up slipping through the cracks and not being picked up. The other factor is that many accountants will not work with you if you end up commingling assets because it will be a lot more work for them.
Alex, as a founder, let’s say I’m self-funding early on. What should I do? Should I just take a thousand dollars out of my bank account, write a cheque to my corporation's bank account, and deposit it at my desk. Write a cheque, turn around, and deposit it? Is that the best thing to do? Or how do I make sure I don't co-mingle if I'm self-funding as an example?
Alex Roytenberg: When people are self-funding, our usual recommendation is for somebody to use the same bank account as their funds are in if you're in the same bank. So if you're doing a Chase to Chase, Bank of America, etc., when you do that transfer online, it's almost instantaneous. As a result of it, there's no need for you to wait two to three days for that ACH or wire to clear, and there are no additional costs to transfer from one checking account to the other one. It also helps individuals trying to keep the amount of cash in the business a little bit tighter. They're able to transfer those funds a little bit more frequently and quickly. So once the company has started, you've incorporated the business. We have a recommended financial stack for somebody to use. One is, “Hey, if you're going to be a startup, you need a bank.” You don't necessarily need a bank that has physical locations. One great bank that we've had great success with is Mercury Bank. Really simple and easy to sign up and use online. The other big one that we usually recommend is to have a business credit card. There's a big difference, and we'll cover it in a little bit more detail later on. There's a big difference between debit cards and credit cards. My usual recommendation is, if you get a debit card in the mail, melt it and throw it out and get yourself a credit card. A credit card gives you an additional layer of security separation from the checking account and any charges. Our recommendations are the usual - Divvy, Brex, etc. And if you're selling online through your website or an app and accepting credit cards, something like Stripe would be a great product.
So, would you consider these early funds? There are two scenarios. You could give your business the money like a loan, or it could be an owner contribution. What do you recommend for early-stage startups, and what's best for tax purposes?
Alex Roytenberg: So the big question is, are you looking to get that money initially refunded but repaid after you raise your Seed/Series A, or are you okay with leaving that money within the business and having that as additional capital invested? If somebody is looking to get those funds repaid to them, it should be set up as a loan within the books and just general record-keeping. The other big thing around that is, it's a question of the duration of the funds being loaned out to the business. So if the funds are being loaned out to the company for over 90 days, and you don't have an agreement between the business and the person who's given the loan to the industry, the IRS can reclassify it as an equity investor. This can cause issues for you if you're trying to distribute the funds at a later point in time.
Suppose someone paid a development firm that didn't work, and they lost 12 grand. Are there any tax benefits that they can take advantage of? Or is this simply an expense on the P&L and, therefore, reducing their tax base?
Alex Roytenberg: It's an expense for P&L purposes. The ability to claim it as an R&D tax credit or expense is a little iffy. The other big question is whether $12,000 is paid to a US firm or an international firm. If it's delivered to a global firm outside of the US, you can't claim it for R&D tax credits, no matter what. So it would just purely be an expense that's on the books. And then you'd go from there.
How do you account for a SAFE note, especially a warrant with an unvalued company? Do you have any recommendations?
Alex Roytenberg: I guess how most of Silicon Valley looks at SAFEs, especially within the YC world, is that it's treated on the balance sheet as an equity investment by the investors. So we'd pick it up as an equity investment, increase your cash balance, and then also improve the equity balance in your account. This also leads us to the next part within the bookkeeping, and both Betty and Adam have touched on this. We get this question of, “Should we do cash or accrual basis?” Suppose you’re going to be an operational business that will be open for the next 10-20 years, and you think that you're never going to be raising money. You're just going to operate the business. In that case, I believe a cash basis will probably be the easiest for somebody to maintain. If you are a business that is planning to grow, raise funds, and expand, it would be most appropriate for you to use an accrual basis of account. The big thing to remember is that if you have your books set up on an accrual basis, you can very quickly, same as what Betty mentioned, look at the difference between cash and accrual. If you have your books purely on a cash basis, it would be a big lift for you to go from cash to accrual. So we usually recommend an accrual basis of accounting. You also don't necessarily have to go into extreme detail on an accrual basis. And what I mean by that is materiality. So if you end up buying an annual subscription for something and it's $120, it's not really cost-effective or operationally necessary for you to advertise that $120 expense as $10 a month. Where we usually go on the accrual basis and break up the monthly subscriptions is roughly $750-$1,000 a month or so because, at that point, you are materially changing or affecting how it's going to be reflected on your financial statements. The fact that an accountant might be doing your books doesn't mean that you don't need to look at them. The worst thing in the world for you to do is not to review your transactions within your bank account or for you to not review your financial statements at least once a month when you get them from your account. When you get your financial information from your accountants, you will also get a list of questions because we can't always know all of the transactions that happened during the month and how they affected your business. So make sure you know your numbers, know where they're moving to, and review the banking transactions. Call it once a week on a Friday afternoon to ensure that there's no fraud or a surprise there.
If I have a bookkeeper, do I need an accountant? Or, if I have an accountant, do I need a bookkeeper? Why are they different?
Alex Roytenberg: That's a constant question that we get. Bookkeepers are there to record your transactions. Accountants are there to review and advise you on what's going on. Some of the accountants can also do the work of a bookkeeper. So the better the accountant, the more experienced they are, they'll be able to give you more value. But they might be a little bit more expensive than a bookkeeper only.
Coming back to taxes, most people think of taxes as just income taxes. The other things to remember are the Sales and Use taxes, Payroll tax, Franchise tax, State Minimum taxes, and International taxes. You have developers in Canada, and you're in the US. The US, I think, is one of the few countries that doesn't have a VAT or GST tax. There are also foreign reporting requirements. This is very important on the foreign reporting side. If you have international investors or international founders in the sense that you don't have a green card or a US passport holder, you need to do extensive foreign reporting. The penalties start with those at $25,000 per form missing with the IRS. So if you have two international founders who didn't do the proper 5471 & 5472 reporting, it's twenty-five thousand dollars per person. Coming to Sales and Use tax, there's a reason why it's called Sales and Use. The State of California does not charge sales tax on software. The State of New York does charge sales tax on software. If you buy software from some companies in California, and you're a New York-based company, they may not charge sales tax on that transaction. But if you are in New York and your software did not have sales tax collected, you need to report Use Tax to the state of New York and pay that sales tax.
Adam Spector: There are big companies now that help you calculate your sales tax because it can be relatively confusing to know where what should be charged and when; there are tools that will help automate some of that.
Alex Roytenberg: The other thing that trips many people up is the W2 or 1099 contractor. The big question is, “Are they only working with you versus working potentially with other individuals or businesses?” You want to make sure that you get your classification of a full-time employee or part-time employee as W2 versus a 1099 contractor done correctly because if that's not done correctly, the IRS can come back two years later and collect social security and Medicare plus penalties and interest on any payments that were made to W2 contractors, that the IRS deemed. With 1099 or international contractors, you need to collect W-8 and W-9 forms. W-9s are for US individuals or businesses. So if they have a US EIN or a US Social Security Number, they will issue you a W9. Suppose it's an individual currently living in Australia and working there remotely because they have a social security number. In that case, they still need to issue you a W-9, and you would still need to issue them 1099. If you have an international business, they will issue you a W-8BEN-E. It ends in an E because it's an entity. And if it's an individual working for you internationally, you need to get a W-8BEN. You don't need to issue any 1099s if you have a W-8. But what you have to do is maintain the records on your side to make sure that if the IRS comes in to audit you and asks why you didn't offer 1099 to this person, you show them the W-8, and you should be covered. As we talked about before, a debit card is directly linked to your checking account. So if somebody fakes your debit card, they can drain your checking account. If you use a credit card, it gives you an additional layer of protection. It helps you with your cash flow. As Betty mentioned, cash flow is king, and you also have the added benefits, loyalty points, and things like that. On the tax side, be aware of R&D tax credits. Other tax credits are available. There are tax credits if you have a 401k program for your business; there are also tax credits last year created because of COVID. Maximize the tax credits available to your business as much as possible. Where do you have to file Nexus? What is your connection to a state? There are two reasons you might have to file in a particular state. The easiest one to explain is a physical connection or physical nexus. Do you have an employee, an office, or a warehouse? Now the trickier one. As a result of Wayfair, a court decision went to the Supreme court back in 2018. The decision was that if you have enough of an economic connection, a business transaction in a particular state, and it's based on where your clients physically set or transact business in, then you would need to have a connection and file in that state. Rule of thumb: if you have over a hundred thousand dollars worth of economic transactions in a particular state, you must file in that state—the other big reason why you want to make sure that you file your taxes: investors. Investors do not want you to have liabilities or issues dragging on historically. So what ends up happening? We do this for several VCs. We come in and do audits or reviews of taxes that were filed, um, by target companies. And any time that you have possible exposures either on sales tax, payroll, or actual tax return filings - that will trigger holdbacks or a percentage of the investment to be held back until you file the taxes. The other thing to remember: extensions are an extension to file, not an extension to pay. Certain taxes need to be paid even if your company is not making a profit. The easiest example is Delaware franchise returns are due March 1st, with minimum payments for corporations $450; for LLCs $350. For states: California- $800, Massachusetts - $456. So make sure that it's not just federal taxes. There are also state fees that need to be paid. This goes back to the other forms of taxes, minimum taxes, franchise tax, and state tax.
Adam Spector: Key takeaways for everyone to know. Number one, get a bookkeeper and accountant. You can get low-cost ones for about a hundred dollars a month. Up to $1000 -$1500 a month, but it's not expensive, given your time. Build basic cash projection models. Compliance is supercritical. It will make your investors happy to know that you have your stuff together and that they’re investing into something that has a lot of liability sitting around that they didn't know about. As mentioned, make sure you get to the vital tech off the bat. There are some great tools, bank accounts, credit cards, QuickBooks, etc., to make you successful. It's not that it's not difficult to do this, do it sooner rather than later.
What are some excellent R&D tax credit resources, and what are some of the minimal requirements to qualify?
Adam Spector: There are many great companies out there that do R&D tax credits. We, at AbstractOPs, are big fans of Neo Tax. We've also written a detailed blog about all the different players out there. If you search for R&D tax credits on AbstractOps, you should see a blog post that outlines all the other major players that are out there. Feel free to send our teams some questions to help you figure out the right software to use.
Alex Roytenberg: Yeah, my position on this is that it's a question of the amount of time that you're going to spend and what the output is going to be. My view on this is if you're not going to get at least a thousand dollars of credit, basically $10,000 of expenses, it's not worth it. One, the bookkeeping company or the accountants might charge you an additional fee. The payroll company might charge you an additional cost. And then the actual R&D study is going to charge you a price. And if your credit is 500 bucks, you're going to end up paying more in services than the actual credit itself.
What are the ways to find the best bookkeepers or accountants for tech startups? Any specific recommendations for early-stage companies?
Adam Spector: We've done detailed research on this topic at AbstractOps as well. This is part of our work for all of our clients. I believe we have blog posts about this to some extent. We recommend Alex and his team, who are with us. But we have a list of different companies that range anywhere from $100-$1000. You have Alex's team, and you have outsourced teams that might be in India. You have things like Zeni Financial or Pilot. There's a variety of different software tools, but it comes down to how much you want to pay, the complexity of your books, and your expectations going forward. In some ways, it's a little hard to research, which is why we've done a lot of research ourselves internally for our customers.
Alex Roytenberg: It's also a question of what you're looking for. If you're looking for just a P&L statement, you can use something that's offshore. But if you are looking to raise funds in six months or so, you might want something a little bit more onshore. Ourselves, Zeni, Pilot - different stages of the business. The other big question is making sure that they fit into what industry you're doing. Certain companies have certain specialties.
Adam Spector: At AbstractOps, we started with an outsourced firm. They're great. We still recommend them to a lot of our earlier stage clients. Then as we continued to grow and raise more money, we moved over to Alex and his team.
Betty Kayton: Let me be the wet blanket here and add something in which is, you can't just hire a bookkeeper and ignore them and expect the books to be correct. You have to be involved. You have to give them the right inputs. You can't just provide them with a stack of receipts. You have to say, “Hey, you know, the reason we bought that $5,000 laptop is that it was for our marketing guy” so that it gets charged to marketing expense. Then you may backtrack and say, “No. That $5,000 laptop went to our VP of engineering”. Well, in one case, it's eligible for a research and development credit. You got a tax credit because it went to the engineering guy, and the other went to the sales guy. So just remember, yes, you want to hire a great bookkeeper, but you're not off the hook. You still have to give them the right inputs: garbage in, garbage out.
I think that's a great note to end on here. Founders, we hope this was valuable. We'll do more of this in the future as well. And big, thanks to Adam, Betty, and Alex for joining us tonight.
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