Best Practices for Setting Up Accounting & Finance Departments at Start-ups & Privately Held Companies

Introduction

Over the last several years I have noticed a troubling trend in the way start-ups and privately held firms are setting up their accounting and finance departments. At some firms it is being done in a poor manner which hinders corporate growth, wastes company resources and can even causes catastrophic issues that forces companies out of business. Based on my experience the 5 most common mistakes made or problems that occur when setting up accounting and finance departments at start-ups and privately held firms include the following:

Some of the most common?reasons for the issues listed are because start-ups founders, owners, investors and senior management do not understand the following:

Accounting and finance departments perform critical functions at start-up and privately held companies, but too often they are not set-up properly and this has long-term negative ramifications or results. Some of the negative results that I have seen over the years include the following:

Please read this article if you work at a start-up or privately held company that is looking to build out, expand or improve its accounting and finance departments. This article can help you understand best practices for setting up accounting and finance departments and teams. And hopefully it can help?you avoid some of the negative ramifications listed above.

Outsourcing vs. Bringing It In-House

Early on in the lifecycle of a start-up or privately held firm outsourcing finance and accounting can be a very wise and intelligent move helping the firm save money.

Outsourced Finance

Start-ups need solid financial advice during their initial years. The best way to obtain this at a reasonable cost is using Fractional CFOs services.?A fractional or outsourced chief financial officer (CFO) is an individual who has CFO experience and who helps organizations with their financial needs on a part-time basis, either on retainer or more typically a contracted basis. Most fractional CFOs have diverse industry experience and have worked for several different companies.?The best fractional CFOs have strong finance and or accounting experience as well.

Fractional CFOs are good for a firm early on in a start-up firm’s lifecycle. Many fractional CFOs provide services to anywhere from 3-7 other companies at any one time. ?As a company get larger and more mature a fractional CFO may have less time to focus on all things that need to get done. Based on my experience after 1-3 years of utilizing fractional CFOs it is often best either to hire a full-time CFO, VP or Director of Finance. This new finance hire should then slowly take over responsibilities of the finance functions from the fractional CFO.

Outsourced Accounting

Start-ups should always initially outsource accounting function because it can save quite a bit of money. ?However, there eventually reaches a point where accounting functions need to be brought in house. Many start-ups and privately held firms wait too long to bring accounting in-house and this can have serious repercussions.

Many of these outsourced accounting firms claim that they are US GAAP compliant. However, in reality they are not as they utilize cash basis accounting. In order for your firm to be US GAAP compliant accounting must be done on an accrual basis.?These outsourced accounting firms utilize proprietary black box robotic processes automation (RPA) accounting software that allows a skeleton crew of accounting clerks to work on your company’s account. And often there is only one CPA supervising these clerks who work on your company accounting along with 10-20 other companies. Many of these outsourced accounting firms are not diligent, make mistakes often and do not have the bandwidth to give your company the time it truly deserves.?Also, avoid using overseas outsourced accounting firms as generally they are not USA GAAP experts and I have seen to many issues with the financial statement they produce. ?

The decision on when and how to bring accounting in-house needs to be made by someone at the firm working in finance in conjunction with the management team. This person will have the best insight and experience as to whether cost savings can be realized and if the timing is right.?Based on my experience there are 5 critical factors??that should determine when you bring accounting in house and that require separate Accounting and Finance Departments:?

The 5 conditions listed above imply that your start-up or privately held firm has reached a critical amount of business activity. If your firm has reached any 2 or more of the 5 milestones listed above then it should seriously consider bringing?accounting in house and also setting up separate accounting and finance departments. Having an in-house accounting department and having separate accounting and finance departments is critical to your company’s long-term success.

Some venture capital investment firms and private equity firms tightly control the spending and operating structure of their start-up investments or portfolio private companies. In doing so, some of them strip out the accounting and finance functions from their investment and have internal groups at the venture capital or private equity firm that perform these functions. This is not a good strategic move long-term as you often lose the internal industry expertise and knowledge that can only be gained by having an accounting and finance teams on-site at the firm.

Separate Accounting & Finance Departments

Another troubling trend these days is too many start-ups or privately held firms combine accounting and finance functions into one department. This is especially a problem in tech start-ups and small privately held government tech and defense contractors. As mentioned in the prior section if your firm has reached any 2 of the 5 critical factors then it needs to set-up separate accounting and finance departments.

Some people use the terms accounting and finance interchangeably to mean the same things, but they are not.?They do not understand the difference between finance and accounting.?There is a clear distinction between accounting and finance and understanding the difference between the two is criterial to helping start-ups grow and ensuring that the proper resources are in place to handle this growth. Accounting department and finance departments both focus on a firm’s financial statements and everything that goes into them. However, the key difference is that finance focuses on future events or things that have not occurred where-as accounting focuses on past events or things that have already occurred. (1)?Separation of accounting and finance duties is critical for effective internal control because it reduces the risk of both erroneous and inappropriate employee actions.

What is an accounting department?

The accounting department is responsible for making sure that all financial transactions at a company are accurately captured, recorded and entered into a firm’s general ledger and accounting system. This usually includes processing all accounting receivable, accounts payable, reconciling all cash accounts, capturing payroll, entering expense accruals, tracking changes in balance sheet accounts etc.

All of these accounting functions should be performed according to the Generally Accepted Accounting Principles (GAAP), to ensure the consistency and accuracy of internal and external reporting. One might question why a start-up or privately held company needs to follow GAAP, and the quick answer is it doesn’t as it isn’t publicly traded and is not subject to SEC scrutiny. However, I highly recommend that every privately held firm and start-up follow GAAP rules form day one as it provides a solid foundation for the firm’s long-term success.

The ultimate goal of GAAP is to ensure that a company’s financial statements are complete, consistent and comparable. This makes it easier for investor to analyze and extract useful information from a company’s financial statements. Errors and omissions in accounting caused by not following GAAP can be costly and lead to incorrect business decisions. Following GAAP implies credibility with lenders and potential future investors. I have seen too many times where start-ups did not follow GAAP early on and then had to spend hundreds of thousands of dollars to re-audit and restate financial statements to make them GAAP compliant. Based on my experience, these companies would only have had to pay 30% more in salaries to be GAAP compliant earlier on which is a lot less expensive long-term. (2).

What is a finance department?

The finance and FP&A department provides company senior management with information necessary to make strategic decisions such as which markets to enter, projects to pursue, the payback periods for large capital outlays and the decision about what % of a company's earnings should be paid out as dividends and what should be reinvested internally. The finance department is the part of a company that is responsible for helping acquire funds for the firm, and managing spending withing the company. It is the part of a firm ?that ensures efficient financial management and financial control necessary to support all business activities.

The finance department goal is to understand the company’s finances and financial information with long-term growth and strategic planning in mind. Corporate finance reporting and forecasting are largely based on financial data that is analyzed to produce key performance indicators (KPIs) , financial metric, and non-financial metrics that can be utilize do help make better future business decisions. The finance departments should be in charge of the annual budgeting and planning process ?Budgeting and forecasting should not be done by the accounting department as this is a clear violation of GAAP.

Most finance departments as start-up and privately held companies perform basic treasury functions such as helping acquire funds for the firm, cash flow management, and managing spending within the company. Another key finance department treasury function is managing the firm’s relationship with external banks and tax providers. Note, these relationships should not be managed by the main accounting department to ensure GAAP compliance. Once a company gets large enough then separating out the treasury functions from the finance department so that there is a stand-along treasury department should be completed.

Composition of Accounting & Finance Departments

Start-ups should hire at least one finance team member before setting up an accounting department in-house. Some start-ups early on set-up an accounting team first before the finance department. Often this can be a strategic mistake because the accounting team doesn’t have the corporate finance expertise to help the firm make the best financial decisions.?When the decision is made to build out accounting and finance teams the following department structures can be extremely efficient long-term:

Accounting Department Structure

The initial existing accounting team (often usually 2 or 3 people) just doesn’t have the bandwidth or time to handle all of the firm’s accounting and finance needs simultaneously and in the best manner. Many senior leaders become frustrated that the accounting team is not getting all of their requests done, and the simple fact is often there just isn’t enough staff. Often a lonely controller has to lead on all accounting and finance functions, which is not humanly possible. This leads to internal strife, high turnover rates at some firms and inaccurate accounting and financial reporting as well.

An accounting department at a start-up or privately held firm should usually consists of a least 3-4 individuals at a minimum. This will ensure that there is enough headcount to meet the various accounting challenges and to provide a minimum segregation of accounting functions to try to be as GAAP compliant as possible from day one. ??The first hire for any start-up or privately held firm should be a Controller or Director of Accounting, who ideally is a CPA with both an undergraduate and usually a masters in accounting. The second hire at a start-up accounting department should be an entry-level junior accountant ?or accounting clerk to help with the initial grunt work. The third hire in an accounting group should be a senior accountant who has a bachelor's degree in accounting ?and may or may not have a CPA.?As the company get larger a more mature accounting team is shown in the chart below:

A mature accounting department should contain anywhere from 5-10 people depending on the size of the company and volume of business activity.

Finance Department Structure

Newer, rapidly growing firms such?as start-ups may not need a whole finance department at first and can usually get by with 2-3 people.?But as the company grows and finances become increasingly complex, they will need to hire a dedicated core finance team to help manage processes.

The first hire for a corporate finance department should be a director of finance or financial planning & analysis (FP&A) director. This person should have at a minimum an undergraduate business, finance or economics degrees, and usually has an MBA. Sometimes this person has?other credentials such as a CPA, CFA, CMA, CTP, or FRM. It is not necessary for the director of finance to have a CPA, but only to have a good understanding of both financial and managerial accounting. Many start-ups make the mistake of having a director of finance with a CPA but a controller who doesn’t have the credential. This is a big problem as the controller is the individual who has day to day responsibility over key accounting and it is better suited to make sure things are done right at the start. The second hire in a corporate finance department is usually a financial analyst or Jr. budget analysts. ?The third hire for a finance group should be a finance manager. Other hires for a more mature finance department are shown in the table below:

A mature finance department may contain anywhere from 5-10 people depending on the size of the company and volume of business activity.

Managing Accounting & Finance Departments

For most start-ups, very early on the CFO and Controller are often the same person. This is fine when the firm is in its infancy but once the firm grows then these responsibilities need to reside in separate positions. Once a firm reaches any of the 2 of the 5 critical factors mentioned earlier then the firm must have a solid and distinct chain of command with regard to separation of accounting and finance functions, duties and responsibilities.

The post-Enron legislation Sarbanes Oxley requires CEOs and CFOs to sign off on the validity of financial statements if companies are publicly traded and subject to SEC and GAAP requirements. While privately held companies such as start-ups are not subject to this requirement a good CFO should operate with the mindset that he or she is still responsible for the financials and to ensure that they are correct, clear and an accurate reflection of the firm.

Based on my experience, if you have to choose between a CFO or VP of finance & accounting with a CPA verses a controller who is a CPA it is always better to have a controller with the CPA. The primary reason is the controller is person who is closest to the day-to-day accounting issues and will ensure that things are done correctly from the beginning. Many technology and software start-ups or small government technology or defense contractors often look to hire CFOs, VPs or directors of finance and accounting who has a CPA.??Again, if you have limited amount of funds for salaries you would be better off paying to have the CPA in the actual accounting group in your controller slot rather than in a senior management position.

Lastly, the finance group should not report to accounting, and the accounting group should not report to the finance group. Accounting and finance groups should each report independently to a CFO or a VP of Finance and Accounting. This ensures the independence of each group, and the validity of the work they produce and ensure compliance with GAAP requirements and industry best practices.

Accounting & Finance Systems

Another common mistake that start-up and privately held companies make is not investing in the proper accounting and finance systems and platform at the right time and doing too much in Excel. Note, accounting and finance department have separate needs when it comes to systems and platforms from a functionality perspective but they are very inter-related. ?Companies need to consider the needs of both the accounting and finance departments when making systems and IT decisions.

A start-up company needs to get an accounting system with general ledger functionality up and running as soon as possible before any finance systems. Many start-ups use simple entry level accounting packages like QuickBooks or Xero (which does Zero) when they first start operating. These entry level accounting packages are good for only 1-3 years in a start-up’s life cycle before they are no longer up to the task. ?After 2-3 years, these firms should migrate ?to more mature and capable intermediate accounting platforms such as as Sage Intacct or Microsoft Dynamic Great Plains (GP). I highly recommend that for some start-ups that are experiencing explosive growth, that they consider skipping intermediate accounting platforms and jump directly to robust cloud-based ERP platforms such as NetSuite, SAP or Oracle Financial.?This will save the company the cost of spending funds on an intermediate accounting package implementation only 3-4 years down the road ?to then have to implement ?firmwide ERP platform with accounting and general ledger modules.

Once, the accounting system is in place then the finance department will need a budgeting, forecasting and planning system for general FP&A functions. Entry level ?and many intermediate accounting systems do not have built in budgeting and forecasting modules, which means companies are often left to do budgeting and forecasting in Excel which is a very poor practice long-term. If a firm has invested in a more robust ERP platform, then usually, they have budgeting and forecasting modules built in such as NetSuite and SAP. Another option for finance departments is to utilize the new breed of cloud-based budgeting and software packages such as Adaptive Planning, Planful or Anaplan that allow for the development of complex corporate finance model in a more structured environment then Excel. ?(Please see my article on cloud-based budgeting and software at the link The Best Cloud Based Budgeting & Planning Software for Corporate Finance & FP&A Groups )

Conclusion

Accounting and finance departments perform critical functions at start-up and privately held companies. However, many start-ups and privately held firms are setting up their accounting and finance departments in improper manner and do not follow best practices. This article discussed some of the key issues related to the 5 common mistakes and hopefully will provide you with some insight in how to address issues before they become serious problems with negative consequences.

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