How to Lower Your Investment Risk in a Startup

As a CFO, if I were investing my own money in a preseed or seed startup, there are six areas I would closely scrutinize during due diligence.  If more than two of these are non-standard it would be a red flag to me.

1. Who is the Startup’s Banking Partner?

A startup should have a business account with a bank that specializes in startups.

Startup Banking Dos & Don’ts

• Open a bank account for your startup early on that is supportive to the startup community with features like:
  • Special services offered for startups that result in lower costs
  • Facilitate networking of clients and others in startup community
  • Potential future source of venture debt (SVB and Bridge Bank)
• Never co-mingle personal finances with your company out of the same bank account
• Select banks that interconnect with your accounting software
• Make sure to set up bank accounts with appropriate financial controls – e.g. dual authorization required on outgoing wires
• Set up business debit and credit cards, as opposed to using personal credit cards. Consider corporate credit card options with no personal guarantee requirements.

See Burkland’s recommended partners for banks and credits cards for startups.

2. Who is the Startup’s HR and Payroll Partner?

Among Burkland’s 500+ startup clients, roughly 40% use PEOs and 60% use payroll providers such as Gusto. We find that the all-in costs of administrative fees and insurance can be close between the two options, with PEOs often a little more expensive.

HR & Payroll Options We Like

3. What Financial Systems are Being Used?

Make sure the startup has best-in-class systems in place that interconnect, automate and have a range of add-ons with a robust approval workflow.

Type	Examples	Comments
Accounting Software		QBO and Xero are cost-effective and integrate well with outside apps and services Avoid QuickBooks’ desktop product, which Intuit is phasing out
Employee Expense Reimbursement		Syncs with accounting software and streamlines a traditionally manual, cumbersome paper-based process Multi-tier approval workflows
Accounts Payable Management		Syncs with accounting software and streamlines a traditionally manual, cumbersome paper-based process Multi-tier approval workflows
Cap Table Management		Streamlines management of cap tables and reduces legal fees Carta also provides cost-effective, high quality 409A valuations, which are facilitated via the software platform

4. Does the Startup Have Basic Financial Controls in Place?

Financial controls help to mitigate the risk of fraud and embezzlement. Download Burkland’s Financial Controls Matrix for a detailed recommended controls matrix by stage of business.

Segregation of Duties

• 2+ sets of eyes on all cash disbursements
• One person prepares checks and another person signs

Approval Processes

• At earliest stage, CEO should approve all cash disbursements
• As business grows, other leaders in organization can take on approval responsibilities
• Require approvals for payroll adjustments and commissions
• Approval processes can be system supported (e.g. vendor payments via Bill.com)
• Establish expense reimbursement policies

Banking Access

• Bank accounts can be set up with restricted access, approval limits, dual authorization requirements and other controls
• Checkbooks kept locked up with one person responsible for writing check and another responsible for signing
• Only CEO and office manager have access to corporate credit card initially

Financial Statement Review

• Always at least two people involved: preparer and reviewer
• Monthly review with CEO to look at budget vs. actuals and monthly variances and deep dive to review unexpected variances

5. Are the Startup’s Corporate Taxes Up to Date?

Cleaning up mistakes from missed or inaccurate tax filings can be extremely cumbersome and costly.  It also can be a proxy for how detail oriented the founders are.  If they can’t even file taxes which are so easy to file at this stage in their lifecycle how trustworthy will they be with my investment dollars?

Recommendations:

• Hire a tax professional who can make sure you submit filings accurately and on-time
• Keep track of all your expenses and ensure separation between your personal and business expenses
• Take advantage of the R&D payroll tax credit, a recently instituted federal tax credit benefitting startups
• Sales tax compliance can be complex; check out Avalara as a possible cloud-based compliance solution

See our calendar of 2022 tax deadlines for startups.

6. Financial Reporting – What to Look for…

Financial reporting requirements for startups ramp up after they raise their first round of funding due to Board and/or investor reporting requirements. What do their current financial reporting look like?

• Have a standard financial package that is shared with your Board of Directors at each meeting, ideally reflecting performance vs. plan and/or monthly trendlines. Want to see past packages. Should include:
  • Financial reports: Revenue, Expense, Cash mgmt. / burn all vs Plan / Budget
  • KPIs, varies by company/industry e.g. for a SaaS company would include metrics such as ARR, churn and LTV/CAC. Some some metrics should be tracked to show trends
  • Target closing your books each month within 10 business days
  • Implement a chart of accounts that enables your desired level of financial reporting and business analytics; think ahead to how you wish to set targets for your business and ensure you will be able to easily measure whether you have achieved those targets
  • Move from cash based to accrual accounting
  • Investors will periodically request financial reports. Provide year-to-date monthly income statement, balance sheet and cash flow reports, which you can download from your accounting systems

Pre-Seed and Seed

• At this stage we do not recommend fancy fully integrated financial models with Balance Sheets and Cash Flow Statements. Total overkill.
• Instead, we want to see and understanding of:
  • Key assumptions driving the business and the thought process behind it
  • Unit Economics and a logical TAM calculation
  • Customer Acquisition Strategy and assumptions – Revenue Model (spreadsheet)
  • Hiring plan, what triggers bringing on additional people
  • Cost of Goods (if relevant)
  • A few KPI’s and the rationale behind why these are the right metrics
  • A Board Approved Budget and hopefully a Rolling Forecast
  • Cash management report, how controlling burn

Learn more about Burkland’s financial due diligence services for VCs and other startup investors.