“There's a lot that goes behind the scenes in running a startup. Getting the legal, finance (equity allocation, vesting), accounting, and other overhead right will save you a lot of pain in the long run”. Kirsty Nathoo, CFO at Y Combinator.
The ecosystem of a startup is different from a regular small business. Startups are created in all types of businesses and all over the world. This ecosystem consists of individuals (entrepreneurs, venture capitalists, angel investors, mentors, advisors). One of the world’s most famous startup-ecosystem is Silicon Valley in California. Note, however, you do not have to be a Silicon Valley birth to be investible and successful, nor do you have to be the most represented founder in the startup game.
Before we dive into the basic accounting for startups per the authoritative guidance, part one of this article will help us garner some basic knowledge to disabuse us of any misunderstandings concerning startups. There is absolutely no doubt that many of us are unaware of the differences between a startup and a regular business.
What is a Startup?
Iman Jalali, Chief of Staff at Contexmeda answers this perfectly for us. He posits that “Startups are pressure cookers. Don’t let the casual dress and playful office environment fool you. New enterprises operate under do-or-die conditions. If you do not roll out a usable product or service in a timely fashion, the company will fail. Bye-bye paycheck, hello eviction”. I suppose his position is incontestable since a startup requires patience, resilience, and what I particularly term as possible professional, emotional, and financial suicides. Therein the startup process lies the strangulating deadlines to develop a prototype or prototypes and to get the product ready for market. Additionally, therein also lies the expectations of investors and other stakeholders of their return on investment of time or cash. The process may be more testing if the founder is underrepresented.
There is no perfect prescription or blueprint for a successful startup, but as Richard Branson postulates, “The best way of learning is by doing”. Consequently, given the high uncertainties associated with transforming and commercializing an idea, sustaining effort is required as the process can take a long period of time, by one estimate, three years or longer (Carter, et.al, 1996; Reynolds & Miller, 1992).
What is and is NOT a Startup
One should note that once an investable idea or innovation metamorphizes into a regular company, in that, it is now engaged in full-scale operations by providing a good or product for a profit, it is no longer considered a startup.
A self-employed/sole trader works for himself, whether by himself or a member of a team. This is a very simple business model (not innovative, ingenious, or inventive). Think about your average barbershops or hairdressing parlors. From day one there is a business model, and such a business is not readily scalable.
An organization markets goods or services for profit. In this business model, there is a proven business model, clear pricing of goods and services, and there is an existing market for goods and services.
A Startup, however, has a different business model. This is birthed from an innovative and inventive conception. This is a temporary organization that is created to look for a repeatable and scalable business model to sell. Note, in this case, the product of this model is the temporary company itself, so it, (the business model), must be sold at the end of the startup phase. Selling a startup usually take different forms, which include the acquisition by a larger company, merging with other businesses, or become a public entity through an initial public offering (IPO). Notable examples of startups include Airbnb, Facebook, Google, WhatsApp, Target, and TripAdvisor. These business models were germinated to solve a problem or to survive disruptions and today they boast market valuations in billions and even trillions. Again, these were scalable and repeatable business models that either went public through an IPO or were acquired by larger corporations. Note, WhatsApp, a startup, was acquired for $19 billion in cash and stocks in 2014 by Facebook.
The first source of funding usually comes from bootstrapping. The founder/s may also benefit from loans or gifts from friends and family. Additional sources of funding may be explored at various stages of the startup. The main additional sources of funding include:
Raising capital through the Investment Rounds
There are rounds of funding available to a startup which begins at the prototype phase right through to its listing on a public exchange. These rounds are:
1. Seed Round - This is the early prototype phase where investors, mainly angel investors, provide capital before startup operations.
2. Series A Round - At this phase, the development phase, traction has been gained, and the invention may be realizing some returns. Investors are looking for a high return on investment (ROI). The investors in this round are venture capital (VC) firms alongside angels or super angel investors. Top VC firms include GGV Capital, Index Ventures, and Sequoia Capital.
3. Series B, C, D Rounds - This is known as the late-stage funding round. At stage C, the startup is expected to continue its growth and expansion by creating new products, acquiring new companies, or expanding its reach. The startup is now considered extraordinarily successful and less risky for investors. This is the stage where it is ramping up for an Initial Public Offering (IPO).
External vs Internal Startups
Like an entrepreneur who risks his or her resources to commercialize an idea, there is also the intrapreneur who utilizes a company's resources to promote investable innovations and inventions. The intrapreneur works within an independent company that is created within an existing business or division of the parent company. The intrapreneur must lead the process from ideation to profitability.
With these internal startups, the company’s goal is to disrupt from the inside out. Successful companies such as FedEx, Proctor and Gamble, Cisco Systems, General Electric (GE), and MasterCard have capitalized on the internal startup concept by utilizing the talents and assets they have internally to transform and grow their business models. Examples of internal startup innovations are:
1. TripAdvisor- this innovation became part of Expedia in 2004. In December 2011, it launched successfully as a stand-alone entity, a disruptor of the business models of traditional travel agencies.
2. Target- the Target we have come to know today, as the number seven (7) of the top one hundred retailers according to Retail Info Systems (RIS) in 2019, is a spin-off of Dayton Hudson. This was an innovation to survive the disruptions of the department stores by discount retail in 1962. Today, Target boasts over USD 60 billion in market valuation.
3. SenseAware -this is a FedEx internal innovation to help customers, especially those in the healthcare sector, monitor shipment/s in real-time. This innovation allows customers to connect with their most sensitive shipments through the monitoring of location, precise temperature, humidity, barometric pressure readings, light exposure, and shock events.
According to The Ultimate Startup Failure Rate Report, 2020, an estimated 90% of startups ultimately fail. The failure rate of startups varies by industry, the lowest being in the Finance, Insurance, and Real Estate industries, and the highest being in the Information industry. Many startups fail due to:
The prevailing characteristics among successful startups can be summarized as follows:
A startup begins with a disruptive innovation to provide a solution to a problem or range of problems. However, to be successful, the startup must verify or refute the need for innovation through market validation, lest time is wasted creating a solution for which there is no market. Remember, the goal of a startup is not to market goods and services for profit as do other for-profit businesses, but an inventive, and scalable investable model designed to change the way we conduct business or live our lives. In that, the startup company, the idea, the invention, the innovation, is the product that will be ultimately be sold, merged, or listed for ongoing for-profit business operations at the end of the startup phase.
Now that we have cemented our understanding of what a startup is, we will better appreciate the basic accounting for the costs, investments, and revenue generated in part two on this topic.