If you don’t understand accounting, you won’t know if your startup is succeeding or failing
As a mentor at various accelerators and university startup programs, founders often ask me what books I recommend.
Certainly, there are important books that explain fundamental concepts like The Lean Startup and Business Model Canvas. There are classics like Crossing the Chasm that define the way we analyze customers. And there’s no shortage of useful books with advice on critical topics from marketing to social media.
But there is really only 1 book that every founder needs to have on her bookshelf; 1 book a founder needs to fully understand: an accounting textbook.
Huh? I hear you say, I’m a founder, not an accountant. I can hire an accountant to do the company accounting, the same way I hire a lawyer to handle the legal stuff. I don’t need an accounting textbook any more than I need a set of law books.
Well…if you think you don’t need to understand accounting, your startup is doomed to failure.
Accounting isn’t just a tool for paying bills and taxes — it’s the process of analyzing the health of a business, and every founder needs to understand it. Intimately. It’s the language of business and if you’re in business you have to speak it as your native tongue.
Here’s a little quiz.
You have a SaaS product. You have 1 customer who paid $1,200 on May 1. How much is your company sales?
Simple, right? You’ve made $1200. Well… maybe.
The answer depends on how you’re doing you accounting — cash or accrual. If you’re doing your accounting on a cash basis, you’ve sold $1,200. Congratulations. Go sell some more. Most small businesses do their accounting on a cash basis. It’s simple.
All big companies are on an accrual basis. It gives a more accurate and nuanced understanding of the state of the business than simple money in and payments out can. Startups need to be on an accrual basis, too.
In this example, the $1,200 is probably for a 1 year subscription which would be accrued at a rate of $100 per month.
While the $1,200 has been pre-paid for a full year, which is great for the company’s cash flow, the money is only earned for the service which has been provided, in this case, one month so far, so $100. The rest is just a deposit.
Revenues have to be matched to actual shipments of products and provision of services. This helps us understand the health of the business beyond just the effectiveness of the sales team.
When you’re pitching investors and they ask your sales, you’d much rather answer $1,200 than $100. But if you tell them $1,200, you’ll be giving the “wrong” answer.
In fact, it’s not uncommon for a technical founder to answer $1200. The investors scratch their head and ask, how are you accruing your sales? The CEO stands there, confused and uncomfortable. And that, essentially, is the end of the pitch.
Afterwards, when we talk amongst ourselves, the founder is called clueless and hopeless. “He doesn’t even know his numbers!!!” someone always says, incredulous.
You can say we’re being unfair and unreasonable and I won’t disagree, but that founder isn’t getting funding.
With personal finances, a glance at your paycheck and bank account statement is sufficient to know whether you’re thriving or on the road to bankruptcy.
If you run a small business like a coffee shop or a plumbing contractor, you can get a strong sense of how things are going by looking around the room at seats filled, the appointment books, the daily receipts.
That doesn’t work for venture startups where every day is a new experiment. Quickly understanding what works and what doesn’t is critical to eventual success.
The P&L, balance sheet, and statement of cash flows show where you’ve been and where you’re going.
The only class out of 2 years of MBA studies that turned out to be truly useful for running a real business was accounting. Ironically, it’s also the class I did the worst in.
I thought accounting was boring and a waste of time for a technical marketing manager. It was something I didn’t need to think about until the day I became responsible for a product’s success. That’s when I found the accounting textbook in a box in the back of the garage and gave it a 2nd reading. And a 3rd and a 4th.
When I built my first startup, the old accounting textbook stayed on my desk next to my copy of Quickbooks.
The profit and loss statement tells me daily how the company is doing. What were my sales, how much did those sales cost, what were my other expenses. Increasing revenues is great, but how much did it cost to get them and is that sustainable?
For most startups, the P&L is mostly L — losses. But I need to know how much I’m losing and whether that’s increasing or decreasing. A key metric investors will always ask is what is the burn rate. I’d better have a clear answer, as well as a projection of whether that burn rate will increase or decrease as we hire more people while growing the revenues.
The balance sheet then tells me how much I’ve got left in reserve. How much money have I raised and how much of that remains. How much more will I have to raise and how soon will I need to raise it?
These are the most important questions a CEO has to answer for himself and be able to communicate clearly to investors.
You can hire a bookkeeper to enter the daily invoices and payments. You should hire a controller or CPA to do your taxes and audit your books. You can bring on a CFO to build sophisticated financial models. But you need to look at the numbers yourself. Every day. And understand them. And discuss them with your team, your board, your investors.
In other words, bookkeeping is something someone can do for you. But accounting is the process of understanding the financial health of your business. And that is something every CEO has to be able to do herself.
So if you don’t have an accounting book, buy one now. If you haven’t taken a basic accounting class, find one at your local community college or online. Get your own copy of QuickBooks and review reports every day.
And when we ask you how the revenue numbers you’re bragging about are accrued, smile, look us in the eye, and say with confidence, “These numbers are accrued on a monthly basis according to GAAP rules, but let me show you our orders, too, which are even better.”
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