Emerging company founders and their teams have many competing priorities: product development, engaging with customers, hiring and motivating great people, and more. Funding these priorities often requires negotiations with angels, VCs, banks, and strategic investors, and it eventually entails negotiating an exit. At this point, these parties usually request financial and accounting information from the company.

The common framework for communicating this information uses generally accepted accounting principles (GAAP). It is also typical for preferred stock purchase agreements and bank loans to ask that founders represent that their information provided complies with GAAP.

Examples can include the following text for a preferred stock purchase agreement:

“The Company has delivered to each Purchaser its unaudited financial statements for the fiscal year ended December 31, [year], which have been prepared in accordance with GAAP applied on a consistent basis throughout the periods indicated.”

Or a bank loan may require the following representation from a founder:

“All financial statements delivered to the Bank present fairly in all material respects Borrower’s financial condition and results of operations. Calculations must be made following GAAP.”

Avoid Trouble – Use GAAP with Professional Guidance

Despite GAAP’s importance, founders of early-stage companies need to be careful not to overcommit on their compliance by agreeing to these representations without professional guidance. We have seen investors hold these representations against the founders down the road when the business is not achieving its objectives; the investors claim to have been misled and try to obtain a redemption of their equity or rewrite the issuance to further dilute the founders.

Furthermore, in our view, attempting to prepare fully GAAP-compliant financial statements too early improperly prioritizes where the company cash and time should be focused. There is a time and place to start moving toward GAAP compliance, and we believe a staged approach is most sensible. To help founders assess and communicate their status with respect to GAAP compliance, we have developed the Clark Nuber Roadmap to GAAP Compliance depicted below.

GAAP Basics – Stages 1, 2, and 3

The basics of GAAP (what we call Stages 1, 2, and 3) are straightforward and a good practice through the early stages of fundraising and customer engagement. They focus on tracking cash spend, billing customers (which are likely to be small at this stage), maintaining control of company documents, and complying with legal requirements to file tax returns.

GAAP – Stage 4

As the company grows its customer base, funding usually moves toward priced seed and Series A equity rounds. At that time, we believe GAAP Stage 4 includes proper analysis and filing of sales tax returns in all relevant jurisdictions and also developing policies to assign revenue to the proper months based on the complicated GAAP rules called ASC 606 – Revenue Recognition. So, by this point, a company is reporting revenue based on GAAP and has a solid understanding of its obligations for sales taxes.

GAAP – Stage 5

Once a Series A is closed and the company continues to progress on its objectives, the company is likely targeting a Series B financing. At this point, we believe it is worth a company’s cost and effort to enter Stage 5 and analyze its cost structure and develop accounting practices to comply with GAAP. This entails determining whether to record some portions of software development costs and sales commissions on the balance sheet for recognition as expense in future years.

Leases – typically for offices, lab, and other equipment –  are required to be shown as long-term liabilities on the balance sheet with an offsetting asset representing the right to use the offices and equipment. Prior financing arrangements, stock options, and income tax returns are also assessed to follow complex GAAP rules that often result in significant non-cash expenses being recorded. Other tasks are outlined in the Clark Nuber Roadmap to GAAP Compliance.

Once Stage 5 is completed, a company is ready to subject its financial statements to audit by an independent accountant and comfortably represent to investors, bankers, and buyers that its financial statements comply with GAAP.

GAAP – Stage 6 and Set-up for the Future

As a company moves onward from its Series B financing and towards additional financing and potential exit opportunities, the company can choose to enhance its internal controls, expand its disclosures, and continue to upgrade its accounting, billing, and customer relationship management systems.

Each company’s funding and maturity path is unique. Founders should build a team of legal, financial, and accounting advisors to help guide them along the way.

We enjoy working with founders, their teams, and investors. Contact Cassie Binford, Emma Tsuber, Matt Sutorius, or Matt Medlin for more information about when to focus on GAAP compliance for emerging companies.

© Clark Nuber PS, 2024. All Rights Reserved.

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.