Accounting for Scale Up

Anne-Marie Henson:

When I walked through this audit plan and the process with the CEO and the CFO and explained what our plan was and also the additional investment, the additional cost, they immediately accepted it. And the CFO said something that really sticks with me. They said the way they view this is that it wasn't a sunk cost or a necessary evil that we hear sometimes about accounting and audit. What it was to them was an investment to be able to access a significant additional market share.

Narrator:

Welcome to Accounting for the Future, a BDO Canada podcast for financial leaders to navigate change and achieve business grow. We'll uncover the challenges financial leaders may not have dealt with yesterday but will definitely have to manage for the future.

Armand Capisciolto:

Hello and welcome to Accounting for the Future. I am your host, Armand Capisciolto, BDO Canada's National Accounting Standards Partner and leader of Accounting Advisory Services. On today's episode, I'm joined by Anne-Marie Henson, a BDO partner from our Montreal office. Anne-Marie leads both audits and accounting advisory assignments, and the types of clients she works with include public companies as well as many technology companies in both the startup and scale-up stages. Anne-Marie, welcome to Accounting for the Future.

Anne-Marie Henson:

Thanks, Armand. I'm really happy to be here.

Armand Capisciolto:

This is a really interesting topic that we're going to be discussing today, accounting for scale-up, dealing with companies in the scale-up stage of their life cycle. I guess the first thing, just to kind of orient our listeners, is what are we talking about when we talk about a company that's in scale-up? How does scale-up differ from startup versus if I'm dealing with a mature company?

Anne-Marie Henson:

Yeah, it's a really good question, and I'm sure there's a lot of different interpretations out there, but the way I kind of look at it is startup companies are really at the true beginning of their life. That idea of a couple of people working out of their garage or kitchen or not really having a formal structure or formal space to work in is something that I've seen a lot in experience, and that lack of formal structure is meant to be that way because the focus is on innovation, building this idea.

A scale-up company is really just a startup that's successful and that's moved beyond that startup stage. So, what that probably means is the company has now hired a couple of permanent employees. It's not just the couple of founders anymore. They've probably started to generate sales, or if they haven't generated sales, at least they've been able to prove that their technology or their product works, and they have a bit of a proof of concept. And also, another aspect of scale-up is they've been successful at raising money or are starting to be, so they're going out there, and they're looking at getting financing from outside parties.

Then a mature company is one that's been successful at scaling and has moved beyond that, has a stable revenue base, is probably able to support itself through its day-to-day operations and cash flows, and is perhaps looking to the next stage of its life, maybe expansion, M&A, or going public.

Armand Capisciolto:

When we look at a company, though, that's in scale-up, in your experience, what does their accounting and finance function look like?

Anne-Marie Henson:

Yeah, oftentimes, I find what I've seen is companies that have moved from startup to scale-up may not even realize that transition has happened, right. And so, they're scaling up in terms of their employees in terms of their marketing and their ability to go out and get financing, but they haven't really scaled up their accounting and finance function. So, that whole aspect of accounting and financial reporting hasn't really changed often from the startup scale to the scale-up state.

Armand Capisciolto:

Yeah, and that's interesting because obviously, we're accountants. We think accounting's critically important and everybody should be thinking about accounting and finance functions all the time, but as a company that's growing and trying to make it to that next stage, they might look at accounting just as compliance and not something that's critical to their business. I'd like to think there's a happy medium between people like us who think accounting is the be-all and end-all and companies that look at it and it's just a compliance exercise that they don't want to invest a lot in.

Anne-Marie Henson:

Yeah, no, I totally agree with you. I think there really is a happy medium, and I think companies that are successful as they grow and scale are companies that see accounting and finance as more than just compliance and choose to invest in that function because they understand that having that proper accounting and finance structure in place is something that's actually going to help them move their plans forward.

Armand Capisciolto:

That's really interesting. So, the accounting can move their plans forward. Accounting is more than compliance. It is something that's needed to move their business plan forward. Do you have any examples of that?

Anne-Marie Henson:

Yeah, so I guess I can give an example by explaining things that can go wrong if we don't invest in accounting and finance. Often, for companies at this stage, the most important, critical thing for them is investment, getting financing, being able to raise money to move on to that next stage and develop their product and go to market with it. So, as companies grow and start to really need additional financing to help them, I've seen situations where deals for financing have been delayed and even sometimes fallen apart and not worked out because the company wasn't able to produce financial statements, accurate financial statements in a timely manner so that investors could potentially make decisions about how much to invest in the company.

There's also, I think, another aspect beyond just a deal getting delayed or financing falling through that's really important about financial statements, and it's investor confidence. I think it's such an important part of it. So a lot of investors may not invest in your company based on the financial statements alone. They could be using different valuation metrics, and the statements, the historical financial statements, might not be something that they use to decide to invest.

But one thing I've seen often is a lot of private equity and VC firms put a lot of importance on a company having financial statements prepared, and that's because it gives them confidence that the company values the accounting and finance function and therefore, gives them trust that a founder is doing the right thing and investing in that.

Armand Capisciolto:

That's really interesting because... So, are you saying that if I am a potential investor, and I see that a company can produce financial statements in a timely fashion, and they give appropriate information, is it giving them more confidence because he's like, "Well, that company's actually... They're managing their risks. They're ensuring they have the information to make appropriate business decisions." Is that kind of the warm, fuzzy feeling that investors are getting from that function beyond just what the financial statements say?

Anne-Marie Henson:

Exactly. Yep, that's exactly it. I think it just gives investors that confidence to say, "Okay, this company has invested in the right places. They care about their financials, and they've allocated appropriate resources to be able to produce financial information on a timely basis."

Armand Capisciolto:

That's really interesting, and we see situations all the time. You gave examples of deals falling apart. We see examples all the time of what I'll call last-minute requests, so those deals don't fall apart, right. And I want our clients to succeed, and to me, having to rely on a professional services firm for all your last-minute requests, although good for a professional services firm, it makes me worry about that company's ability to succeed, their ability to make appropriate decisions going forward to succeed. Because if they don't have that information, how are they actually making these decisions?

Anne-Marie Henson:

Yep, no, exactly. And being able to make those decisions, sometimes when we're dealing with last-minute requests, we've all been there, and we've all responded to those and put together something. But it's happened that maybe if we'd had a little bit of advanced notice, and we'd been able to take the time to talk upfront about what our client was trying to achieve, and perhaps, instead of just dealing with the impacts, the accounting implications of a specific transaction, if we'd known in advance, maybe we would've been able to evaluate different alternatives for them so that they could make the best business decision, not just from how's it going to look in your financial statements, but what's the best business decision for you. What makes the most sense? And unfortunately, when we have to help at the last minute, we're not truly able to do that for clients. It's really just dealing with the emergencies.

Armand Capisciolto:

Yeah, and it's that thought process, that discussion. As much as both of us enjoy accounting and talking about accounting issues, I'm not one who thinks accounting should ever drive a business decision, but the implications of the accounting could have business implications, and it's really about having that time to work with a client or for a client, for a company to consider on their own what are the implications of this transaction and how it's going to be accounted for, and are there any potential negative outcomes that, or potential scenarios that I want to deal with in advance versus being surprised at year-end when my auditor comes in.

Anne-Marie Henson:

Yeah, exactly. And I think when decisions are being made and rushed, sometimes those implications are really detrimental to the company. We've seen situations where something, a transaction ends up being recorded in a way that now violates the debt covenant or that has to be recorded at fair value, and that has a huge negative impact on the company's income statement. So, there are situations like that where there's been a rush to come to a conclusion, and we got to the right conclusion, but that conclusion wasn't necessarily what was originally thought out.

So, definitely the earlier we can think about these things, I think, the more value we can add to this process and really help founders and companies understand the best options that are available for them.

Armand Capisciolto:

Yeah, for sure. So, Anne-Marie, we learn from our mistakes right, or mistakes of others.

Anne-Marie Henson:

Yep.

Armand Capisciolto:

I prefer to learn from mistakes of others rather than my own mistakes. And you've given us some good examples of not mistakes ... I don't want to say mistakes ... but maybe unfortunate situations where it could have been a little bit better. Do you have any examples of where you've seen a client, you've seen a company have everything in place, do the right things related to their accounting and finance infrastructure, and as they move from startup and through the scale-up stage that it benefits them?

Anne-Marie Henson:

Yeah. Yeah, and these stories I love talking about. There's one in particular that's happened pretty recently in the past few months, and I think about this client, this company a lot because it's such a nice success story in terms of doing the right thing at the right time. So, there was a company that is exactly in the scale-up stage, had started off with just one founder and had slowly built up their team, and was generating revenue, but realized that the next phase of their growth was going to be accessing the European market.

And to access the European market, they needed to change accounting standards to apply international financial reporting standards, which was a change from what they were previously doing and is an investment. So, there was added time. We needed to spend more time as the auditors. The CFO and his finance team also had to spend more time with us. But when I walked through this audit plan and the process with the CEO and the CFO and explained what our plan was and also the additional investment, the additional cost, they immediately accepted it.

And the CFO said something that really sticks with me. And they said the way they view this is that it wasn't a sunk cost or a necessary evil that we hear sometimes about accounting and audit. What it was to them was an investment to be able to access a significant additional market share. So, they said, "We spend this amount, and we invest this much time, but it gives us access to a market and to be able to grow our revenue significantly, and therefore, it's worth it."

And it's been successful. I can happily say that they have now entered the European market and are doing really, really well. So, it was, it's one of those situations where they did the right thing and understood the benefits of investing a little bit of time upfront.

Armand Capisciolto:

I love that story. That story's so good.

Anne-Marie Henson:

I know.

Armand Capisciolto:

It's just like, how do we get that company to speak to all of our clients to think about it that way because they're not thinking about it as compliance. They're thinking about, yes, there is a compliance exercise here, but that compliance exercise is needed to achieve the next stage in their business plan, and that just makes me all warm inside hearing that story.

Anne-Marie Henson:

Exactly. I know.

Armand Capisciolto:

That's just such a great story and a great segue, a great segue as we switch. We were talking about their accounting and finance function and really kind of let us get into the meat of some of the accounting issues. You talked there about a client changing to international financial reporting standards, IFRS, and that's actually a really interesting question. In Canada, we operate in a multi-GAAP environment. We have accounting standards for private enterprises. We have IFRS, and many entities actually apply U.S. GAAP in Canada as well. When you look at this, what do you see most of your clients in the scale-up stage applying?

Anne-Marie Henson:

That's a good question, and I have to say I think it's all over the place. I can't say that I have clients that are mostly IFRS or mostly U.S. GAAP or ASPE, the private standards. And I think there's a reason for that. I think that the most important thing isn't necessarily which accounting standards you choose. It's choosing the right accounting standards based on where you see your company going. It does ask for a little bit of thinking ahead, right, but you almost have to look. You're in the scale-up stage, and perhaps just relieved that you made it past startup and that you're moving on to that next stage with the company, and sometimes it's really difficult to think five years ahead.

But what I've seen in the market, especially in the past couple of years, is just this accelerated growth. So, instead of being in the scale-up stage for, let's say, five years, well, now it's like two to three. It's that sort of fail fast. It's go to market. Obviously, being Canadian, we have access to a quite large market with our neighbors to the south, and that's easily doable for a lot of companies, especially the technology and companies that don't need a lot of physical infrastructure.

So, I don't know if I have a recommendation in terms of what are the best accounting standards, but having that discussion upfront with your accountant, with your Advisor, we'll ask the right questions in order to say, "Okay, where are you going to get your financing? Are you going to expand? Do you think you're going to go public?" And what have we seen in the past few years in terms of other types of companies in those industries so we can help guide their decisions?

Armand Capisciolto:

Yeah, and Anne-Marie, you know, we have a publication on this for companies like what you-

Anne-Marie Henson:

Yeah, a great publication.

Armand Capisciolto:

... choose. Yes, it's quite good. I think we had some really good people add content to it, but I think you nailed it there. It's kind of, where are you going, what are you scaling up to, and do the accounting standards you're using, are they taking that into consideration, and who your users are going to be as you achieve that scale-up.

So now, let's get even more specific and now talk about some of the complex issues that companies in scale-up start experiencing and some of the fun discussions you and I get to have about the types of things, types of transactions that we see in companies in this stage of their life cycle.

Anne-Marie Henson:

Yeah, so I think the first area where we see the most in terms of complexities is really, and we've been talking about a lot for the past little bit, is financing. A lot of times companies in this stage don't really have access to your traditional bank loans or that type of financing, so they often raise money from private equity firms or venture capital, and the types of financing arrangements they enter into end up being a lot more complex than simply here's a loan with a stated interest rate, and just pay me back on a monthly basis.

Armand Capisciolto:

Yeah, so what are some of these instruments then? If it's not a bank loan, what are we seeing?

Anne-Marie Henson:

Yeah, good question. So, we see a lot of complexities in terms of instruments sometimes that could be either debt or either equity. Sometimes they're both. For example, there are notes that look like a loan but are convertible into shares. Sometimes they're convertible into shares at a discount, which adds an added complexity to the accounting.

A lot of the types of instruments that we see, are, also include, let's say, what we call sweeteners. So, here's a loan. The interest rate isn't as high as what you would normally charge a company in that startup or scale stage, so we'll give you some options or warrants to go with that loan. And there's also other types of arrangements where it's we give you money upfront, and we'll just participate in the next equity round, which we know commonly as SAFEs, simple agreements for equity.

Armand Capisciolto:

SAFEs with the word simple in them, right?

Anne-Marie Henson:

Exactly.

Armand Capisciolto:

Definitely, those are an instrument, or those SAFEs are a type of instrument we're seeing a lot of in both startup and scale-up, and I think they're called simple because it's simpler for the lawyers, not necessarily simpler for the accountant with the name. Can you expand a little bit on what these are because they are, again, relatively new in the Canadian environment. Definitely been around for quite a bit in the U.S. in the Silicon Valley area. I think that's where they originated. But for those that aren't familiar with them, what are these things?

Anne-Marie Henson:

Yeah, and I agree. I've had that discussion a lot about them being simple perhaps from a legal perspective because often they're like four or five-page agreements, and yet the complexities from an accounting perspective sometimes can be pretty significant. So, I guess in a nutshell, you issue a SAFE when, as a company, as a founder, you're looking to raise an equity round at some point in the future, say in the next year, but you need money upfront.

And you need money upfront for a few reasons. Sometimes it's to help you pay for the legal and due diligence costs associated with raising that equity round. Sometimes you know that you're going to raise an equity round, but you just want to issue sort-of one set of shares at the same time, so you don't need to constantly call on your lawyers and perhaps even reprice if you're issuing rounds throughout the year and there's been sort of an increase in your valuation.

What the investor does is they say, "I'll give you money. I'm going to sign this SAFE agreement, and the next time you raise a round, an equity round, I want to participate in that round." But often, there are clauses in that agreement that add complications because if you listen to what I just said, you think, "Well, that sounds pretty straightforward. You give me money now. I give you shares later." But oftentimes, that giving you shares later comes at perhaps a discount from the offering price. Sometimes the discount is ... There are different scenarios, so if you raise five million, the discount is X. And if you raise 10 million, the discount is Y.

So, those types of clauses can have a massive implication on what those SAFEs look like on your balance sheet and ultimately also on your income statement.

Armand Capisciolto:

Yeah, it's interesting. As you were talking about those different clauses because I'll often get the question ... I'm pretty sure you get the same question is, I've entered into a SAFE agreement. How do I account for it? What they're implying by asking that question is, all SAFEs are the same

Anne-Marie Henson:

Right

Armand Capisciolto:

But they're not. It's those variations. Yes, they're short. They're three or four pages long, but the clauses may be slightly different. And those slight differences could have an implication on the accounting.

No, thanks for talking about those because they are a very common instrument in the scale-up type stage of a business, so talking about them a little bit and making people aware that the accounting isn't the same for all of them, and although simple, they all differ a little bit, I think is important for our listeners to know.

That's financing transactions. Is there anything else in the scale-up phase that gives us a little bit more heartburn than other areas when we're dealing with our clients?

Anne-Marie Henson:

Yeah, I think another area is with revenue recognition, which is an important one for companies.

So, I've seen it a lot, and it's quite common also in the sort of technology space, but there are times when you're at those initial stages, and you perhaps only started off with having a few customers. So, the arrangements, the agreements you enter into with those customers can differ one from the other and can include a sort-of upfront trial period.

Maybe you're asking for upfront money to help you with the integration and implementation, but does that upfront money really mean that you've earned revenue and that you can record that, or does that need to be deferred over the contract term? Things like discounts or giving customers a deal if perhaps they enter into more than one agreement with various locations if you're providing services.

So, there are a lot of complexities with regards to revenue, and the sooner that you get ahead of that and understand what the implications are, the better because we all know that revenues are a really important multiple for companies to see how they're doing and from a valuation’s perspective. So, it's a situation where the accounting for your revenue contracts could have a real impact on your valuation at your next equity round, which is true dollars in your pocket, so it's really important to get ahead of that in advance.

Armand Capisciolto:

That valuation issue, and companies like this being valued as a multiple of revenue, I've actually seen a situation where I had a client that private equity was getting ready to invest in them, and all of a sudden, people start asking questions about whether revenue is gross versus net.

Anne-Marie Henson:

Right.

Armand Capisciolto:

I said, "Oh, that's an interesting question because if it's net, that significantly reduces revenue, and then if they're applying that multiple, significantly reduces the valuation." So, it just becomes really real for them. It's impacting their ability to raise money.

Anne-Marie Henson:

Yup.

Armand Capisciolto:

So that's real for them. But the other thing is just, I think, in the scale-up phase, companies are still working out their business model, so they're trying different things, right. Well, what if I change my agreement this way? Just because you came to one conclusion on the first contract, if you've slightly changed some of those clauses, you might come to a different conclusion on the second contract. As companies grow, they're dealing with this complexity, which isn't easy, which is why the first part of our conversation was the importance of having that accounting and finance infrastructure to deal with all of these issues.

Anne-Marie Henson:

Exactly.

Armand Capisciolto:

I think, Anne-Marie, financial instruments, revenue, two great examples of complexity for companies in this scale-up stage. Before we end today, any last comments you want to leave us with before we close on any things we've missed that you think was really important for companies in this stage to be aware of?

Anne-Marie Henson:

No, I think this is really fun to come here and discuss these issues. And I think probably just to sort of recap a little bit, I think accounting can be really complicated, especially when a company is at the stage where you're trying to raise funds, you don't have access to traditional financing, you're starting to earn revenues. So, the more you know about the implications, the better prepared you are as a founder to be able to advance and to communicate these implications to your stakeholders.

There's lots of experts. I think Armand, you and I might be two of them who really enjoy these types of issues, and we like to help our clients figure these out and give them alternatives and deal with them, so it allows founders sort of the peace of mind to be able to continue to do what they do best, but reaching out to individuals who see these on almost a daily basis and can help advise them through this really important stage of the company's life.

Armand Capisciolto:

Okay. I think by saying we enjoy these things, I think you just called us both accounting nerds, and I'm okay with that. I think you're okay with it too.

Anne-Marie Henson:

Yeah. Yeah, I've accepted that title. I'm okay with it.

Armand Capisciolto:

Okay. Well, Anne-Marie, thank you very much. Myself and our audience, appreciate your time and expertise. I'd also like to thank our listeners for tuning in today. I'm Armand Capisciolto, and this has been BDO's Accounting for the Future. Please let us know if you found this topic interesting and useful, and remember to subscribe if you like it. We'll see you next time.