No VC will ever fund your company if your finances and compliance are a mess. This VC tells you why you need to get your house in order from the beginning.Sanjay Swamy
Most startups are founded by people who have an incredible passion for solving a problem in an innovative and disruptive way.
The simple five-step evolution that most founders should follow are:
1. Define the customer segment(s)
2. Validate the problem and proposed solution
3. Raise angel funding
4. Build an initial product and establish product-market fit
5. Raise venture capital & scale the company
Although the process seems simple, we’ve all seen and heard of startups that had tremendous potential and great ideas, but were weak on execution. The old adage “ideas are cheap, execution is key” is something people shout from the rooftops - and yet more often than not, appears to go unheeded. If you are a typical entrepreneur, you’ve probably ignored the finance, legal and HR areas, and most often are likely to be clueless about their role in the larger scheme of things.
Some even consider finance an “overhead” or worse, an “unnecessary evil”
Over the years, I’ve come to respect not just the work Finance people do but the criticality of the role, and the importance of doing finance right, very early in the lifecycle of the company. In particular, for companies that are raising venture capital, doing this poorly hurts the best of startups very early on, and the cost of not doing things right from the get-go is disproportionately higher than the cost of doing so.
I’ve unfortunately seen the cycle repeat umpteen times in startups - and nobody will forgive poor accounting and compliance practices, regardless of the great growth numbers or excellent product and team. Some might be more patient than others in certain circumstances - but compliance is non-negotiable to all. In the early stages, most entrepreneurs tend to look at finance as a waste of money - and aim to spend the minimum on this front, sometimes as low as $500 per month (Rs 35,000) to get the lowest-cost bookkeeper or auditor they can versus a more competent one that may cost you say $1,500 per month (Rs one lakh).
Let me show some simple arithmetic to tell you how much this costs you:
● Assume you start a company and raise an angel round of $500,000 (Rs 3.5 crore). You start building the product and sell it to customers who start using the product. As a frenzied startup with limited runway you keep going from customer to customer and signing them up - and keep in your mind a recording of the incremental revenue each customer brings. You’re also busy hiring, designing marketing campaigns, booking your own travel, etc. and slogging 18 hour days, seven days a week. In the midst of it all, an employee complains that the toilets are dirty and gets an even dirtier look from you.
When you’re down to $150,000 (Rs one crore) in the bank and have about four months of runway left you start talking to later stage institutional investors - and suddenly your pitch deck and these meetings take over - only you have to do all this while maintaining business momentum, else nobody will invest. The VCs ask you for financial models, growth curves, reference calls, etc.
When you are down to $50,000 (Rs 35 lakh), you get the magical call from one or two VCs for a termsheet for a Series A round of say $4 million, and you weigh your options and accept one from a reputed VC. You’re now breathing better and heave a sigh of relief, fully expecting the money to hit your bank account in eight weeks. You congratulate yourselves and suddenly the dreams for your startup don’t seem that unreal anymore. You start drawing up plans for whom you’re going to hire, call some friends, and confidentially tell them, “quit your job at IBM and join us - we’ve raised funding!”
If you’re an early-stage entrepreneur, all of this should sound familiar to you. And indeed, that’s how it’s meant to be. The VC now sends an email congratulating you and introducing you to their finance and legal team for due diligence!
The well-meaning CFO of the VC firm sends you a due diligence checklist - and that’s when things get difficult.
If you are like most founders, you probably realise that:
● You have not billed any customers or collected any money
● You haven’t reconciled your bank accounts
● Your Rs 25,000-per-month accountant is just a bookkeeper, and a poor one at that
● You haven’t had a proper accountant look at your books
● You have gone for 18 months without auditing your books
● You never allotted shares to your angel investors
● You had some overseas money come in and never did your "FC-WTF's"
The list goes on and on. The CFO then calls the partner and says, “This company has a major compliance problem - everything that could be violated has been.”
I’ve seen companies delay their financing rounds by as much as six months because of compliance issues. If you are lucky, your VC will say “I believe in you and in your business, we will stand by our termsheet but you need to fix all of this, else my fund compliance will be in question.” Some might sign a shareholders agreement (SHA) but put all of this in the dreaded ‘Conditions Precedent’ bucket, which means you tie the knot and don't receive the money until you fix things. This is the worst time for an entrepreneur!
To be clear, no VC will ever fund your company if your compliance isn’t in order.
If you still have money in the bank and a friendly VC, you can pull through this situation and fix things at a hefty financial cost - but if you don’t have money left, the consequences can be dire.
Some basic arithmetic will make this even more harsh - when you close your funding of $5 million (Rs 35 crore) in India that would yield you seven percent interest in the bank, or $30,000/year (~ Rs 20 lakh per month). It turns out that the cost of a high-quality finance exec who would’ve handled all the required compliances would be probably be about Rs 1-2 lakh per month - not necessarily a CFO, but a senior finance executive.
This person would have ensured that:
● Your customer contracts are in place
● Customers are being invoiced
● Revenues are collected from customers (which means more runway)
● Books and reconciled with bank accounts
● Compliance filings are in order
The list goes on and on and on but the fact of the matter is that this person would’ve paid for themselves many times over. Most founders assume frugality and capital efficiency is the same as “not spending money”.
To be clear, investors like frugal founders and capital-efficient businesses, but love founders who know where to spend the money.
My advice to founders-
Treat Finance, Legal and HR as a first-class citizen from the get-go.
Acknowledge what you don’t know, and get the right experts/professionals to handle it. Finance, Legal, and HR are areas you don’t mess around. At all stages of the company the finance, compliance functions need to be handled by someone competent and someone who is on top of things.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)