Let’s say you’ve put together a great pitch deck over the last half a year. You’re culminating your perfect narrative, and every graph in your deck is showing positive growth with great product-market-fit. You’re finally meeting with the venture capitalists you’ve desired to meet with, and the chemistry is great. They’ve sent the term sheet, and you’re happy!
Now you have to go through the financial due diligence step.
Now your perfect pitch deck is going against your ledgers. The investors send the due diligence you’ve done to their internal auditors to do a deeper analysis. For fast-growing startups, this is usually the end for them. What the founders thought was doing internal bookkeeping fast, now the investors think the founders have no fiscal discipline, and they don’t have a problem with the line items they have in their accounts.
Seed and Series A investors buy into your vision, but they also buy into your execution. If your bookkeeping looks like it was done by amateur bookkeepers, the investors look at the fate of your operations like it was done by amateurs too. You cannot rely on bookkeeping and business continuity for a large-scale funding round. What are the common problems that derail the due diligence process of venture capitalists, and how can they be solved using current technology and business processes?
According to the Diligence Reality Check Industry data, up to 30% of signed term sheets become unstable or are subject to major negotiations in the due diligence stage. The biggest problem causing delays and broken deals is the management of historical accounting and the verification of SaaS performance metrics.
1. The Messy Garage: Unreconciled Accounts
Investor confidence can be quickly gained and lost based on the quality of financial records maintained. Venture Capitalists read your financial records with the expectation of seeing a clean balance sheet. A growing company often has ledgers with unverified suspense accounts or hundreds of thousands of dollars in unassigned transactions.
Let’s look at the problem from a venture capitalist perspective. If your bank balances, credit card balances, and loan balances are not matched with your accounting system, your financial numbers are probably an estimate. If you report your monthly burn rate as $45,000, but your bank balance has $15,000 of unassigned transaction fees, your financial records are unreliable.
Account reconciliations are a continuous process that must be actively managed. Every account must equal $0 at the end of a month. If you are creating high quality financial records driven by a legal obligation of due diligence in the week following a term sheet, you will make an error, cause a delay, and inform investors you are not managing your company well.
2. The “Ghost Revenue” Trap: Deceptive Revenue Recognition
Recording revenue may be the most crucial aspect of your SaaS or subscription business. A cash mindset is understandably common with new founders. If a customer pays their annual subscription of $12,000, it is an easy decision to record that payment as total revenue for the month.
It should come as little surprise that the decision is concerning for both an investor and an auditor. According to GAAP and IFRS, that amount should be subdivided and reported monthly as $1,000 with the remaining balance recorded as deferred revenue.
Financial reports that combine cash receipts with revenue recognized in accordance with GAAP render your ARR, MRR, and growth metrics meaningless. Once the revenue inflation through cash bookings is revealed in the due diligence process, expect a valuation decrease or an investment withdrawal since your company is misrepresented.
Did You Know?
A venture capital audit primarily focuses on your Net Revenue Retention (NRR) and Customer Acquisition Cost (CAC) ratios. If your back office is unable to separate true MRR from one-off implementation or consulting fees, your core metrics will be considered invalid by the institutional investors.
3. Co-mingling and the “Founder’s Sandbox”
Company founding can involve a lot of grey areas. For example, you might have needed to buy the team supplies on your personal credit card, or your family dinners might have been paid on the company card after the fact..
Some of this is reasonable in a pre-seed structure, but things are different for the seed funding rounds. Absolute financial integrity and operational transparency are necessary. If personal and lifestyle expenses show up in your financials during an investor’s due diligence, there will an immediate loss of trust, and there will be many questions regarding the financial discipline.
Your business’ finances should not look like a personal sandbox. This means that your previous financial statements need to be cleared out of all your personal expenses, each of these expense lines needs to be restated in the books under the appropriate expense category, and also all loans and the equity of the financed founders needs to documented and be clearly constructed within your financial statements.
4. Disconnected Tech Stacks
Today’s investors know top-performing financial teams. They want your invoicing, payroll, and expense management tools integrated seamlessly with your bookkeeping tools.
If your historical data is being updated manually in your expense management system every month to resolve system discrepancies, your reporting process is highly susceptible to human error. This is where manual tracking and SaaS accounting automation differentiate. During the due diligence process, VCs want to know how data is entering your financial statements. If that process is broken or maintained with questionable manual intervention, deal friction is significant. AI bookkeeping services reduce that friction. The Investor Perspective A deal cannot progress if there are delays with the due diligence process. If fixing the startup’s books is the reason for the delay, the investor will lose interest.
Modern Ways to Update Your Infrastructure
Fixing the issues brings us to a smoother operational foundation and higher scalability after funding. If you’re preparing to start a capital raise in the next 3-6 months, this is your guide:
Switch to Accrual Accounting: Stop using outdated methods to report on a cash-basis. From hereon, the only way to consider scaling to the real level of institutional scale is using a disciplined, accrual-based view of your financial positions.
Utilize SaaS Accounting Automation: Integrate your payment processors directly to ecosystems like Xero or QuickBooks Online, so staff no longer have to enter data manually.
Timely Month Closes: Set a hard deadline of 10 to 15 days after month-end to fully close and reconcile the books. No matter the length of time, this type of operational maturity is beyond what most others have.
Professional Infrastructure: Stop treating bookkeeping as a part-time administrative task. You need the eyes of a professional and trained staff Bookkeeping is a mechanized and tech-enhanced infrastructure for start-ups, and it shows.
The Changing Importance of Financial Operations
Poor financial records just draw criticism, but having accurate, clear records that can pass an audit causes investors to have a higher opinion of you. Knowledgeable investors are going to be appreciative of you protecting their capital. They will see that you are aware of the risks and understand the implications of increasing your burn rate. It shows that your company is ready to start going from an early-stage company to a well-established company.
Ready for Series A Scrutiny? Let’s Clean Up Your Books.
Our goal at Kandor, is to help growing companies fill any financial infrastructural gaps. We blend our competitive advantage of AI-driven bookkeeping with Ledger.ai with the oversight of seasoned strategists. Financial Due Diligence is time consuming. We make it easy with our services that help you to better manage your historical reconciliations, inquiries, and workflows along the growth continuum. Don’t allow your back-office operations to have a negative impact on your capital raise. Call us to make an appointment.