As a startup founder, accounting mistakes are probably the last thing on your mind.
Your responsibilities include masterminding business growth, bringing your offering to market, generating customer interest and managing your team.
It’s no wonder that maintenance of your financial records often falls to the wayside. But neglecting your accounting and bookkeeping can cause some serious problems for your company down the line.
You don’t want to be caught unprepared when a lender asks for your financial statements or when the IRS sends a letter about your unfiled tax return.
This article will discuss the most common accounting mistakes that startups make, why they’re dangerous to your company and how you can avoid them.
Let’s get started.
Failing to Create Sufficient Founders’ Agreements
Every startup needs to create a proper founders’ agreement, ideally towards the beginning of the company’s development.
These agreements are legally binding contracts that guide both the day-to-day operations of the business and outline the more technical details like founder compensation and ownership percentages.
Unfortunately, founders often either draft a contract that fails to address all the necessary issues or skip writing down the information altogether.
But this can come back to haunt you in any of a dozen ways, and often leads to both co-founder conflict and financial complications.
For example, if a startup fails to clearly define compensation plans, founders can end up taking too much cash from the business (bleeding company reserves) or not enough (artificially inflating profitability).
Here are some other items that should be addressed in every founders’ agreement:
- Initial capital and subsequent contributions: To become a founder, each partner needs to contribute something of value like money, property, or services. Make sure to document these contributions and define the value of anything non-cash.
- Ownership structure: Make sure you include a summary of the ownership percentages for each partner. You’ll need this for tax purposes when they exit the company or when new partners enter. This section should also include details relating to your startup’s status as an LLC, partnership or corporation.
- Roles and responsibilities: It’s easy to discuss these details verbally and leave it at that, but make sure you have at least a general breakdown of who will be responsible for what tasks in your founders’ agreement. You don’t want anyone to be resentful of or confused by anyone else’s duties.
Even if you’re the sole founder, you’ll still need to create a document to help answer future tax or accounting questions.
Either way, don’t try to write one on your own. Take a look at some templates to get a general understanding of what they should include, then reach out to a lawyer or accountant to draft the document for you.
Combining Personal and Business Cash Flows
One of the most common accounting mistakes that startup founders make is running all of their cash flows through a single bank account. This may seem harmless in your company’s early days, but it can quickly become a nightmare as your revenues and expenses grow.
Every startup founder should, at the very least, open separate accounts for their business and personal transactions.
Trying to use one bank account for everything makes creating accurate financial statements much more difficult, and startups need clean financials for both funding and tax purposes.
Acquiring Loans and Funding
Every time your startup goes through a round of funding or looks for a business loan, you’ll need to be able to demonstrate your financial health to your investors or lenders.
They’re going to be looking at your profitability, liquidity and growth metrics to decide whether they’re likely to recoup their investment in your startup.
Having inaccurate or messy financials due to an intermingling of your personal and business cash flows can quickly disqualify you. Even if your business is thriving, you need to be able to demonstrate it on paper.
Navigating Tax Season
It can be surprisingly difficult to remember months after the fact which of your expenses were tax-deductible.
When travel, meals or entertainment are involved, it becomes even more complicated. Was that five-day trip entirely business-related? Which meals were client-facing and which were personal?
You’ll need to be able to demonstrate with certainty that the deductions you take on your tax return were ordinary and necessary for your business operations. Just separate everything from the start to avoid any confusion.
Using an Incorrect or Inconsistent Accounting Basis
Though there are Generally Accepted Accounting Principles (GAAP), you may be surprised to know that not every startup needs to bother following them.
GAAP was designed to prevent large, public companies from manipulating their books to deceive investors. To be GAAP compliant, your startup would have to use the accrual method of accounting, one of two fundamental ways businesses can recognize their revenues and expenses.
- Cash Method: Recognize revenues when you receive cash and expenses when you spend cash.
- Accrual Method: Recognize revenues when you earn them and expenses when you incur them, regardless of the timing of your cash flows.
Many businesses choose the cash method for its simplicity. It makes cash flows easier to monitor and allows you some flexibility in timing your transactions, which can be beneficial for tax purposes.
The accrual method is more complicated since you’ll have to track unearned cash receipts and unpaid expenses, but it is more accurate in the long run and might be a requirement if your startup grows large enough. Adopting it from the beginning can save you a headache in the future.
Whichever you choose, make sure you stick with one unless you officially make a conversion with the IRS.
Startups get themselves into the most trouble when they mix and match between the two accounting methods. Make sure you understand the pros and cons of each and then stay consistent.
The Simplest of all Accounting Mistakes: Waiting too Long to Start
If nothing else, make sure to address your startup’s accounting function as early as possible.
Even the best tax advisor in the business would need to work with you ahead of time to save you any significant amount of money on your taxes.
The earliest stages of a startup are usually the least organized, and that’s when accounting strategy and bookkeeping are the most neglected.
But the same principle holds for more established startups: if you wait until the end of the calendar year (or worse, until the following tax season) to start getting your accounting affairs for the year in order, it’s going to be too late.
Remember, an ounce of prevention is worth a pound of cure.
Stay proactive and establish your accounting function from the beginning of your business. Check in regularly with your accounting team, if you have one, or sit down to examine your books yourself throughout the year.
It’ll help you avoid costly penalties, messy records and having to redo your financial statements while under pressure from an important investor.
Consider Outsourcing: Eliminate Accounting Mistakes
Accounting can quickly become a full-time job and then some.
Consider hiring an appropriate financial professional for your startup’s current stage of growth and scale those services up as needed.
If your startup is still facing limited cash flows, start small: just hire an affordable bookkeeper to manage your records.
Remember that making the mistakes outlined above can end up costing you thousands of dollars over the life of your business. Take the time to do your accounting right, as early as possible.
Founder’s CPA is all-in on startups — helping founders like you use accounting as a tool for growth. Check out our free consultation and see how we can make your life easier today.