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Strategic Accounting

February 10, 2003

by Wendy Hall, Larta Staff Writer

For startups struggling to bring products to market, raise capital and grow a company, accounting is often mistaken as a peripheral issue. Christian Jester, instructor for the upcoming Larta University class, Startup Accounting And Tax Issues, discusses what has and hasn't changed for emerging technology companies as the economy remains challenging, and accounting practices become more scrutinized.

What the current challenges are for emerging technology start-up companies right now in regards to accounting practices?

I don't think anything has changed as far as emerging companies are concerned. I think young companies have always struggled, especially with organization and resources. They also struggle in not having the expertise to spot some of the more complex things that early-stage companies might get into before they've actually taken on an accounting firm, or put in more sophisticated financial functions in the business.

Those areas typically tend to be surrounding equity issues, because young technology-based companies obviously use their equity in different forms, whether it's buying services that might have complex preferred financing arrangements, or they use a lot of equity instruments, like stock options, to compensate their employees. Because of some of the complexity in the accounting of those manners coupled with administration, which sometimes gets put on the backburner, a lot of problems typically arise. A lot of rules and interpretations of specific accounting literature is really evolving. If you're not up-to-date or if you're just not experienced with it, there's a very good chance you've got your revenue recognition model wrong. So that's where the expectation settings can get afoul, and that's where companies have to rethink how they're doing things. If you look at it early enough, you can structure a contract or agreement to get closer, or actually get to, the desired treatment. But a lot of times when you have early-stage companies getting into those arrangements, the way they structured their agreement wasn't going to work for what they were expecting, or just the ways their business models work you would never get a result. They just don't know that until they go down the road a little bit, and they start to think about those things in detail.

Many companies have treated that as sort of a free currency where there's not really a big financial impact on the company's issuing options. In some cases--most people have an understanding of a deluded impact, but in the way, let's say, an option is structured and the pricing in the way that company values its own equity, a lot of times there could be a compensation element that is being ignored, or it's just the options that are deemed to be used more as a free currency are used a little bit more recklessly. With preferred stock, what we see commonly is that a lot of the more complex preferred stocks really look and operate more like debt than they do equity, with some of the redemption rights, or liquidation rights, and things that go along with those areas, and other rights that go on top of that, and a lot of companies get surprised when the actual accounting requires that to be included outside of equity. There's often misconceptions about whether a preferred stock round really truly established the fair value of the company, and the big issue there is, who are your big investors? Are they insiders, are they strategic partners who maybe are investing in a certain price because there's a benefit that they're getting because of maybe a potential commercial arrangement. Another misconception we see is that a preferred stock round doesn't always set the bar on evaluation, because it depends on what the composition of that bar is. Whereas a pure financial round without investors would establish a more objective evaluation for the company.

Even though the Sarbanes-Oxley Act pertains to public companies, does it have any affect on the way startup (private) companies conduct accounting practices?

That's a good question. There's not any direct relationship at this stage of the game, because Sarbanes-Oxley is definitely related to legislation, rules and regulation that is going to be applied by public companies. So we know there's that distinction. But that doesn't mean it doesn't relate in any way. Clearly the legislation, just in general, raises the bar in corporate responsibility and what is a good company. What public companies are having to adhere to is going to be the standard and the benchmarks that I think the private companies, in practice, are going to be held to. Because at the end of the day a business is a business. I think the bar is going to be raised on issues such as internal control and corporate governance. Specifically what will be an interesting issue is when these young companies that are going to go into the public markets is having the internal control structure firmed-up. One of Sarbanes-Oxley's provisions is that it requires basically by law for companies to have a substantive and effectively working and designed internal control structure, and also requires auditors to actually attest to that. There's a new standard that's been created there. The interesting thing for a young company looking to go public is the preparation needed to go into that in order to become public. Like flipping a switch, once you go out into the market, you actually have those controls and procedures in place so you can adequately make those certifications, and auditors and regulators can come in and look and validate those assertions that are being made. That's a dramatic difference in the IPO preparation, or the security filing process, from what companies previously have had to do. I see that being a pretty profound difference in what that's going to entail.

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