(Newsletter: tsCFO.001 v2 2023.02.13)
Why aren't there more Tech Startup CFO's?
Why are tech startup CFO's almost as common as hen’s teeth? A well respected tech executive recently told me the CFO's he knew were with public companies that have externally regulated reporting requirements. Fair enough, public companies have a lot more moving parts on the reporting side than private companies (think IFRS, MD&A, investor relations - none of which are my idea of a good time). So why am I implying that most tech startups (aka early stage tech companies) are complex enough to need initial CFO level guidance?
If you accept the old saw that “a stitch in time saves nine”, you have your answer. There is a design component to launching the financial and admin side of a tech startup, and a series of checklists to work through. If you start with a solid foundation, you will be in position to grow straight and true. If you are building on soft mud and thinking you can fix the foundation later, you are saving money and effort in the near term, but setting yourself up for a big bill down the road.
Even in a well established and profitable tech startup, the CFO role is not full-time. This is implied in the traditional term “Contract CFO”, or the updated and ever so sexy term “Fractional CFO”. Having said that, with a new client in “clean up / upgrade mode”, the Fractional CFO role can be temporary full time (including late nights and weekends), especially if management reporting improvements are an urgent priority for the CEO, or a major financing is anticipated. The Fractional CFO role is often disruptive to the existing accounting team because it typically involves uprooting the GL structure at the first year-end opportunity, which means disrupting the comfortable legacy accounting process. I am touching on a series of future CFO Newsletter topics here, but suffice it to say that an effective management reporting system necessarily involves the integration of a deep understanding of the existing business model, the best possible guess at how it will evolve over the next 36 months, and a forecast model that captures both in numerical form. The GL structure must be updated to capture actuals data in the same revenue and expense lines designed for the forecast model. Designing and integrating those pieces together for effective management reporting requires CFO level experience.
Once management reporting processes are running smoothly, actuals are being scrubbed quarterly, a data room is set up with complete and accurate documents (that means fully executed legal agreements), executive team compensation is sorted out, and all tax filings are current, a tech startup Fractional CFO has much less to do unless there is a big growth spurt or a major financing. There is a bit of ongoing year-end reporting and tax work, but I find the Fractional CFO role typically involves a large hump of design / cleanup activity at the front-end, followed by a longtail of much reduce effort, until a special requirement comes along. Even then, if you’ve been managing things proactively, a major financing deal should go relatively smoothly on the finance and admin side.
Balancing roles - Bookkeeper vs. Controller vs. CFO
Let’s consider each of these three roles in turn. A bookeeper’s role is to follow established patterns in recording transactions accurately, completely and efficiently. These patterns are supported by automated features in current web versions of QuickBooks Online (QBO) and Xero, but it is still a tedious task to apply the attention to detail required to get the job done right. The GL detail that bookkeepers record is the foundation for accurate actuals data, where transactions are adequately explained. A good bookkeeper, with some formal accounting training for context, is a treasure who will never be wanting for employment.
The Controller role involves a well qualified individual (often a recent CPA,CA grad) who can supervise the generation of accurate financial statements, deal with tax compliance matters, and support the management reporting effort beyond producing actuals. It will be obvious when you need to think about bringing on a Controller - your highly valued bookkeeper will have sprouted a fresh crop of grey hair and be found browsing employment web sites during their coffee breaks. The Company’s transaction volume has grown faster than they can manage. Hiring a second bookkeeper is not the answer, unless you choose to replace the Controller role with Fractional CFO oversight. With growth comes the need for systems improvements, including ways to automate or otherwise reduce manual effort.
As mentioned earlier, the Fractional CFO role is typically characterized by a front-end hump of design / cleanup activity, followed by a longtail period of reduced activity, at least until the next year-end rolls around or a major financing is underway. So here we come to a dilemma. Almost any seasoned tech startup entrepreneur will readily agree that tech startups can benefit significantly from Fractional CFO guidance. Given the number of tech startups (there is no shortage of them) producing an overwhelming demand, why is there a relative dearth of tech startup CFO’s to satisfy that demand? The answer is that tech startup CEO’s naturally have more urgent priorities than “finance and admin” on their critical path. Tech startup CEO’s are jugglers, and the natural flow of their most urgent priorities involves developing a prototype, validating customer demand, upgrading the prototype to commercial production, and finding a distribution channel able to sell in enough volume to achieve positive cashflow (stop the bleeding!). Given the complexity and challenges involved in this R&D-S&M journey, it isn’t surprising that finance / admin takes a back-seat. Unfortunately the attitude of an overwhelmed CEO can be, we will fix those problems later by throwing money at our accounting / legal firms.
Here is a trick question. What is the most important organ in the body? The answer is, the one that isn’t working. That is because your body works as a system. Your car works as a system as well – if the starter is burned out, you aren’t going anywhere even if its role is very limited in the grand scheme of the car’s safe operation. Tech startups also work as a system, and the finance / admin function is an unavoidable part of that system. Doing the right finance and admin tasks at the right time will save headaches and money in the long term, even if it isn’t obvious to an overwhelmed CEO trying to juggle multiple balls in the air. A CEO can manage the juggling act if they trust, delegate, and respect the importance of all parts of the tech startup “system” needed to maintain overall health. It is possible to make enough mistakes in the finance and admin area to poison an investment deal which would otherwise have turned the tech founders into millionaires. Sometimes messy deals still happen, but at deeply discounted valuations.
A Logical Path to Affordable Fractional CFO Involvement
In the naturally cash strained environment that tech startups operate in, another reason why there are a dearth of Fractional CFO’s relative to demand is a self-inflicted wound caused by billing practices. I commonly hear of part-time arrangements with Fractional CFOs / Controllers based on working “one day per week”. This arrangement has never made sense to me, because it is inconsistent with the natural demand for Fractional CFO services. The initial hump of Fractional CFO activity in a new client relationship is based on an intense period of business model investigation, followed by management reporting systems design. During this phase there is an overwhelming amount of work to do, and 1 day per week is pathetically inadequate. In the longer term, once management reporting and other financial processes are running smoothly, one day per week far exceeds the level of service required from a Fractional CFO. From a logical perspective, one day per week is almost never right, but a predictable fixed monthly fee (fixed amount of hours billed each month) is important in letting the CEO manage a typically tight cashflow situation.
When making a Fractional CFO service arrangement for one day per week, the parties are confusing cashflow / ability to pay with service timing. This is forgivable for the CEO who likely has no background in accrual accounting, but I suggest it is a timid offering by the Fractional CFO who fully understands the possibility of a separation between hours worked and when a service provider gets paid for them. Assuming the Fractional CFO is willing to accept some risk for unbilled hours (in sympathy with the CEO who is accepting exceptional levels of risk for their unpaid hours), they can negotiate a fixed hourly rate for services combined with a fixed monthly fee (hours to be paid each month), based on a balance between what the client can afford, and the anticipated demand for Fractional CFO services. The Fractional CFO tracks and reports all hours worked each month (accrual accounting), and the unbilled hours (the portion that exceed the fixed monthly billed hours / fee) are recorded as an accrued liability. This arrangement frees up the Fractional CFO to provide services based on client need, while giving the CEO certainty and predictability on the cashflow impact of bringing a Fractional CFO on board. It is not a perfect solution, as a spike in Fractional CFO expense still shows up on the P&L, but this is a very sensible compromise that works well for both sides. Yet I have rarely seen it outside my own practice.
There is nothing unusual about having unbilled hours carried forward in a professional service arrangement. Informally, lawyers do this all the time by batching modest hours worked into legal invoices that may only be issued a few times each year. The main difference is that lawyers don’t typically report accumulated unbilled hours to their clients each month so the appropriate accrued liability can be recorded. A helpful lawyer will automatically issue an invoice to flush out hours worked up to the client’s year-end, or at least advise the client what their unbilled fee was at that date. Continuing the analogy, legal activity also tends to be a combination of service spikes (especially during a significant financing transaction) and a modest longtail maintenance level of support (annual filings / AGM, maintaining Board minutes, etc).
At this point an astute reader will be wondering how the accumulated unbilled Fractional CFO hours get resolved. In my experience there can be different triggers. A successful financing or significant SR&ED refund can enable a lump payment. If the Fractional CFO and startup are parting ways (for example, if replaced by a full-time CFO with an expanded operational mandate), that triggers a lump payment as a cost of the transition. In other cases, the situation naturally resolves itself in the longtail portion of the Fractional CFO service when hours worked become less than those paid at the negotiated fixed monthly fee.
Conclusion
CEO’s are naturally drawn to the urgent priorities of developing a new product or service, and selling it in enough volume to achieve positive cashflow. This preoccupation with R&D and S&M can mean the G&A (finance and admin) function gets undervalued and ignored. However, I argue that all organs in the body are important - they are all part of a healthy system. The CEO should make timely use of a Fractional CFO in the earliest days to set up the finance and admin systems - this takes little time / cost, and sets an important foundation for growth. As the tech startup matures, a Fractional CFO can be engaged without incurring a significant cashflow hit by negotiating a fixed fee arrangement where the Fractional CFO takes on a share of the startup risk themselves by banking a portion of their fee as unbilled hours for future resolution.
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