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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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Sayahh’s Financial Statements For August 2011

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Now that Dick and Jane have added a CTO to SayAhh’s founding team, they’ve turned their full attention to working on their product. Today, we’ll look at the impact of the expenses to date on the P&L, Balance Sheet, and Cash Flow Statement.

Since SayAhh is in the pre-launch development stage, the company doesn’t have any revenue yet. They also haven’t launched a product, so there is no corresponding “cost of goods sold” – the direct cost of delivering their product. This results in a gross margin of $0, where gross margin is revenue – cost of goods sold.

The default Quickbooks setup uses “Income” to refer to “Revenue”. Since the Income (“Revenue”) line is $0 and the the gross margin is $0, Dick and Jane haven’t really noticed this yet. For now, we’ll leave it as is but once Dick and Jane meet with a mentor who is a CFO we expect this will change.

As of Aug 31st, here is their P&L.

The largest expense a company usually has at this stage is salaries. However, Dick, Jane and Praveena have decided to initially forgo salaries which helps them conserve cash in the near term. A company at this stage could also face product development costs from consultants if they decided to outsource product development. However, Praveena has committed to personally get the first version of the product up and launched without outside consultants, so there is no expense here either.

Dick is focusing his effort on getting some early customer validation and is using a Lean Startup approach. Dick’s friend Samir, who is hoping to land a job with Sayahh, agreed to put together several static landing pages and email collection forms. Once these were up Dick launched several AdWords campaigns to test customer interest.

Dick, Jane, and Praveena decided to get a small office so they could work out of the same space. Dick recently had a child and didn’t want to use his house as it was too distracting, and both Jane and Praveena felt like their apartments were too small to all cram into. They made the decision that being together every day was better than working separately, so they signed a 1-year lease at $1500/month (prorated from mid-August) and they invested $1930 in capital improvements to remodel the entryway and install a sign. After signing the lease, Samir suggested that they could have saved a lot of money by using a co-working space but once the decision was made and the lease signed, there was no turning back.

In addition to the capital improvements (which show up on the balance sheet below as “Leasehold Improvements”) our fearless founders bought some tables, chairs, and a few other random things at Office Depot. Both the renovations and furniture purchases are “capitalized” on their balance sheet rather than being expenses on the P&L. While the cash is gone, the “expense” is “depreciated” over several years (depending on the type of asset).

Following is the balance sheet and the changes from July to August.

Our founders had some other expenses, including business cards and a trip to an industry conference where they talked to a number of potential customers. While the conference was educational, Dick and Jane were frustrated with the dull gaze they got from uninterested prospects when they tried to explain what they were doing, but couldn’t actually show anything. On the flight home from the conference, Dick and Jane agreed they both needed to help Praveena get the first product out, whatever it took.

Following is the third key financial statement – the Statement of Cash Flows.

In total, SayAhh burned through over $8000 during the month. Annualizing this number, SayAhh could expect around $96,000 in negative cash flow for the year. However, Jane realized that $3430 associated with the new office space security deposit and rennovations is essentially a one-time expense. This resulted in an annualized burn rate more in the neighborhood of $55,200 ($4,600 * 12).

Overview of Balance Sheet and Statement of Cash Flows

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When we were last with our SayAhh cofounders, they had implemented an accounting system and Jane had contributed $50,000 for a 55/45% equity split. This week we introduce two of SayAhh’s key accounting documents: the Balance Sheet (BS) and Statement of Cash Flows (SCF) showing how this investment is accounted for.

The investments by the founders created two transactions. Since SayAhh is a C corporation that is incorporated in Delaware, they decided to have a very low non-zero par value for their shares, set at $0.00001, to prevent higher franchise stock taxes. Thus for the 10M shares issued to the them, Jane invests $55 and Dick invests $45. Jane also invests $50,000 as previously agreed. These deposits increase the checking account balance and also the equity accounts, and results in a solvent company and a decent starting bank balance.

Below is the Balance Sheet as of 8/21/11. Fred Wilson’s MBA Mondays series shows how to think about the balance sheet – namely as a picture of the company at a point in time.

The Balance Sheet respects something called the Basic Accounting Equation. The Basic Accounting Equation states that Total Assets always must equal Total Liabilities plus Equity. In SayAhh’s case, you can see that the assets (cash in a checking account) equals liabilities (zero) plus equity. Assets = Liabilities + Equity.

If you use spreadsheets to keep track of your books, you could accidentally violate the Basic Accounting Equation, but not in accounting software program. This is one of the reasons that Dick and Jane chose to use QuickBooks, even at this very early stage, as it guarantees that their books will conform to double entry accounting.

Equity is comprised of two things. The Ordinary Shares equity account represent the par value paid by Jane and Dick for their 10M shares ($100). The Paid-In Capital account shows Jane paid in an additional $50,000. Combined these two amounts equal total equity, or $50,100.

The other accounting document we are introducing today is the Statement of Cash Flows (SCF). The SCF breaks down how changes in balance sheet accounts and income affect cash. When presented in the SCF, these transactions are broken down into three categories: operating, financing and investing activities. Note the interconnected nature between these statements. The net $50,100 from financing activities all went into equity on the Balance Sheet.

Currently, SayAhh’s financials are very straightforward – even boring, but we’ve got to start somewhere. Next week we will introduce the Cap Table, and show how it changes when adding a co-founder.

Financial Literacy

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I’m stunned by the lack of financial literacy of so many people in so many contexts. The commentary by politicians, economists, and the media on the European debt crisis and the US debt ceiling dynamics is appalling. The general media and blogosphere commentary on the financials of high growth companies, especially those who have either recently gone public or filed their S-1′s, range from perplexing to just plain incorrect. And more and more entrepreneurs who I’m exposed to who are presenting their companies for financing have a complete lack of understanding of their financials – both current and projected. Of course, some of my fellow board members don’t understand how to read financial statements either, which doesn’t help matters much.

Fred Wilson took on some of this with his awesome MBA Mondays series, including several great posts around financial statements that every entrepreneur should go read right now:

In my experience there are four specific things that people struggle with.

  1. An inability to read the Balance Sheet, P&L, and Cash Flow statements.
  2. A lack of understanding of how the Balance Sheet, P&L, and Cash Flow statements fit together.
  3. A lack of understanding how non-accounting metrics (e.g. bookings) impact the financial statements.
  4. A lack of understanding of GAAP (Generally Accepted Accounting Principles) and how to use the financial statements to help normalize out all the weird things GAAP makes you do.

I used to think it was all a GAAP problem. GAAP is complicated, continuously evolving and changing, and often creates more ambiguity that it resolves. But unless you actually understand how to read a financial statement, GAAP doesn’t even come into play. And by financial statement, I don’t just mean the income statement (or P&L) – I mean the income statement, balance sheet, and cash flow statement, along with understanding how they interact with each other.

If you understand how to read the financial statements, then you can start to solve for the GAAP challenges. You’ll be able to understand things like the implications of deferred revenue on cash flow, stock option expense on net income, and the actual equity dynamics of the balance sheet.

While there are so many things about this that I fantasize about (e.g. “the media would actually learn this stuff” and “accountants would make GAAP simpler and clearer vs. more complex”) the only thing that really matters in my world is that entrepreneurs understand how to think about this stuff. So, in the spirit of Fred’s MBA Mondays series, I’m going to write a series of posts that describe how my brain processes the financial statements of a typical high growth company with a goal of adding on to the great base that Fred has created.

I’m open for suggestions as to whether I should take on one that is newly public (e.g. the S-1 and historical financials are available), or a private company (I’m open to volunteers, although it’ll mean you are publishing your financials – at least at this moment in time.) If you’ve got suggestions or want to volunteer, just leave a comment.

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