By the time your company is raising a Series A round, investors are probably including a requirement to provide GAAP (“Generally Accepted Accounting Standards”) financial statements as both a condition to closing the round and for financial reporting on an ongoing basis. Many founders will agree to these terms. Here’s the thing - I’ve never seen a Series A stage company with GAAP financials.
To qualify that statement, I should say that the companies that I’m seeing generally don’t have full-time leadership in the finance function. That’s kind of my whole business. But even for the occasional series A stage company that does have a small finance team, it’s likely that they are focused on operational efficiency and supporting the management team with non-GAAP KPIs. They aren’t focused on generating audit-ready financial statements until further down the road.
Let’s dive into (a few) of the ways your financial statements are not GAAP:
Footnotes - The most obvious feature that you’ll be missing from your financials is the footnotes that provide additional context to the basic four financial statements (yes, four, not three. See the next bullet). If you look at any annual filing by a public company, and review the Financial Statements section, you’ll see that the financials are accompanied by dozens of pages of notes outlining accounting policies, detailing investments and liabilities, etc. For reference, here are Apple’s 2022 financials (which surprisingly contain only 16 pages of notes).
Statement of Stockholder’s Equity - That’s right, there are four*, not three, basic financial statements when it comes to US GAAP. The income statement (or “statement of operations”), the balance sheet, the statement of cash flows AND the statement of stockholders equity. This statement is exactly what it sounds like: a rollforward of all the equity balances from one year to the next. Typically, prospective investors are receiving detailed cap tables and equity ledgers as part of due diligence, so this statement is a bit superfluous in that context and is rarely included in a startup’s financial statement package.
Revenue - Your customers pay you, and you record that as revenue. If your customers are paying you for an annual contract, you recognize the revenue ratably over the year. Sounds easy enough. But ASC 606 may have other ideas. ASC 606 is the section in the Financial Accounting Standards Board’s (“FASB”) codification of accounting rules that deals with revenue. It’s too complex to discuss here, but unless you have specifically done an ASC 606 study on your revenue model, it’s more than likely that an auditor would have some significant notes on how you are recognizing revenue.
Presentation - What does your income statement look like? Specifically your operating expenses section? You probably have some broad categories for employee compensation, legal, travel, R&D and marketing expenses, right? That’s not GAAP. A GAAP P&L has all of your operating expenses broken down into two or three categories:
Research and development expenses
Selling and marketing expenses
General and administrative expenses (this line is often combined with S&M to create a single line for “Selling, general and administrative expenses”)
This means that in order to run a GAAP P&L, you need to be coding all of your expenses into these three categories, including your employee compensation.
Reserves & Estimates - Every GAAP set of financials requires some level of judgment from an accounting perspective to allow for reserves. Some common examples of reserves include:
Bad debt - If your company has a history of clients skipping out on paying what they owe you, then there should be an “allowance for doubtful accounts” on your balance sheet as a contra-AR account
Warranty - For companies selling a product that may break or has the possibility of defect, there should be a warranty reserve as a liability on the balance sheet to account for future claims.
Legal reserves - Companies that operate on the cutting edge of technology may find themselves in some legal battles around intellectual property. Any pending litigation should be assessed for financial impact in a GAAP balance sheet.
Stock-based compensation expense - A number of startups I see actually do record this. But a lot of them don’t.
Lease Accounting - Recent changes were made to lease accounting rules that require companies to gross up their balance sheet with a “right of use” asset and a lease liability in order to represent the value of the company’s lease commitments in a more detailed way.
This is not a comprehensive list. But I think it illustrates just how difficult it is to maintain GAAP financial statements. Realistically, if you have not undergone a financial audit, your financial statements almost certainly aren’t GAAP.
So how important is this? Well, I can’t say that I’ve ever seen a management team get in trouble for saying they had shared GAAP financial statements and then an investor came back yelling “these financials don’t even have ROU lease assets on the balance sheet!”. However, I’m a big believer in a) doing what you say you’re going to do and b) knowing what you’re talking about. So when I’m involved in an SPA negotiation, I make a point to clarify the language around financial statements. Here’s how that process might shake out:
Default language: “The Company has delivered to each Purchaser its unaudited financial statements for the 12 months ended ________. The financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) applied on a consistent basis throughout the periods indicated, except that the financial statements may not contain all footnotes required by GAAP. The Financial statements fairly present in all material respects the financial condition and operating results of the Company as of the dates, and for the periods, indicated therein.”
Ideal language: “The Company has delivered to each Purchaser its unaudited financial statements for the 12 months ended ________. The Financial Statements fairly present in all material respects the financial condition and operating results of the Company as of the dates, and for the periods, indicated therein.”
Compromise language: “The Company has delivered to each Purchaser its unaudited financial statements for the 12 months ended ________. The financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) applied on a consistent basis throughout the periods indicated, except that such financial statements i) may be subject to normal year-end audit adjustments ii) may differ from GAAP in certain attributes of presentation and iii) do not contain all footnotes required by GAAP. The Financial Statements fairly present in all material respects the financial condition and operating results of the Company as of the dates, and for the periods, indicated therein.”
You can see that in the ideal language, we’ve removed the reference to GAAP altogether, but are still representing that the financials “fairly present... the financial condition and operating results of the company”, which is ultimately what the goal of startup accounting should be. In the compromise language, you still have the reference to GAAP, but have the wiggle room of “normal year-end audit adjustments” and “attributes of presentation”, which in my estimate would include all of the non-GAAP items I listed above. I have a strong preference for the ideal language, but some investors (or lawyers) may insist that there be some reference to GAAP.
So the next time that an investor asks you for your GAAP financials, consider gently pushing back. By setting expectations and getting aligned on what everybody wants to get out of the Company’s financial reporting, you’ll be setting yourself up to a) do what you say you’ll do (i.e. delivering non-GAAP financials) and b) also demonstrate that you know what you’re talking about.
*Really it’s four and ½. There’s a fifth statement called the statement of comprehensive income which can be represented independently, or as a tag along to the statement of operations.