Startup Chart of Accounts Best Practices

Set the right foundation for startup decision making, due diligence, and fundraising

Most early-stage startups should engage a fractional CFO to install the proper foundation to build a venture-scale company. A proper foundation consists of:

• A robust accounting system
• Managerial reporting
• Bottoms-up financial modeling
• Proactive tracking & management of actual performance vs. projected targets
• A culture of strong operational financial planning & analysis (FP&A)

However, after several decades of working with startups, I've found that over 95% startups have a poor foundation for proactive financial governance. This includes startups where a CPA or purported fractional startup CFO set up the financial infrastructure.

In the same way that a seasoned CTO knows that shortcuts in design and development of a software platform creates technical debt, a true startup CFO knows that weak, neglected financial infrastructure creates heavy FP&A debt that accumulates over time. Any startup with a structurally unsound foundation needs to take corrective action quickly, as it will only get harder and harder to fix as the company continues to grow. Building a second and third story on a home with a cracked foundation is a recipe for extensive and expensive rework down the road.

Entire books could be written on how to build a proper financial foundation for a startup, but here, I will only focus on one thing: your chart of accounts (CoA). Yes, that's right. The chart of accounts from your QuickBooks, Xero, or NetSuite accounting system. Most people who set up the chart of accounts spend no more than 30-40 minutes making minor edits to the default chart of accounts that comes standard with your accounting system. This is a mistake. Let's talk about how to avoid incurring excessive FP&A debt.

Your Chart of Accounts is Foundational - Get it Right

The CoA is one of the first things to set up in your accounting system. If you're a programmer, it's analogous to the data model for your app. Everything is built on top of it. If you put it together thoughtlessly, you will make it harder to gain management insights, calculate critical startup metrics, and grow with your startup as it gains traction and scales.

A Good Chart of Accounts Simplifies Due Diligence

When fundraising, every interested investor will perform due diligence to make sure the startup truly has the potential claimed in the pitch and has a clean bill of health. One of the most requested documents will be your financial statements. A well-designed CoA enables an investor to quickly and easily understand the financial condition of the business. In fact, a CoA designed by a seasoned startup operator also makes it clear how key startup metrics such as gross product margin, customer acquisition costs, and monthly recurring revenue are calculated. This removes friction from the due diligence process.

Best Practices with Your Chart of Accounts

Scott Hoover, an interim CFO and CPA, has an excellent article on what is a CoA and why it's important. In it, he makes seven key recommendations:

1. Design your CoA for managerial accounting.
2. Clearly define gross margin.
3. Thoughtfully identify overhead costs that are indirectly related to sales.
4. Organize operating expenses to reflect management preferences and match budgeting level of detail.
5. Use account numbers
6. Consider separate accounts for key month-end entries
7. Leverage all relevant features of your accounting software.

I'll briefly summarize several of these recommendations, with some comments on how they apply to startups.

Design your CoA for managerial accounting

Most accounting systems are set up to simplify compliance with tax reporting or Generally Accepted Accounting Procedures (GAAP). However, it's usually better to optimize the CoA for managerial decision making. For most early-stage startups, it's very possible to set up the CoA for managerial accounting while staying in alignment with GAAP. GAAP should not be ignored, but strict GAAP compliance is usually only needed by banks, insurance, and investors agencies when the numbers get large.

But wait, aren't investors important to a startup? Yes, they are, but most startups only raise a round of funding every 18-24 months. A smart founder will look at the company's financial statements several times a month, which is why prioritizing managerial accounting over blindly rigorous GAAP compliance often makes sense for early-stage startups. If your CoA aligns with GAAP, then mapping managerial financial statements to fully GAAP-compliant statements should not be a painful ordeal. CPAs map book to tax adjustments all the time, so book to GAAP would be somewhat similar.

Clearly define gross margin

Modern investors pay close attention to your company's financial metrics. Some metrics vary according to the way you charge for your product, but one metric that is common across all business models is gross margin percentage. Every company needs to define a sensible set of expenses that are directly related to sales. Direct sales expenses almost always include direct labor and direct materials costs but may also include affiliate commissions, payment processing fees, and compute costs to deliver a SaaS service.

“Direct costs on your managerial financial statements should be the same as the costs you factor into quoting or pricing calculations”. – Scott Hoover, Interim CFO

Regardless of how you define gross margins, make sure it's consistent and properly disclosed. Designing your CoA carefully can make the disclosure self-evident in the income statement.

Organize operating expenses to reflect management preferences and match budgeting level of detail.

I'll address five issues here.

Reduce Friction to Calculate Basic CAC

One of the most common startup performance metrics is Customer Acquisition Cost or CAC. Every founder knows CAC is important, but most founders have no plan to set up an automated system to track CAC. Seasoned startup CFOs know to design CAC-related costs into specific accounts in the CoA. Common CAC costs include:

• Growth marketing channels (advertising, trade shows, events, content development and search engine optimization, etc.)
• Wages of your sales and marketing team, including bonuses and commissions
• Payroll taxes and payroll admin costs for your sales and marketing team
• Benefits costs of your sales and marketing team
• Sales and marketing contractors
• Software subscriptions for your sales and marketing team (e.g., Apollo, Clay, Mailchimp, Hubspot, LinkedIn, etc.)
• Sales-related operational expenses such as meal, travel, local transportation

Segment CAC for Better Insights

Most startups have a land and expand sales motion. After closing the first sale of 100 units (users, CPUs, widgets, whatever) with the Philadelphia office of a new customer, many startups will then try to expand the footprint to another 50 units in the same Philadelphia office, or another 200 units to the customer’s larger office in Chicago. In these cases, founders must decide if it makes sense to track the “landing CAC” separate from the “expanding CAC”, as the costs may be very different.

Or, if a startup sells the same $10/user product to a 10-user small business and a 2,000-user enterprise, it probably makes sense to separate the SMB CAC from the Enterprise CAC, since a blended CAC number becomes somewhat meaningless.

To avoid unnecessary complications to the CoA, research your accounting software to determine what features may simplify the collection of transaction-level data to support management-level segmentation, reporting and insights. QuickBooks class tracking, category tracking, or transaction tagging may be useful here.

Prepare for Advanced CAC Metrics

Startups that really dig into CAC will often find executives, board members, and savvy investors asking for advanced CAC metrics such as Cost of ARR, basic CAC Payback Period, and Dollar-based CAC Payback Period. A solid CoA foundation will help facilitate the detailed reporting of these metrics. Other advanced CAC and general SaaS metrics can be found at The SaaS Academy and The SaaS CFO.

Plan for Research and Development Tax Credits

Many startups qualify for up to $250K or $500K in tax credits from the US Federal government and many state governments for certain expenses related to research and development. This R&D Tax Credit has strict requirements, including careful record keeping for qualified expenses for qualified activities, processes, or products. Expense tracking for the R&D Tax Credit should be designed into the CoA.

Stabilize the CoA Before Accounting Integrations

Many third-party products have integrations to your accounting system to automatically send or receive transactions for bookkeeping purposes. For example, we regularly advise founders to deploy a financial modeling software platform to build their detailed forward-looking financial plan. And once the plan is built, integrating with your accounting software facilitates analysis of projected vs. actual performance. To avoid problems, the CoA should be stabilized before any such integrations are activated.

Use account numbers

Most mature companies assign account numbers to segregate and sort how the accounts appear on the balance sheet and income statement. Early-stage startups can simplify future operations by assigning account numbers when you set up the accounting system. We prefer four- or five-digit account numbers because most people struggle to recognize and retain numbers that are six-digits or larger.

We usually prefer to assign accounts from the following range of account numbers:

Leverage all relevant features of your accounting software

Many small-business accounting platforms include a fair amount of functionality. Make sure you are leveraging the built-in features to simplify operations (such as the CAC example earlier) and maximize value.

For example, many startups adopt a B2B SaaS billing model that emphasizes recurring revenue. A sizable portion of customers will pre-pay a year of license fees in advance to receive a discount. If a customer chose to pre-pay $1,000 for the subscription fees (instead of maybe $100 per month), proper accrual accounting would require $1,000 to be booked as deferred revenue with $83.33 of revenue recognized each month. The Advanced tier of QuickBooks has revenue recognition feature that automatically recognizes the proper amount, reducing the deferred revenue and increasing revenue each month.

We Can Help Build the Right Financial Foundation

The CoA is the foundation for your financial infrastructure. It organizes the thousands of individual transactions in your financial “distribution center”. In the same way a physical warehouse at Amazon receives incoming goods, organizes them, and stores them according to a logical system, your financial warehouse does the same for every bookkeeping entry. And just as Amazon relies on an efficient pick, pack, ship system to get goods where they need to go, a well-designed CoA presents organized data that drives executive insights.

Fundable Startups has worked with startups for over 20 years. I’ve been an executive employee for five different startups, serving as CEO once, CTO once, and a Technical VP three times. I typically work as a fractional founder and often help entrepreneurs become fundable before launching their fundraise. As an investor with Band of Angels, I regularly evaluate startups for their fundability and risk before writing an investment check or making a recommendation to the other angel investors considering the fundraising ask. I commonly redesign the Chart of Accounts to streamline operations, fundraising (or M&A) due diligence, and managerial decision making. If you want to learn more startup concepts and best practices, consider our training classes. Or if you need help, feel free to book an initial consultation with us.