By Jussi Paski, KPMG — Head of Startup Services
I believe that startups who know their business and figures attract more interest from investors and thus increase possibilities for funding to support their growth to success. In addition, the requirements for good governance and corporate restructurings are on the path for startups as they grow and raise international funding.
To comply with applicable regulation and to proactively detect and solve possible problems it is important for startups to have reliable partners i.e. accountants, auditors, advisers or board members.
In the pre-revenue stage, the financial statements of startups focuses mainly on development costs and funding transactions due to the nature of the business. If applicable laws have been applied rationally, this should also reflect on the company’s balance sheet. There are a couple of general accounting principles I would like to pinpoint for consideration when drafting year-end financials before the Annual General Meeting (AGM).
Intangible assets and government grants
Research and Development (R&D) expenses arise before the financial use of the asset. It is important to understand that due to this nature, the development costs can be capitalized to the balance sheet as intangible assets, if they are expected to generate revenue for more than one fiscal year.
The main criteria according to Finnish accounting standards is that these future income expectations must be documented in a reliable manner. The capitalization of development expenses decreases costs from the Profit and Loss (P&L) and thus increases equity in the balance.
Government grants (Tekes etc.) should be recognized in a similar manner as the development costs related to the particular grants. If the development costs of the project are capitalized, one appropriate practice for government grants is to recognize grants in the balance sheet accordingly to minimize the capitalized development costs (and future depreciations).
In addition, it is also good to be aware that capitalization of research expenses is not allowed.
Equity and funding transactions
When no capitalization is done, the costs and grants flow through P&L and usually result in bigger losses and increase the possibility of negative equity. The Board of Directors is required to report to the Trade Register if the Company’s equity is negative. Failure to report is a breach of a Limited Liability Companies Act which may result in the personal liability of the CEO and members of the Board of Directors.
It can cause damage, for example, by the fact that the company’s financier or supplier, without knowing about the loss of share capital, grants a credit to the company, which will not be paid due to the company’s financial situation. The liability for damages is always assessed on a case-by-case basis and requires that the breach has a clear connection to the occurrence of the damage.
Because of the nature of the business, cash flow from operations is generally negative in early-stage startups. The development of operations and services are usually financed through equity and debt financing or mezzanine instruments (which is a combination of the first two). The use of research and development loans (Tekes etc.) is also common.
One important thing about the shares, is that they will only entitle the shareholder to the shares when the shares are registered in the trade register and the share capital must be paid before registration. In practice, this means, for example, that the shareholder receives voting rights and rights for distributions of profit after the registration. It is also worth knowing that different series of shares may have different rights. In relation to founders ownership, it is recommended to think about the tax effectiveness of the ownership structure at an early stage (e.g. before investor involvement).
Capital loans are a Finnish specialty most often considered as a debt item in the balance (can be presented in equity if certain terms are met). However, capital loans are always calculated as a batch to accumulate total equity. Capital loans must be paid before recognition. One thing to notice though is that it is possible to convert, for example, trade payables or other debts into capital loans.
Most of the things mentioned above require also additional presentation in the notes of the financial statements. In the post-revenue stage, the P&L top line growth shifts the financial spotlight of startups also into revenue recognition principles and presentation of the revenue but that is a topic for another post in another time.
If you want to hear more about our services for startups, VC’s and areas of interest, please reach out and let’s have a chat via coffee or lunch.
The co-operation with KPMG utilizes the extensive international network of KPMG experts and member companies’ services to Maria 01 startups aiming to establish in themselves internationally. KPMG wants to wrap up sleeves and invest in innovative thinking, experimental culture, promoting the development of new ideas, services and at the same time to build the success of existing and future startups. We want to be a partner with which the future is built, not only a past events auditor.