(Note: This is the third in a series of articles that describe best practices for corporate governance at successive stages of growth of early stage technology companies. You can view the first article, “Governance Practices by Stage of Growth for Early Stage Technology Companies”, at 6.13, and the second article, “Governance Practices at the Start-up and Development Stages of Growth”, at 6.14. This article was edited post-publication in 2019.)
At the rapid growth stage, the company is achieving its goals. It has proven its business model as revenues are accelerating. Early adopters are embracing the product, and the company is beginning to gain traction among mainstream customers.
This is the point at which the company used to look for venture capital to fund its growth. However, since the global financial meltdown in 2008-09, the venture capital sector has severely retreated. The asymmetry of venture capital investments is also now becoming better understood. As a result, many technology companies are looking elsewhere for expansion capital. Fortunately for entrepreneurs, it is becoming easier and cheaper to launch companies and bootstrap them all the way to exit, avoiding the challenges of angel and venture capital investment. Where financing is needed, the angel networks are investing the larger amounts formerly provided by VCs. Whereas angels previously invested independently and somewhat secretively, angels are now formally organizing themselves into angel investment groups. These groups aggregate the diverse talents and experiences of the angel members to improve the breadth and depth of diligence, and also syndicate investments to increase the quantum and share risk. Along with the deeper diligence and larger investments, angels and syndicates are investing more often in the form of preferred shares. Hopefully, the angels will accept a “simple” liquidation preference which on exit allows them to choose between recouping their investment with a small accumulated dividend, or, converting to common shares so that all shareholders are treated equally. Venture capitalists invariably look for a “fully participating” preference in which they receive a multiple of their investment off the top, but then also participate pro-rata in whatever is left. It will be interesting to see if angels are true to their name or become more greedy.
Financial controls and documentation increase at this stage. The company will have an experienced accounting team with segregated duties, including a Controller and CFO or Director of Finance. The investors will require the company to engage an external accounting firm, typically one of the big 4 (KPMG, Deloitte, pwc, or Ernst & Young), but they may also accept one of the excellent second-tier firms like Smyth Ratcliff, BDO Dunwoody, Grant Thornton, Meyers Norris Penney, or dozens of others. The company will need to produce full accounting statements with notes prepared according to GAAP, IFRS or ASPE, and have the external firm either review or audit them. A history of reviewed, or better, audited financial statements by a recognized firm is very reassuring to potential investors or acquirors, so the earlier the company engages the auditor, the better.
The Company’s financial systems must strengthen in this phase. The CFO must prepare an annual budget for the Board to review and approve prior to the start of the year including projection for the income statement, balance sheet and cashflow. The CFO must report variances against the budget for each month and Board meeting, with a summary discussion, and a forecast for the balance of the year. The accounting team will closely manage accounts receivable and payable to closely monitor and forecast cash balances.
The Company should compile and maintain electronically a due diligence binder containing copies of every important document in running the business. These include all material contracts, and also financial statements, share cap table, sales funnel, development plans, investor presentations, product descriptions, list of Intellectual Property, market studies, and so on. A detailed table of contents for a diligence binder is widely available online or from the company counsel. A comprehensive and well-organize diligence binder is helpful and credible to the financing and acquisition processes.
One of the most frustrating financial statement requirements which appears at this stage is stock-based compensation. GAAP, IFRS, and ASPE rules require that companies calculate an arbitrary value for the stock options which vest over the course of the year and recognize it as an expense on the income statement. The calculation is arduous as it must be performed for every stock option and adjusted if the option is exercised or cancelled. The amount of the expense is often significant and distorts the income statement. Many companies resort to reporting an “adjusted EBITDA” calculation which removes stock-based compensation along with other non-cash charges so that readers, like the Board of Directors, can obtain a clearer picture of the company’s financial performance. In the US, the options process is further complicated by the requirement to have a formal valuation done in every year in which options are issued.
Another serious challenge arises when the company starts making sales into the U.S. Most companies discover only after many months and sales go by that they may be required to collect and remit sales tax individually to each state in which they sell products or services, and in many cases, even at the city or county level. In fact, there are 16,000 tax jurisdictions in the U.S. The rules are complex and steadily tightening as the states grab every tax dollar they can, particularly from foreign companies who don’t vote. To mitigate the exposure, it is advisable that every contract and sales order include language that requires the U.S. customer to self-assess and remit state sales tax. Many customers, particularly large ones and government entities do self-assess, but nonetheless the onus remains with the supplier. U.S. state sales tax compliance is an area where companies should engage experienced help. The large accounting firms can help, but at significant cost. There are also boutique firms who specialize in U.S. tax compliance for small Canadian companies at more reasonable cost. If the company opens up an office, or hires employees in the U.S., they may also be required to file income tax returns to the IRS and to the state government, with large potential penalties for late filings.
As the rules tighten, the exposure grows for Canadian companies. US tax exposure is now an item of due diligence for investors and acquirors. Target companies need to demonstrate that they are knowledgeable and in compliance with U.S. income and sales tax provisions and can reasonably estimate their exposure. Companies that are not sufficiently diligent may be at risk not just from the taxes, interest and penalties, but also from the collapse of financings or acquisition.
The Board of Directors continues to broaden and deepen its oversight in this phase. The Board may be restructured to ensure that there are a majority of either independent directors, or directors appointed by the investors. The Board should constitute an Audit Committee to continuously review the financial statements, accounting policy, and preparations and execution if the annual review or audit. The Board should also strike a Compensation Committee consisting only of non-management directors to review and approve executive and Board compensation annually. The Board should continue to meet monthly until the company is comfortable generating positive cashflow.
The Company should also be holding formal Annual General Meetings to receive the financial statements, elect the Board of Directors, and in general account to the shareholders for the performance of the executive team.
This article first appeared in the Fall 2013 edition of The Hire Standard – the newsletter of Corporate Recruiters, British Columbia’s leading recruiters of high technology talent.