Common Accounting Mistakes Startups Make and How to Avoid Them

It’s estimated that up to 44% of all startups fail due to running out of money, poor cash flow or ineffective financial management. Even startups that don’t fail are likely to be negatively impacted by poor financial management, notably when it comes to growth and fundraising.

This all underscores the importance of having the right financial leadership in place for your startup. While the right service or product offering is key to attracting customers and gaining market share, your startup must be responsibly managed to ensure sustainable growth and long-term success.

The good news is that many of the major accounting pitfalls are largely preventable so long as the right financial leadership is in place. When it is, it represents more than just checking an important box, but can serve as a competitive advantage for your startup, especially when it comes to achieving sustainable growth and attracting investors during fundraising rounds.

Mixing Personal and Business Finances

In the early days of any startup, it’s common for founders to do everything. From operating the startup to basic bookkeeping, founders take it upon themselves to do everything while their resources are limited and they work to gain market share. However, for founders inexperienced in basic accounting and financial management, this can lead to costly errors.

One of the most common mistakes founders make is mixing personal and business finances, which can have significant consequences for tax reporting, investor due diligence and a startup’s overall financial clarity. Commingled finances blur the legal separation between personal and business, which can increase the risk of audits and even violate fiduciary standards, often leading to cash flow problems that impact daily operations. Commingled funds can also lead courts to ignore legal separation between a startup and its owners, which may allow creditors to pursue owner assets to satisfy business debts.

Some ways to avoid mixing personal and business finances include:

• Formalizing your startup and selecting a legal structure (i.e., LLC or Corporation) to create a separate legal entity from the owner/founder.
• Open a dedicated business bank account for your startup to ensure you keep any personal accounts separate.
• Establish clear payment procedures that ensure all business-related activity goes through your startup’s dedicated bank accounts. This will help you accurately track business expenses and maintain clear financial records, which is critical for tax reporting, audits, and investor due diligence.

Misclassifying Employees and Contractors

Worker classification is also important for your startup. The legal distinction between an employee and an independent contractor isn’t always clear, especially for rapidly scaling startups that use independent contractors to save money on payroll. However, over time, independent contractors may take on more responsibilities that mirror a full-time employee (i.e., attending meetings, set hours, etc.), which can trigger a misclassification.

Worker misclassification can derail investor deals due to higher perceived risk during fundraising rounds. Misclassification can also come with its fair share of legal and financial penalties, including:

• Owing employees back wages, overtime pay and unpaid unemployment taxes.
• Federal and state fines.
• Lawsuits and potentially even criminal charges related to fraudulent misclassification.

Finally, your startup may also experience reputational damage and financial trouble in the fallout from the legal and financial turmoil related to worker misclassification.

Understanding Worker Classification Rules

Understanding the IRS’ criteria can help determine worker classification. The IRS uses a common law test based on behavior control, financial control and worker relationship to determine whether an individual is an independent contractor or an employee.

• Behavioral control helps determine whether your startup has the right to direct and control the work being done.
• Financial control assesses if your startup controls the financial and business aspects of a worker’s job.
• The worker relationship examines how the startup and the worker perceive their relationship.

Startups often misinterpret by misclassifying the various control factors and getting too caught up in the cost-saving incentives of independent contractors. However, misclassification can lead to significant financial obligations, such as employment back taxes and other fines and penalties, underscoring the importance of getting this right from the start.

Setting Up Compliant Contractor Agreements

Properly documenting contractor relationships is also key during growth phases and can help avoid classification issues. Independent contractor agreements must contain various elements that help establish the reasoning behind an individual not being an employee. Some of the foundational elements include:

• Explicit independent contractor status
• A detailed scope of work
• Compensation and payment terms
• Tax liability
• Duration of agreement and terms of termination

When onboarding, independent contractors should have the minimum access necessary to do their job, and should agree to clear roles and responsibilities. If your startup is in a position to transition an individual from an independent contractor to an employee, it must follow a process that involves formalizing the relationship with a new contract and ensuring that administrative changes (i.e., new hire paperwork, benefits enrollment, etc.) are properly handled.

Neglecting Accrual-Based Accounting

Neglecting accrual-based accounting is another common mistake many startups make. While it’s common for startups to begin using cash-based accounting methods, it’s best practice to switch to accrual-based methods once they reach a certain point in their evolution.

While accrual-based accounting is more complex than cash accounting, it provides a more accurate picture of a startup’s financial health and is key to attracting investors and lenders. Accurate financial reporting is critical at this stage, ensuring stakeholders have a clear view of the company’s performance. The IRS requires startups that exceed $26 million in annual gross receipts over three years to use the accrual accounting method.

Poor Revenue Recognition Practices

If your startup isn’t recognizing its revenue properly, it’s likely to cost you. Startups should follow ASC 606, a unified accounting standard for recognizing revenue, which requires them to recognize revenue when control of goods or services is transferred to customers.

Some common errors associated with revenue recognition include:

• Recognizing revenue too early
• Not accounting for any deferred revenue
• Confusing cash and accrual-based accounting
• Confusion with bundling services and the impact on revenue recognition

SaaS Revenue Recognition Pitfalls

SaaS startups are often specifically challenged with revenue recognition based on their unique business model. While SaaS startups are prone to making some of the same mistakes as any type of startup, revenue recognition is often more complicated based on the greater likelihood of deferred revenue from multi-year contracts.

SaaS startups also have to navigate performance obligations and other variable considerations (i.e., discounts, refunds, usage-based fees, etc.).

Some of the SaaS pitfalls that are likely to trigger audits include timing errors, improperly valuing free trials, billing errors and pricing discrepancies.

Inadequate Financial Documentation and Record-Keeping

Poor documentation is often a death knell in accounting. Not only is it indicative of poor financial management, but it can also often lead to problems during audits, red flags during investor due diligence and issues with tax filing.

Startups should aim to retain documents for at least seven years. These documents should include tax returns, legal contracts, payroll records and financial statements. Formation paperwork, business plans, employee agreements and intellectual property agreements are also ideal for proper record keeping.

Many documents are best stored digitally in the cloud on services like Google Drive, Dropbox or OneDrive. It may even be worthwhile to back up files on an external hard drive.

Ignoring Tax Planning and Compliance Deadlines

Tax planning isn’t just something that your startup should be doing once tax season rolls around — it should be a year-round strategy. Optimizing tax credits, deductions and making strategic elections has the potential to save your startup tens of thousands of dollars, which can be rolled back into your startup to help facilitate growth.

Strategic Tax Planning Oversights

If you’re not properly planning your taxes, you’re likely leaving money on the table. Some of the key oversights that many startups make include:

• Not taking advantage of R&D tax credits
• Failure to structure stock options to allow for maximum benefit
• Not knowing of tax credits and deductions specific to startups
• Not aligning equity grant dates with your startup’s lowest valuation (and filing a Section 83(b) accordingly)

Managing Multiple Tax Jurisdictions

If your startup does business in multiple states or even internationally, it must consider various tax obligations. Familiarize yourself with nexus rules, which are sales tax rules created when your startup’s sales surpass a certain threshold (either revenue, number of transactions or a combination of both) in a specific state. This is imperative to sales tax compliance, which is especially important for SaaS and eComms startups.

It’s also important to know various franchise taxes and state-specific obligations that must be met. For instance, the Delaware franchise tax is an annual fee that all entities that maintain business in the state must pay.

Delayed Implementation of Scalable Financial Systems

While spreadsheet-based accounting is a viable method for a certain period of time, it’s not likely to suffice long-term. Your startup should upgrade from spreadsheets to more robust accounting software when transactions escalate in volume, if you’re having problems managing growth or if you’ve evolved to a multi-entity enterprise. Spreadsheets are time-consuming and prone to errors when finances become too complicated, underscoring the need to move to more advanced software with time-saving automated features.

Transform Your Startup’s Financial Foundation

Are you ready to transform your startup’s financial foundation to ensure you grow sustainably and avoid many of the mistakes that could derail your future? Graphite Financial is here to help. As a full-service professional accounting firm, we specialize in working with startups and implementing robust financial practices to support growth, cash flow management, and prosperity. Good accounting practices aren’t just essential to growth, but to successful fundraising outcomes. Contact us today for more information and to schedule a consultation.

Frequently Asked Questions

When should a startup switch from cash to accrual accounting?

Startups should switch from cash to accrual accounting when they experience significant growth. While more complex than cash accounting, accrual accounting provides an accurate picture of a company’s financial health and is also key to attracting investors and lenders. Accrual accounting is also key to ensuring IRS compliance. The IRS requires startups that exceed $26 million in annual gross receipts over three years to use the accrual accounting method.

What are the penalties for misclassifying employees as contractors?

Penalties for misidentifying an employee as an independent contractor can be significant, and may include a mix of financial, legal and reputational consequences. Financially, your startup may owe employees back wages, overtime pay and unpaid unemployment taxes. You may also face federal and state fines for such oversights. Legally, your startup may be subject to lawsuits and potentially even criminal charges related to fraudulent misclassification. Finally, there’s also reputational damage that your startup may experience in the fallout.

How can startups prepare for their first financial audit?

The best way for startups to prepare for their first financial audit is to get organized. Startups should ensure their financial records are clean, detailed and reconciled, and all supporting documentation, such as invoices, contracts and bank statements, is on hand and easily accessible. Startups should also strive to strengthen their internal accounting processes and policies to ensure GAAP compliance and that a monthly close process is adhered to. Additionally, startups should either appoint a qualified employee or work with a professional accountant to serve as a point person in working with the auditor. This individual should be tasked with understanding the scope and requirements of the audit and serve as the sole point of contact.

Which accounting software is best for early-stage startups?

Early-stage startups have several accounting programs at their disposal for financial success. While programs depend on your startup’s budget and overall needs, some of the most popular options include QuickBooks Online, Xero and Zoho Books. QuickBooks Online is known for its automated features, strong reporting capabilities, and ability to integrate with other applications and programs, while Xero and Zoho Books are more budget-friendly and user-friendly. Startups should assess their income statements, cash flow statements, and other relevant financial data when selecting the right accounting software.

What documentation do investors expect during due diligence?

Due diligence is the process by which an investor thoroughly assesses a startup before deciding whether to invest capital in it. Part of the due diligence process involves combing through your startup’s financial records, projections and tax documents to assess its financial health and compliance. In addition to financial documentation, investors also assess legal documents, such as articles of incorporation, bylaws, IP filings, licenses, permits and more. Finally, business plans, market analyses, and assessing startup founders and leadership are also often part of any due diligence process.

How do R&D tax credits work for software startups?

R&D tax credits are designed to incentivize and reward innovation. Such credits represent a dollar-for-dollar reduction in federal and state tax liability for numerous activities. Startups can benefit from R&D tax credits even if they’re not yet profitable via a payroll tax offset, where they can use the credit to offset up to $500,000 per year of their federal payroll tax liability for up to 5 years. Profitable startups can use the credits to reduce their income tax liability. Startups must meet four key criteria to qualify for the R&D tax credit.

What are the most critical financial metrics startups should track?

Some of the most important financial metrics startups should track include cash flow, burn rate, cash runway, customer lifetime value to customer acquisition cost, gross margin, monthly recurring revenue and churn rate.

When is the right time to hire a fractional CFO?

While there’s never a wrong time to hire a fractional CFO, most startups elect to work with such professionals when they are experiencing rapid growth, preparing for fundraising rounds, or when financial management has become increasingly complex and too much for startup founders to handle. Fractional CFOs are professionals who provide strategic financial guidance and can help build robust internal processes within your startup at a fraction of the cost of a full-time professional.