Internet startups: the essential role of the finance function

Transcription

1 Internet startups: the essential role of the finance function There is much to focus on when establishing an internet start-up, such as finding an investor who shares the belief in your vision, designing prototypes and building a business plan all this activity can mean the essential role of the finance function is often forgotten. Overlooking this crucial part of a fledgling company can cause real, and frequently dire, repercussions as the business grows. 48 Volume 5 Issue 4

2 Authors Ricardo Steuer Manager Advisory Services EY, Germany Sven Westeppe Consultant Advisory Services EY, Germany 49

3 Internet start-ups: the essential role of the finance function As the start-up grows, investors demand due diligence and transparency of operations and security, introducing complex processes that often require a large investment of resources. The term start-up is usually associated directly with internet businesses, such as social networks or online brokerage services (see Figure 1). However, there are many variations such as corporate, small businesses or lifestyle business start-ups that often begin as offline business models. Whatever the type of start-up, they all have a common challenge: to secure and manage finance. This article concentrates on internet start-ups due to their broad public awareness, taking into account the fact they show a large variety of different business models in terms of size and complexity. Finance function helps build investor confidence When an internet start-up kicks off, having secured funding during the first phase and raised capital through an investor to accelerate the business idea, things often move forward very quickly. Although a finance function might not be one of the core business building blocks of the young enterprise in its initial stages, it will become increasingly important as the start-up grows and has to manage payments, handle receivables or plan budgets. As the small start-up struggles with the fundamentals, such as establishing its legal entity and tracking payroll or tax-related activities, outsourcing to an external tax accountant may be a good initial solution. This enables the founders to concentrate on the growth of their business idea, rather than spending resources on back-office activities that could be provided by an external party. Figure 1. Types of start-ups Common appearance of online or internet start-ups Scalable Buyable Social Corporate Small Lifestyle companies These start-ups are born to become big, as founders and investors believe that their idea will change the world. They hire the best and brightest, and focus on creating equity in order to go public in the future. Google, Skype Crowdfunded or backed by angel investors, these start-ups build web or mobile applications and seek to be acquired by a larger corporation. Instagram These type of start-ups can be networks or organizations that operate with the goal of making the world a better place. Sometimes operate as not-for-profit organizations. Jumo Large, mature corporations that understand the need to innovate from inside and invent new business models to stay ahead. car sharing Overwhelming number of small businesses, born out of the founder s desire to run their own business. hairdresser, carpenter Lifestyle startups evolve from a desire by the founder to live the life they love and pursue their passion. surf teacher Source: EY. 50 Volume 5 Issue 4

4 On the other hand, there are multiple finance aspects feeding into the business case, many of which are fundamental to the fund-raising process and attracting investors interest. A central task of the finance function is, therefore, the steering of the start-up through the calculation, monitoring and controlling of its business case. For this reason, the finance function and its of the business case are of particular importance for investors, who are interested to see how their investments are performing. This ambivalence between the need for a finance function due to legal setup requirements, the lack of focus on finance and back-office activities early on, and the interests of the investors in the business case, represents a stumbling block for many start-ups, leading to frequent challenges: Poorly defined finance strategy Lack of a strong foundation of finance knowledge from which the business can grow Decoupled finance activities from business case Missing general accounting and controlling procedures Ad hoc and unstructured ramp-up of finance staff in later stages Organizational challenges during growth and expansion phase Unharmonized finance processes (especially accounting) Missing transparency To tackle and cope with these challenges, a clear finance strategy including service delivery model needs to be implemented, at the beginning, to avoid complications as the business grows. The start-up s life cycle In the traditional life cycle of a start-up enterprise, a young business must go through three stages before it reaches market expansion and maturity: seed, start-up and growth phase (see Figure 2). In the initial seed phase, founders establish their business plan, design the beta version of the internet platform or app and begin fund-raising with potential investors. With the first cash flows from investors, the start-up can roll out sales mechanisms and begin to place its product or service on the market. Typically in this stage, capital resources are scarce, which forces the team to concentrate their resources on activities such as marketing, IT production and development. At the beginning of this phase, one member of the founding team, typically with a business studies background, assumes the responsibility for finance, accounting and other back-office activities. However, shortly after go-live, the scope of back-office and especially of financial and accounting activities becomes more complex. Given the fact that capital Figure 2. The impact of a clear finance strategy on internet start-ups (illustrative example) FTE and revenue Source: EY. Seed Start-up Growth Expansion Outsourced Sourcing trend Evolve finance strategy Translate strategy into daily operations and synchronize staffing Finance function FTC In-house Fully fledged finance organization led to economies of cost and cannibalism of profitability Profit and transparency gap Flexible and modular finance function supports profitable growth Time Revenue curve 1 2 Static finance function Revenue Revenue US$50m US$500m Finance cost Elastic finance function Revenue Revenue US$50m US$500m Finance cost 51

5 Internet start-ups: the essential role of the finance function Young entrepreneurs looking to establish an internet start-up need to think early, during the initial phases, about their business modeling and how to structure their backoffice solution. resources are rare, most start-ups make use of a small tax accounting agency to support the founding team member handling finance responsibilities. These accounting agencies offer to handle all accounting and tax-related activities, allowing the founder to step back and concentrate on core activities making the start-up a success. However, a risk is that they may be unable to handle the substantial increase in activities that could result from the potential success start-ups experience in their early years. Rising sales and brand awareness allow the business to raise additional capital from venture capital firms, and the scope of the finance activities grow. However, as the business success and capital grows, so too must staff levels to meet the growing demand. Companies often look to employ marketing and IT specialists to maintain the growth pace. According to the latest German Startup Monitor issued in June 2013, 75% of start-ups with job postings are seeking engineers, software developers or other technicians. Alternative start-ups: internet incubators Not all start-ups begin in the seed phase. Large internet incubators such as the German Rocket internet or Team Europe, adopt business models that have proven profitable in markets abroad, adapting them to the local market and helping the early start-up into business quickly. Backed by multiple venture capital partners, these incubators support their new business models with funding to boost their market entry. In case the business model gets a foothold in the local market, the incubators invest further millions to grow and foster their market position. If the model is proven to be wrong, incubators halt investments and look for another business model and investment opportunity. Given the size of these start-ups, which can be substantially larger than start-ups emerging from the seed phase, they tend to build up their finance function directly due to the volume of transactions, and need to abide by investor regulations. In both cases, a clear finance strategy faces challenges including how to handle high volumes of payables and receivables, whether to outsource or not, and how to align and integrate the finance function into the entire organization. To meet these challenges, the founding team needs to have a clear vision of their future finance function. Entering the growth phase Depending on the speed of success, and the time it takes to enter the growth phase, internet start-ups eventually achieve a sales volume that most small tax accounting firms cannot cope with. According to Sebastian Esser, founder of German startup networking company CEO Events, the volume of work and expertise required by successful start-ups quickly outgrows such agencies. Especially when it comes to expanding the business model abroad, most third-party accounting providers lack knowledge, forcing start-ups to build up knowledge on their own and perform finance activities in-house, he says. Often, the new internal finance department grows in accordance with the size of the business. But, if finance processes and procedures have been established on an ad hoc basis, then moving from tax accounting agencies to internal functions carries a risk that the finance department may grow larger than needed. Consequently, this leads to a fully fledged finance organization with low profitability. Some well-established internet start-ups have finance departments that are larger than public traded corporations. This rapid growth of finance activities and unnecessary staff recruitment consumes resources that start-ups could otherwise use to foster market position before entering the next stage. The main challenge 52 Volume 5 Issue 4

6 is that many enterprises double their staff numbers as their revenue increases. Therefore, a modular designed and financially flexible organization that has specialized job profiles and an optimized service delivery model should be the target. Another risk of unstructured financial activity for start-ups can be the exit of investors through an initial public offering (IPO) where shares of stock in the company are sold to the general public for the first time. Thus transforming a private company to a public company, creating further financial challenges. As legal and reporting requirements are strict for IPOs, start-ups must restructure and reorganize their finance activities as it s unlikely that standardization of processes, procedures and reporting will have previously been in place. Start-ups that build their own finance departments, often recruit an external, experienced chief financial officer (CFO). Irrespective of the possible exit, many start-ups that are successful in this stage, consider testing their business model on a geographically larger scale, go abroad and enter the expansion stage. This stage inevitably reveals inefficiencies and structural problems caused by a missing finance strategy. A central task of the finance function is the steering of the start-up through the calculation, monitoring and controlling of its business case. 53

7 Internet start-ups: the essential role of the finance function Some well-established internet startups have finance departments that are larger than public traded corporations. Outsourcing can be invaluable In order to avoid or reduce internal, structural problems with respect to finance activities and to make best use of capital a crucial asset for a start-up a combination of outsourcing and in-house finance activities is favorable. If outsourcing is used, similar to large capital enterprises, multiple finance activities can be highly standardized including transactional tasks, such as order, invoice, cash collection as well as the payment process (see Figure 3). The outsourcing of these transactional activities can be done throughout the whole start-up life cycle and beyond. The key to a successful outsourcing strategy is to release internal resources, especially in the start-up and growth phase, where finance activities are often run inhouse, in order to focus on the business. As the start-up grows, investors demand due diligence and transparency of operations and security, introducing complex processes that often require a large investment of resources. There are some crucial early tasks that should be managed internally, however, such as business case setup and its calculation, which should be done throughout all phases by the founding team. Further, highly business-related activities such as campaign evaluation, customer order and billing, exception handling, and liquidity should be handled in-house. Rather than outsourcing all finance activities from the outset, and missing out on the building of internal knowledge, start-ups should 54 Volume 5 Issue 4

8 Figure 3. Finance activities for start-ups Accounts payable Cash Order and billing Accounts receivable General accounting Reporting and consolidation Business performance Finance Transactional activities Value adding activities Purchase order handling Master data Invoice posting Invoice verification Payment processing Liquidity Bank statement processing Cash pooling and Tax computation Tax submission Exception handling Customer queries handling Inbound sales and orders Customer invoicing MD quality assurance Issue Deductions resolution Cash collection process Credit and debit notes Dunning process Financial statement quality assurance Manual journal calculation Standard costs calculation Technical manual journal entries Month-end close Variance analysis and commentary Legal, risk and statutory reporting Profit and loss reporting Balance sheet reporting Creation of reports Data upload Business case calculation and maintenance Function and business support KPI definition Cost allocation and accounting Finance vision and strategy design Interpretation and analysis of results Make or buy decision Retrieval and extraction of KPI from system Outsourcing potential Source: EY. concentrate on few, but essential, finance activities internally to protect the start-up in later stages from expanding the finance function unnecessarily. A well-defined strategy helps to constantly structure the internal and external finance organization, including its process and IT landscape, around the business size, allowing scalability. This flexibility establishes a firm financial base from which to expand the business overseas. From thought to finish Rushing into a start-up business without the necessary regard for the finance function can have negative repercussions for a business once it grows and achieves success. Young entrepreneurs looking to establish an internet start-up need to think early, during the initial phases, about their business modeling and how to structure their back-office solution. They should think about which activities can be managed internally, and which activities are not adding value for their young company and would be best outsourced. References used for this article S. Blank, 6 Types of Start-ups, The Wall Street Journal, G. Cassar and C. D. Ittner, Initial retention of external accountants in start-up ventures, A. Davilla and G. Foster, Management accounting systems adoption decision: evidence and performance implications from early-stage/start-up companies, M. Ozer, The role of flexibility in online business, The outsourced CFO, CFO Insights, cost-efficiency/the-outsourced-cfo-what-startups-need-to-know/. The 3 jobs your start-up should outsource, Forbes, theyec/2012/10/29/the-3-jobs-your-startupshould-outsource/. Outsourcing fills the start-up skills gap, Financial Times, cms/s/0/4ed18b1c-fcbc-11e1-ba feabdc0.html#axzz2bmxvi8ps. Deutscher Startup Monitor 2013, Bundesverband Deutsche Start-ups e.v.,