Understanding finance: the basics of managerial accounting for startups

finance-managerial-accounting

As a founder, you need to understand and be able to explain the quality of your company’s growth – including growth loops, the rate of customer acquisition, engagement, churn, and monetisation.

Financial accounting and financial planning and analysis (FP&A) rely on managerial accounting to connect the finance function to the business opportunity and other functional areas such as sales, marketing, product development, and HR.

This is the third and final article of a series on how to think about entrepreneurial finance.

This article will provide you with the basics of managerial accounting, and why it’s helpful – and even necessary – for startup companies.

What is managerial accounting?

Managerial accounting is the process of creating information that managers will use to pursue the organisation’s goals. This information is usually related to performance of operations, growth, and customer behaviour.

Managerial accounting in a startup setting (often called entrepreneurial or innovation accounting) is about quantifying the value of a new business opportunity that is fundamentally ambiguous and uncertain, and one that bets on breakthroughs and disruption.

To help you keep the workflow of your business running smoothly, you need individual systems within the body of your startup organisation. To know what to account for while your startup grows and scales, you need to be able to track data and reflect financial control at all times. 

This is why your finance function should include independent but interconnected systems that accumulate both financial and managerial accounting data, and which report to the financial planning and analysis (FP&A) process of the company and executives. In a nutshell, this is the basic structure of the finance function.

So, in a startup setting, your managerial accounting process will most likely include systems to track worker productivity, track user growth and interaction, optimise relations with customers, and leverage big data. Your management accounting systems will also be used to reward the talented and top performers within your organisation.

While financial accounting is mainly concerned with informing those outside of a company, the main objective of managerial accounting is to produce useful information for a company’s internal use. Managerial accounting is used to control the organisation’s operations and helps managers within the organisation to make decisions.

A data-driven company culture

Understanding quantifiable measures (metrics) of performance, growth, and customer behaviour should be a priority for any startup founder and their team.

At the risk of sounding pedantic, I want to make sure you understand that metrics are about numbers and rates, which may or may not be financial in nature, but which in most cases have a financial interpretation through FP&A.

You need to identify and target leading indicators (KPIs) that give you a way to link your managerial accounting process to how you will fund innovation, what you will eventually deliver in the form of products and/or services, and how you will achieve long-term growth.

Even though there are many management software tools you can rely on in order to grow, during the earlier stages of your startup your main managerial accounting task is to understand your business data and establish the KPIs that matter to you.

As your startup grows you may integrate software communication tools like Slack or Google G Suite, dashboard-reporting tools like Google Data Studio, Chartio or Tableau; marketing tools like SEMrush, Hootsuite, Buffer or Google Analytics; project-management tools like Trello, Asana or Dropbox; sales tools like YAMM or Hubspot; and workflow-automation software tools like Zapier.

Harnessing the knowledge needed in a coherent and productive way is challenging for most entrepreneurs launching a business, especially for first timers. If there is one main takeaway from this article, it’s for you to understand that as a founder you have to make sure everybody in your startup team feels comfortable analysing and acting on data.

You are free to create your own system and rules in search of a competitive advantage, but everybody in the organisation should be able to hold data-based discussions (vs. opinion based), hence creating a company culture and mindset that is data driven.

There is also a plethora of metrics that are suitable and appropriate to use for each kind of business. The set of metrics you should be monitoring depends on the business model and drivers of your company.

Key performance indicators (KPIs) should be part of a company’s culture and the formal processes; startups that use a data-driven approach when studying customer behaviour are rewarded with higher growth rates.

The managerial accounting process and the resulting reporting is usually highly detailed, technical, specific, and often experimental – finding what you need can take a long time. And as your business evolves, so should the metrics you track.

The process – you are building the product as you deliver it 

Product-market-fit and go-to-market-fit

Tech firms are unique in that there is no certainty in the way product-market fit evolves. Tech business models advance as continuous evolution-through-experimentation takes place. Still, management systems are the foundation for growth.

For example, a tech firm may want to test out an altered product angle, toy with a new website feature, try out a different pricing scheme, and so on. Some experiments will have tiny business repercussions, while others could unleash strategic-level changes.

Numbers may not matter at first, but business economics really do matter

Under conditions of rapid growth, entrepreneurs face unusual paradoxes and challenges, and the management modes required by the companies change.

Generally, young companies begin with few management systems in place. New companies tend to institute financial accounting systems within the first year of company founding. The financial planning systems such as operational budgets are usually instituted about a year after the company’s founding, with cash budgets following quickly. Financial monitoring systems (such as managerial accounting) are usually instituted much later than financial accounting and financial planning systems, about three years after founding.

Investors considering funding ventures will look at how well the venture will likely develop successful operations in the longer run. Managerial accounting needs to be in place to showcase your ‘development muscle’.

Growth path

Management accounting for startups can get extremely sophisticated, and usually happens as the startup evolves. So, how do you join financial and managerial accounting?

The answer is unit-economics.

Each business model has its own unit economics and depending on the analysis you want to do you can choose different ones. For example, for an airline it’s seats and planes; for a restaurant it’s orders and location; for a marketplace it’s customers and transactions; for an online media platform it’s visits and clicks on ads, etc.

The key question to answer is how many (what volume) of unit economic operations is needed to achieve a break-even point. That is, what are the number of units needed to reach the point of no-losses-no-gains, or where profit equals zero.

First you need to be customer focused – hello ‘beta’. Your product team (which may well be you at the beginning) generally starts with a market forecast and works backwards from there.

The goal of the first phase is to create customer cadence, in which real customers flow through the entire experience of dealing with your company and purchasing your product (or why purchase does not take place).

In other words, how your target customers are motivated to buy, how able are they to buy your product and not your competitor’s, and how will they be triggered to make the actual purchase-payout.

  • Motivation: what motivates your target customers to purchase in your market and your product?
  • Ability: how able are your target customers to purchase your product or service?
  • Trigger: which action-triggers are in place that will result in acts of payment? 

A more effective approach to a customer-focused management accounting may be to identify and test specific assumptions and try to match with an identified market – that is, a ground up approach.

At first you will create simple dashboards that include only a few metrics that are both measurable and actionable. For example:

  • Conversion rates, number of customers that buy the product.
  • Revenue per customer, amount customer is willing to pay.
  • Customer discussions, numbers of customers talked to each week (data).

Phase one dashboards of data will serve to ensure early focus on the things that really matter to validate the business opportunity. You want to assure the existence of product-market-fit and go-to-market-fit by mainly measuring customer input.

The second or level two phase is the assumptions phase – AB testing. Leap of faith assumptions (LOFAs) are the most fundamental assumptions that underlie the business opportunity. The goal is to test and validate each of these assumptions and to make sure whatever is built afterwards is built on a solid foundation of product creation and delivery.

In this phase, your dashboards will be used to track and measure the LOFAs that drive the business case. These are the metrics that will make it to a business plan – the critical input.

The dashboard should be simple, although detailed to be considered robust by anyone in the finance department.

At this point, you should be able to answer questions such as:

  • Why does the customer like the product? 
  • Are they repeating purchases, and if so how often (rates)? 
  • How long are they staying (rates)? 
  • Are they willing to pay a premium price? 
  • Do customers refer you (rates)?

The idea is to identify what needs to be done so that these variables can grow sustainably on their own, indicating that product-market-fit and go-to-market-fit have also been achieved and that the business is ready to scale.

Again, most metrics can be categorised into three groups: performance, growth and customer behaviour. 

The third phase is the net present value phase (NPV) – valuing scale. This is about quantifying future success, making pro-forma forecasts based upon broad based assumptions around market size, market share, and the startup operational potential. 

Investors (and yourself) invest in your ability to create value. This is one of the most important points to understand when you begin to think about selling your business.

At this stage you aggregate specific metrics that represent the most important drivers of a long-term business model. These can include those in product-market-fit setting, but the difference is that these roll up into the real-time view of the financials of the business.

These metrics focus on leading indicators of business success and real time data that clearly outline the venture’s progress over time.

For example, in a freemium business model like Linkedin or Spotify, the leading indicators would be number of visitors, percent of visitors that sign up for new accounts and become users, percent of users that pay money, and amount of money paid by each user.

The differentiating thing about tech companies is that a small improvement in a key conversion rate can take the business from x to 2x to 10x  in monetary terms (euros).

In summary

You can not improve something if it’s not measured. You should be able to translate or interpret everything financially, and the impact on cash flow should be figured out. Forecasts and business plans should be updated on a periodic basis.

‘What is the financial impact of such and such?’ should be a recurring question of management accountants as well as department managers, who work with the financial planners and financial accountants of the company. 

The problem is that most startups (and companies in general) are not doing this in a systematic way. Starting up is about strategy development and execution, and the value is created from the innovation or progress made. The value is created within and it’s reflected on projected financials.

You need to be certain about what data to collect and how to turn it into something that fuels growth. You need to find the metrics and targets that mean the most to your business. At the same time, you must be aware not to get carried away by measurements and systems during the early stages of your startup, as most likely you will only need to track two-three metrics during the first couple of years. 

And never, ever forget that at the heart of the management accounting process is the business opportunity.