GAAP and Projections

I have a new project which I started at the end of last week and which must be ready for discussion by Friday.  I need to pull together a projection for a start-up company, determine its capital requirements, figure out how it should be structured by debt and equity class and then make sure that, given a certain range of possibilities, what the ROI is going to be.

Did I mention this has to be done by Friday?

It is interesting and I have a great model I have developed over the years (in my humble opinion) that helps me focus on the big picture while also making sure I cover the necessary ingredients.  One area I have spent a lot of time updating is the revenue projection side.  First, I am trying to design a revenue model which takes certain assumptions, like lead generation rates through sales close rates and figure out how many sales will happen.  And then from there how many sales support people are needed.  And then…

Sorry, I was going to slide right in and describe why I like modeling this so much but really, today I am writing to discuss how Generally Accepted Accounting Principles (GAAP) are causing a serious headache for me in this projection.

Naturally, my first irritation is the requirement of recognizing stock awards as compensation expense, although I know intuitively that it is something the employees earn.  It is still a challenge because the only “cash” part of this is the amount paid in taxes to gross up the award.  Why am I worried about it?  Because I am thorough and don’t want anyone to say they were “Unaware” that earnings were going to be lower than projected because GAAP treats stock compensation differently than cash models.

The bigger concern is the new GAAP on revenue recognition.  You remember, the one I have blogged about here recognizing that this particular headache was coming.  Well, this projection is impacted by it because, naturally, it is a software company that licenses its program on an annual subscription and offers free, unlimited tech support.  Love it.  Revenue recognition side?  Not so much.

I spent about 6 hours last night after the game (nice to see the Saint’s work hard to try and lose but they managed to survive until next week – not much hope there) updating my assumptions page and working through the model to address control and amortization of revenue.  No, I am still not done but I am getting closer.  What I can tell you is, I don’t like the results.

On a cash basis, this particular start-up should get to positive operating cash flow in about 14 months; right now it takes about 52 months to get to profitability under GAAP.  I am also seeing about $8,000,000 in deferred revenues.  That is, by the way, cash collected from customers that the company cannot claim as revenue.  Yes, it is software and there is no right to refund but still, under the control principles in new GAAP, the revenue is unearned.

How I get there is to make certain assumptions about purchasing patterns and I am making a rather aggressive assumption that most purchases will happen in the first part of the year.  It is more intuition at this stage but my research indicates that this is the likely time when this sort of software is installed – something about New Year resolutions.  So, this is only a few months of overall deferred revenues but it is enough to throw off accounting ROI.

Don’t get me wrong, I think the most important information comes from cash flow.  How quickly cash is burned through, minimum cash levels, marketing expenditures are absolutely essential to figuring out minimum equity positions, acceptable leverage, target interest rates; all that delightful CFO stuff that can make or break a project.   But still, I think that potential investors have a right to know everything about the project they are taking under consideration and GAAP is one of those things – because at the end of the day, if the goal is to go public, then GAAP is the beast to tame.

Like I said, I try to be thorough.

I will keep you updated, probably at the end of the week when I meet with the ownership to review what I have and start changing assumptions and figure out what to add.  They want to start pitching by the end of the month so I have my work cut out for me – because I am doing this on top of everything else I do!

If you are looking for an accountant who might be able to help you get to that next level, either by acting as your controller or CFO (or combination) feel free to contact me and lets schedule a time to talk.  I enjoy being of service to growing entities and risk-takers.ready for discussion

Have a great day.


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