Creative accounting: Don’t put investors off
Finance is not a support function so don’t treat it that way: it’s an enabler to making sound decisions and getting investment, so get your act together and stop putting investors off, writes triple Accounting Excellence award-winner Alastair Barlow.
It almost goes without saying that investors need to have a certain risk appetite. However, if your business lacks sufficient and appropriate controls then investors will either not invest in you, or not invest at a favourable valuation to your business.
A recent report from cloud enterprise software company BlackLine has thrown a light on many companies for what it describes as a "lack of appropriate controls" that is creating "an unacceptable and unnecessary level of risk for many companies, which is simply not sustainable in an increasingly complex and challenging business environment."
Almost a third (31%) of investors surveyed in the BlackLine report said if an interesting investment opportunity arose but the company showed bad financial controls, they would impose changes on the company before they invested. It’s an important read for both those in charge of finance but also entrepreneurs seeking investment.
At flinder, we work with fast-growth, complex businesses that are equity-backed. Our background at PwC Consulting and finance function expertise means we provide a huge amount of comfort and value to investors. This is everything from building integrated models, providing due diligence support, developing rich management information that delivers confidence, right through to a robust finance function focused on control, efficiency and insight. We call it the flinder effect.
Our view is that there are three value drivers across the finance function:
- Control; and
While insight is the one that most fast-growth and data-rich organisations vie for to enable better strategic decision-making, it’s the rather unsexy younger sibling that appeases investors' risk appetite: control. In my view, there is often an imbalance between investor expectations and the emphasis fast-growth businesses place on control.
BlackLine's study of investor attitudes towards financial data, risk and reporting threw up some interesting results. The full report, The New Age of Increased Investor Due Diligence, surveyed 760 institutional investors across the US, UK, France, Germany, Australia and Singapore on what they thought about the financial controls and processes in their portfolio. The reading is pretty eye-opening - here's a quote:
“When it comes to impressing investors, one might think that comprehensive market data or a detailed understanding of complex macro-economic trends would help give a company its edge. But the fact remains that some of the best ways to demonstrate business success and future potential can be found in the finance department.”
Finance functions and entrepreneurs looking for investment should take note: the following is what over 760 institutional investors believe:
- 95% either agreed or strongly agreed that clear evidence of good financial management was key to their decision-making process
- 82% believe finance functions often resort to creative accounting to satisfy or attract investors
- 58% are increasingly worried by a lack of transparency in their portfolio companies’ financial statements.
So, while fast-growth entrepreneurial businesses talk about their product, business model and world domination, investors are thinking ‘where are the risks and what’s mitigating them’?
Avoiding unnecessary and unwarranted financial risk is a top concern. So, what are investors looking for and how do finance functions give the comfort they need to get them over the line?
At flinder, one of the areas we spend a lot of time initially improving is their control environment. Here are four areas to consider in your business if you don’t want to put investors off:
- Data integrity
- Processes and controls
- Monitoring risks
- Project management
The BlackLine report cited the fact that 25% of investors singled out evidence of ‘creative accounting' as the factor that would make them the least likely to invest in a company, suggesting that investors not only believe finance professionals regularly fail to disclose—or even deliberately distort—the full picture but also do not have confidence in businesses with opaque financial practices.
Data is everything to investors and it’s one of the major due diligence hurdles. At flinder, we believe there are four key areas to focus on to make data work for you as well as possible. We refer to these as our 4 Pillars of Effective Data™:
- Appropriately structured
Not all businesses need to have leading-practice data. As with most things, there is a balance to be had. However, being aware of how each of these pillars can affect data, allow your business to harness it and ultimately enable more effective decision-making can only help.
In the case of investment, high-quality data that’s not ambiguous will breed confidence among investors. The key ones to focus on to give investors greater trust are high-quality and governed.
When we talk about data, we want it to be high-quality. We often hear the phrase “garbage in, garbage out” which, in our case, means management information is only as good as the data you put in. High-quality data should be:
Clean and accurate: Probably the most sought-after attribute of data – data that is captured needs to be correct.
Complete: Data is captured in all fields and there is no data missing. Without it being complete, we could draw incorrect conclusions from the lack of data being presented. This is typically the largest culprit to reduce data quality.
Consistent: In order to identify trends and analyse data, it needs to be consistent. Definitions need to be consistent, timing needs to be consistent and units need to be consistent. Say, for example, you’re analysing monthly gross margin, if there are inconsistencies in classifying costs to cost of sales or operating costs then this will have a huge impact on the analysis and render it meaningless.
There should absolutely be control and a governance strategy wrapped around data.
Ownership: Like everything, data should have clear owners. Why? Well, clear ownership leads to increased quality and understanding of data. Owners will be responsible for ensuring the data is clean, up to date and appropriately defined.
Dictionary/definitions: A data dictionary defines critical information about each attribute in a business-focused way.
Managed: Managing data involves a broad range of tasks, policies, procedures, and practices, such as:
- Creating, providing access, and updating data
- Storing data across multiple applications
- Disaster recovery procedures
- Ensuring data privacy and security
- Archive, destroy and give relevant access data in accordance with GDPR and other regulatory or compliance requirements.
Focus on the above, and you will have investors’ confidence at an all-time high!
Processes and controls
Processes and controls are probably the least sexy thing about a fast-growth business: they’re often thought to stifle innovation, agility and speed. However, done right, it can have the opposite effect. One thing to keep in mind is balance and appropriateness – they need to be right for the size, maturity and complexity of the business and the environment they are in.
So, where do you start? Here are a few things to consider…
Process manual: The second thing any due diligence (DD) team will ask for, after the numbers, will be a process manual. Well-documented processes coupled with controls highlighted will give a huge amount of comfort to the DD team and investors. However, process manuals should be up to date and if you’re going for real glory, benchmarked to leading practice.
Month end governance: Month end is often a huge source of frustration for businesses. Normally, this stems from a lack of procedure in place. Good practice here would be to develop a close calendar – working back from a board meeting date and including owners on specific tasks. Proper reconciliations, not just transaction listings, and working papers are too often not practised enough (both in industry and by other accountants). Both of these will again add a huge amount of comfort for investors and DD teams.
Reporting: An area that’s very close to us at flinder! Management information should answer questions the decision-makers have. It should be aligned to the business strategy and variances to budget should be highlighted and explained with business rationale. And of course, integrating it to core applications will eliminate any potential human error from manipulating the data in a spreadsheet.
Board meetings: Regular agendas, minutes and action points should all be standard practice. As should sharing the information in advance. We’re also advocates of a close meeting to discuss validity and correctness of results before sharing them with the entire board in order to use the board time effectively rather than dwelling on specifics.
Any decent investor will already have come up with most of the risks before they have finished reading your deck (or even started reading it). As a management team, you should be able to demonstrate you have thought of your risks and, importantly, how to mitigate them.
It’s generally good business practice to have a risk register regardless of whether you are looking for investment or not. The level of detail you need for your risk register depends on how mature your business is, how complex it is, the environment you are in and the amount of funding you need.
I would break the risks down by business functions, channels or a natural segmentation for your business – that will help to identify them or categorise them in a complete way. Then give them a weighting as to their likelihood, along with a risk mitigation and overall impact weighting.
While clearly there has to be a viable business, market and industry for someone to invest into your business, and the financials have to work, identifying the risks and mitigation will go a long way to giving an investor a good feeling about you and your team with this strong wider governance.
Key points to include in a risk register:
- identify risks by business function, timeline, relevant channels or similar;
- describe your proposed mitigation of each of the risks; and
- apply a weighting of likelihood and of impact to each of them.
Example risk register
Sound project management is absolutely key to executing your strategy and spending investors funds. Fast-growth businesses taking investment are typically involved in a number of complex projects and initiatives in order to meet hard milestones and a normally ambitious strategy.
Control absolutely extends to governance of projects and, very importantly, how funds will be spent. Demonstrating strong project management governance and discipline before investors make that leap of faith will give them additional confidence. Neglecting this, which happens too often, will concern them as it adds uncertainty around the ability of the company to control projects, and as the business grows, effectively use resources; people and funds.
Some good project management discipline to follow includes:
Project planning: Develop project plans with realistic dates, resource requirements, milestones, interdependencies and importantly cost/benefit for each project ie what it’s going to cost in cash and resources and what it’s going to deliver.
Ongoing monitoring: Find an appropriate project management application to implement and use it properly to report on status.
RAG status: Ensure workstream owners are updating the RAG status frequently enough for the project managers or programme directors to understand what is at risk or issue and if there are critical path issues or delays.
Ownership: Clear roles and responsibilities are important, both during the project and in business as usual phases especially around changing or new processes.
Processes, controls and risk registers aren’t sexy, and they certainly aren’t ‘state of the art’ in finance and accounting, they are the bare basics. While the business concept and product/market opportunity are what excites investors, the lack of control is what puts them off. Be mindful not to forgo the latter in your quest for investment, as you may never get the funds.
At the time of writing this, 14 clients in our portfolio where we run the entire finance function have had investment in the past 12 months totalling £37.7m. That’s an average of £2.7m per company. Bearing in mind, some of those were pre-seed and seed-funded, there is a fair amount of investment going around. However, the investment is only for those that have the right product/market fit, the right addressable market, the right management team and, as over 760 investors report, the right finance function that gives them the confidence! The latter should definitely not be ignored!
And in case you didn’t believe us, near real-time oversight of a company’s financial data was also hugely important, with 95% of investors surveyed agreeing they need this to make well-informed decisions about a company. Most fast-growth businesses have near real-time operational information, but their financial information lags behind. Finance is not a support function so don’t treat it that way: it’s an enabler to making sound decisions and getting investment, so get your shit together and stop putting investors off.
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Alastair is founder and Chief Dreamer at flinder. flinder provides accounting, consulting and rich real-time management information for growing businesses. As well as his work with fast-growth businesses and transforming finance functions, he writes for AccountingWeb in a monthly column, sits on the ACCA Practitioner's Panel Network and was...