Smart Startups Don't Wait to Set Up Accounting Systems

A study shows that those with early financial monitoring systems grow faster in revenues and head count.

The question of when to set up management control systems such as financial planning and monitoring tools haunts most entrepreneurs involved in startup operations. Until recently, there was little research on the topic, but a new study by Antonio Davila, assistant professor of accounting, and George Foster, the Paul L. and Phyllis Wattis Professor of Management, explores this area.

Davila and Foster studied 78 companies in a variety of technical and non-technical industries, each less than 10 years old. They found firms that acted quickly to institute formal mechanisms such as operation budgets, cash budgets, and financial monitoring systems (tools that measure profitability, customer acquisition costs, variance from actual budget, and so forth) had higher growth rates in terms of revenues and head count. They also had greater and more rapid increases in valuation at successive rounds of venture capital funding.

"Control systems are critical for providing executives with data they can use for their managerial decision making," says Foster. "We can't prove whether growth pushes the adoption of management systems, or whether the adoption of management systems pushes growth, but clearly both are occurring. Larger companies are more complex and need the discipline that such systems can bring. At the same time, it's generally true that managers of early-stage companies are unlikely to predict accurately exactly when growth will occur. Therefore, because significant growth does tend to happen within a year of their establishing management accounting systems, it's likely that these systems anticipate and fuel growth, as well."

Because information about internal decision making regarding management systems generally is not available publicly, the researchers used questionnaires and interviews to glean valuable data about company practices from some 200 startup executives. They found that young companies begin with few management systems in place. These firms tend to institute financial planning systems such as operational budgets on average 1.48 years after the company founding, with cash budgets following quickly. Financial monitoring systems come much later — on average three or more years after founding. Still other systems, such as product development, partnership, and marketing control, come even later.

"Management systems are the foundation for growth," says Davila. "As an executive in one of the companies we worked with described it, 'management by personality' only works up to a certain point. After that, you need to put systems in place."

One key factor driving the timing of when financial management systems are adopted is when a chief financial officer is hired, according to Davila and Foster. "We call this the 'import-in' approach to establishing control systems," says Foster. "Companies look for what's missing in their organization and hire people who have skills in those areas. Bringing on a senior financial officer typically fast tracks establishing financial planning and monitoring systems. It's generally more effective and economical than trying to create something from scratch within an organization."

The study also reveals that venture capital-backed companies tend to establish operating and cash budgets sooner than individually funded startups. "Often managers want to be sure that the funding will not be abused, so they are eager to set up controls as soon as they can," Foster says. "VCs also understand the importance of good financial management and encourage the use of these systems." Companies with more experienced CEOs adopt planning systems earlier than those with greener leaders at the helm, as well. "More experienced executives recognize the importance of formalized decision-making mechanisms and are quicker to implement them," he says.

The study, which was funded by Stanford's Center for Entrepreneurial Studies, is an important step toward helping future entrepreneurs learn from the experience of others about making wise management systems decisions. Davila and Foster are now exploring in more depth not only managerial accounting decisions, but also decisions concerning other systems such as strategy planning, human resources planning and compensation, marketing and sales, product development, and partnership. "We are finding that how these various systems complement each other to support growth," Davila notes.

Moreover, the researchers are globalizing the investigation, extending it to include early-stage companies in Europe. "Preliminary findings indicate that Germans, for example, have a greater propensity for establishing systems at an earlier stage than U.S. companies," Foster reports.