Startup Books Clean-Up Before Fundraising: What Investors Flag

What will investors flag in a startup's books?

Investors flag books that do not tie to outside evidence: bank and card balances that differ from the statements, SAFE or note money counted as sales, income and bills recorded only when cash moved, payroll and contractor costs that do not match their filings, and founder spending mixed with company spending. Each is a record problem. Federal rules already require a corporation to keep books sufficient to establish its income and deductions (26 CFR 1.6001-1), and the same records answer an investor's questions.

A clean-up is not simple when a Form 1120 was already filed from the wrong numbers, when staff were paid without payroll, when customers prepay annual plans, or when founders paid costs before the corporation existed. Start by gathering the records in the list below.

What records should we gather first?

Gather the outside records first, because the books are rebuilt from them, not from the spreadsheet. IRS Publication 583 names the supporting documents books rest on: invoices, paid bills, receipts, deposit records and account statements.

A statement alone proves payment, not that the company incurred the cost; Publication 583 says to keep invoices or sales slips as well.

How long does a books clean-up take before a raise?

There is no standard length: the time depends on how many months are behind, how many accounts there are, how many transactions each holds, and how many special items need rebuilding. Payroll, contractors, prepaid customer plans, financing instruments and missing statements each add work.

The work runs in this order, because each step depends on the one before:

1. Collect statements and documents for every account from the first day.
2. Reconcile each account month by month, oldest first, as Publication 583 describes: once bank charges missing from the books and deposits or checks not yet cleared are accounted for, the books and the statement must agree.
3. Classify every transaction, and move financing, founder items and transfers between accounts out of income and expense.
4. Book payroll and contractor costs from their reports.
5. Add accruals: unpaid bills, earned but unbilled revenue, and deferred revenue on prepaid plans.
6. Tie the SAFE, note and share balances to the signed documents and the cap table.
7. Compare each closed year with the Form 1120 filed for it.
8. Close the reconciled months so later edits do not change them.

If a return is due while the books are behind, see catching up on overdue books for a return-ready catch-up first.

Do our books have to be on the accrual basis before we raise?

Tax law does not require accrual books for every startup, but cash-basis books cannot show what an accrual set shows. Under the cash method, income is recorded when received and costs when paid; under an accrual method, income is recorded when earned and costs when incurred (Publication 538). Prepaid annual plans, unpaid bills and accrued payroll appear only in accrual books.

Whether a C corporation with average gross receipts of $32,000,000 or less can keep accrual books while its return stays on the cash method, and how the tax change works, is covered in switching from cash to accrual.

What does an investor-grade clean-up cover: bank and card reconciliations, payroll, contractors, prepaid plans?

An investor-grade clean-up covers every balance on the balance sheet, not only the profit and loss. Each balance either ties to an outside document or has a schedule that explains it.

Missing Forms 1099, payroll filings or state registrations that the clean-up uncovers are tax filings, not bookkeeping; see tax clean-up before investor due diligence.

How should SAFEs, notes and founder shares show in the books so they tie to the cap table?

SAFE and note money is financing, not sales: it belongs on the balance sheet, one line per instrument or a schedule by holder, with the date and amount on each signed document. A convertible note also carries accrued interest under its terms. Founder shares show as stock and paid-in capital equal to what the founders paid; an amount promised but unpaid needs its own record.

The total of SAFEs, notes and paid-in capital in the books should equal what the cap table and signed documents show was invested. Whether a SAFE is treated as debt or equity, and where it goes on Form 1120 Schedule L, is covered in SAFEs and convertible notes. If founder shares were issued after SAFE money came in, see founder shares issued after a SAFE.

Founders paid company costs on personal cards: how do we fix that in the books?

Record each cost in the company's books on the date it was incurred, with the receipt and the business purpose, and owe the amount to the founder. Then settle the balance one of three ways: reimburse it, treat it as a written loan from the founder, or issue shares for it.

• Reimbursement: corporate officers who work in the business are employees (Publication 15). A reimbursement stays out of wages only under an accountable plan: the expense is a business cost paid while working for the corporation, the founder substantiates it within a reasonable time, and returns any excess. Receipts given within 60 days of the cost are always on time; older ones depend on the facts (Publication 463). Otherwise the payment is wages.
• Loan: a signed note with terms makes the balance a liability the cap table will not show.
• Shares: a contribution for stock changes the cap table and has its own tax rules.

Personal charges paid from the company account are the reverse: record each one as owed by the founder, then have it repaid or treat it as pay. Publication 583 advises a separate business account from the start. Costs founders paid before incorporating follow other rules; see startup costs before launch.

Do the cleaned-up books have to agree with the Form 1120s we already filed?

The return comes from the books, so the two should agree or the difference should be explained. The Form 1120 instructions say the Schedule L balance sheets should agree with the corporation's books and records, and Schedule M-1 reconciles book income to taxable income (Schedule M-3 instead once year-end total assets reach $10,000,000). A corporation whose total receipts and year-end assets are both under $250,000 can skip Schedules L, M-1 and M-2 by answering Yes to Schedule K question 13, but its income and deductions still come from the books.

If the clean-up changes a filed year's taxable income, the corporation may need Form 1120-X. A refund claim is generally due within 3 years after the original return was filed or 2 years after the tax was paid, whichever is later (Form 1120-X instructions). A changed loss also changes the losses carried to later years; see net operating losses for startups. Moving the return from cash to accrual is a method change on Form 3115, not Form 1120-X.

What if the lead investor later asks for an audit?

A bookkeeping clean-up is not an audit; an audit is a separate engagement by an independent auditor who tests the balances. Reconciled months, schedules for every balance, signed financing documents and kept support give the auditor a starting point. Keep the support as long as it may matter to a return (26 CFR 1.6001-1(e)): generally 3 years after filing and 4 years for employment tax records (IRS), and longer for a loss year while its loss is still carried to later returns.

Example

These examples are illustrative; figures are in US dollars.

Eight months in a spreadsheet, a seed round in three months

A corporation kept eight months of books in a spreadsheet. A $1,200,000 SAFE received in February was entered as revenue. It has three bank and card accounts with about 1,500 transactions. The clean-up moves the $1,200,000 to a SAFE balance, reconciles each account for each of the eight months, books payroll from the payroll reports, and adds unpaid bills at each month-end. Revenue drops by $1,200,000; the balance sheet now shows the SAFE that the cap table lists.

Accrual books for $300,000 of annual prepayments

Customers prepaid $300,000 of 12-month plans during a calendar year: $50,000 starting January 1 and $250,000 starting July 1. Cash-basis books show $300,000 of sales. Accrual books show $175,000 earned this year ($50,000 plus half of $250,000) and $125,000 of deferred revenue to be earned next year.

A founder paid $40,000 of company costs personally

A founder paid $40,000 of software, travel and legal bills on a personal card after incorporation. The clean-up records each bill on its date with its receipt and an amount owed to the founder. The board then chooses: reimburse under an accountable plan, sign a note for a $40,000 loan, or issue shares for the $40,000. The receipts stay with the books either way.

Different for you?

• A tax return is due and the books are behind: see catching up on overdue books, and get bookkeeping help.
• The clean-up changes a filed Form 1120: compare and correct it with corporate tax help.
• The tax return must move to the accrual method: see switching from cash to accrual.
• Investors sent a request list: see financial records investors ask for in due diligence.
• Customers prepay annual plans: see deferred revenue for SaaS subscriptions.
• SAFEs or notes need their tax treatment settled: see SAFEs and convertible notes.
• The clean-up uncovers missed filings: see tax clean-up before investor due diligence.
• Founders paid costs before incorporating: see startup costs before launch.
• The round has closed and the board wants monthly reports: see monthly financials for investors and the board, with ongoing bookkeeping help.