September 27th 2005

MANAGEMENT ACCOUNTING DOES IT MEET THE MARKET TEST?: EVIDENCE FROM EARLY- STAGE COMPANIES.
BY GEORGE FOSTER WATTIS PROFESSOR OF MANAGEMENT STANFORD UNIVERSITY AND VISITING PROFESSOR AGSM

CURRENT RESEARCH AGENDA ON EARLY- STAGE COMPANIES

STRATEGY, GROWTH AND MANAGEMENT DEVELOPMENT OF CONTROL SYSTEMS VALUATION GLOBALIZATION STRATEGIES

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MARKET BASED TEST

EARLY STAGE COMPANIES START WITH RELATIVELY OPEN SLATE AS REGARDS SYSTEMS SPEED OF ADOPTION OF INDIVIDUAL SYSTEMS PROVIDES INSIGHT INTO THEIR PERCEIVED VALUE KEY INFLUENCER(S) ON ADOPTION PROVIDES INSIGHT INTO WHO PERCEIVES THEM TO HAVE VALUE ACTUAL COMPANY PERFORMANCE MAY PROVIDE INSIGHT INTO CONTRIBUTING ROLE OF SYSTEMS IN GENERAL AND ACCOUNTING SYSTEMS IN PARTICULAR

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Management systems
A management system is a recurring and formalized set of institutionalized protocols, routines, or information gathering mechanisms designed to assist management in their decision making or the fulfillment of their responsibilities 8 Systems examined:

Strategy planning systems Financial planning systems Financial monitoring systems Human resource planning systems

Human resource compensation systems Product development systems Sales/marketing systems Partnership systems

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TWO MAJOR STUDIES

FIELD RESEARCH PROJECT
78 EARLY STAGE COMPANIES FIELD STUDY WITH OVER 200 INTERVIEWS OF 60-90 MINUTES & QUESTIONNAIRES

VALUATION PROJECT OF 502 EARLY-STAGE COMPANIES WITH IPO IN 1996-2000 PERIOD

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FIELD RESEARCH PROJECT Sample construction

Companies in the initial database Minus Companies that went out of business Companies acquired Companies ineligible in some other way1 Companies that did not respond2 Companies that declined participation Final sample of companies

624

94 88 41 188 135 78

1 These are companies that are too small, too old, or subsidiaries of other companies. 2 These are companies that did not respond to the five telephone contacts.

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Table 2 Descriptive statistics on sample of companies Panel A: Industry Statistics

Industry Biotechnology Information technology Other industries Total
1

Number of companies 12 48 18 78

1 Other industries include business services and consumer products.

Panel B: Financing Statistics

Financing type Venture capital financed Other forms of financing Total Number of companies 60 18 78

Panel C: Company Statistics

Mean Number of CEOs Years of total experience of CEO Age of the company Number of employees2 Revenues (000)3 Income (000)3 Number of VC rounds Valuation (millions)4
1 2 1

Std. Dev. 0.78 8.48 2.44 62 11,853 15,668 1.78 229.6

Q1 1 12 3 71 2,437 -12,469 2 21.5

Median 1 20 5 113 7,300 -4,700 3 67.25

Q3 2 25 7 155 15,000 29 5 192.7

1.65 18.42 5.47 118 10,923 -9,455 3.43 168.6

Estimated for all CEOs in the sample. Employees is calculated at the peak of each companys size. 3 Revenues and profits are for the last year of data available. 4 Valuation statistics are for the largest valuation round available.

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U.S. only: All systems All industries

U.S.
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Rank of Systems Adoption : Based on % of Adoption Each Year

% of companies having adopted the system by the end of: Financial planning Cash flow projections Operating budget Sales projections Strategic planning Definition of strategic (non-financial) milestones Customer development plan (plan to develop market) Headcount/human capital development plan Product portfolio plan (plan about future products) Investment budget Human resource Core values Mission statement planning Organizational chart Codes of conduct Written job descriptions Orientation program from new employees Company-wide newsletter Financial evaluation Capital investment approval procedures Operating expenses approval procedures Routine analysis of financial performance against target Customer acquisition costs Customer profitability analysis Product profitability analysis Human resource Written performance objectives for managers Written performance evaluation reports evaluation Linking compensation to performance Individual incentive programs Product development Project milestones Product concept testing process management Reports comparing actual progress to plan Project selection process Product portfolio roadmap Budget for development projects Project team composition guidelines Sales management Sales targets for salespeople Market research projects Sales force compensation system Sales force hiring and firing policies Reports on open sales Customer satisfaction feedback Sales process manual Sales force training program Marketing collaboration policies Customer relationship management system Partnership development plan Partnership Policy for partnerships management Partnership milestones Partner monitoring systems Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 2 3 3 1 2 1 2 2 2 1 1 2 11 5 6 3 5 3 6 4 4 6 4 5 6 12 15 17 13 16 6 6 13 13 17 17 12 16 20 18 15 17 20 8 13 18 19 17 1 8 15 13 16 15 4 6 8 8 10 14 4 1 1 4 6 8 9 15 23 24 23 24 12 8 7 9 12 9 12 16 10 12 17 11 39 32 34 30 28 29 15 13 11 7 2 4 15 19 19 15 8 13 21 14 11 15 8 7 31 37 44 46 44 40 31 28 37 39 35 27 36 28 30 38 31 28 17 20 18 9 13 9 17 16 5 5 7 5 17 21 8 9 10 11 26 30 23 23 20 21 10 11 17 20 21 20 22 23 31 32 36 38 23 22 25 25 25 22 23 25 28 28 29 30 27 25 27 29 29 30 27 23 25 26 26 26 33 27 35 40 40 34 23 31 21 21 22 22 27 33 35 32 36 37 27 33 22 21 24 25 33 33 31 34 39 41 37 40 29 27 27 30 37 36 39 34 34 38 40 44 45 44 45 45 42 45 33 31 32 36 42 45 46 45 46 45 42 38 43 34 32 30 33 38 38 34 38 34 40 40 41 41 42 42 42 42 41 43 42 42 42 42 39 41 40 42

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U.S. only: Financial systems All industries

U.S.
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Cross-country comparison between U.S. and Germany: All systems All industries

U.S.

Germany

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Cross-country comparison between U.S. and Germany: Financial systems All industries

U.S.

U.S.

Germany

Germany

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Early Stage Entrepreneurial Company Sample: Evolution of Product Development Management Control Systems over Time Panel A: Full sample
0.8 Percentage of Companies Adopted 0.6

0.4

0.2

0 0 1 2 Age (years) 3 4 5

Panel B: Venture-backed firms sample

0.8

Percentage of Companies Adopted

0.6

0.4

0.2

0 0 1 2 Age (years) 3 4 5

Panel C: Non-venture-backed firms sample

0.8 Percentage of Companies Adopted 0.6

0.4

0.2

0 0 1 2 Age (years) Project milestones Portfolio roadmap Progress to plan Concept testing Project budget Product team Project selection 3 4 5

Early Stage Entrepreneurial Company Sample: Evolution of Product Development Management Control Systems over Time
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Early Stage Entrepreneurial Company Sample: Evolution of Product Development Management Control Systems over Size (Number of Employees Panel A: Full sample
0.8 Percentage of Companies Adopted 0.6

0.4

0.2

0 <10 <20 <30 <40 <50 <60 <70 <80 <90 <100 <110 <120 <130 <140 <150

Size (number of employees)

Panel B: Venture-backed firms sample

0.8

Percentage of Companies Adopted

0.6

0.4

0.2

0 <10 <20 <30 <40 <50 <60 <70 <80 <90 <100 <110 <120 <130 <140 <150

Size (number of employees)

Panel C: Non-venture-backed firms sample

0.8

Percentage of Companies Adopted

0.6

0.4

0.2

0 <10 <20 <30 <40 <50 <60 <70 <80 <90 <100 <110 <120 <130 <140 <150

Size (number of employees)

Project milestones Portfolio roadmap

Progress to plan Concept testing

Project budget Product team

Project selection

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Each of the seven systems (project milestones, reports comparing progress to plan, budget for development projects, project selection process, product portfolio roadmap, product concept testing process, product team composition guidelines) is coded yearly as 1 (if the company reports having adopted the system) and 0 otherwise. For different number of employees (x-axis) we add the number of companies that have adopted the system over the total population to obtain the percentage in the y-axis.

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VENTURE-BACKED COMPANIES WITH IPOs : 1996-2000

FINANCIAL PROFILES RELATIVE IMPORTANCE OF FINANCIAL STATEMENT INFORMATION IN VALUATION COSTS AS INVESTMENTS IN EARLY-STAGE COMPANIES

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Financial Profile Evolution of Early-Stage Companies for Pooled Sample: Private Market (Pre-IPO) and Public Market (Post-IPO) Event Time
Panel A: Pooled Revenue & Pooled Expense Deciles (.1, .3, .5, .7, .9)
$600,000,000 Revenues $400,000,000 $200,000,000 $0 -$200,000,000 -$400,000,000 Expens es -$600,000,000 .10 Percentile .90 Percentile .10 Percentile .90 Percentile

Year -3

-2

-1

+1

+2

Year +3

Eve nt Time (where IPO is in Ye ar 0)

Panel B: Pooled Net Income Deciles (.1, .3, .5, .7, .9)
$250,000,000 $150,000,000 .10 Percentile $50,000,000

-$50,000,000 -$150,000,000 -$250,000,000 .90 Percentile

Year -3

-2

-1

+1

+2

Year +3

Eve nt Time (where IPO is in Ye ar 0)

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Financial Profile Evolution of Early-Stage Companies: By Private Market (Pre-IPO) Financing Round (Calendar Time)
Panel A: Pooled Revenue & Expense Deciles (.1, .3, .5, .7, .9)
$100,000,000 $80,000,000 $60,000,000 $40,000,000 $20,000,000 $0 -$20,000,000 -$40,000,000 -$60,000,000 -$80,000,000 -$100,000,000 Expens es .10 Percentile .90 Percentile .10 Percentile Revenues

.90 Percentile

Series A

Series G

Financing Round Prior to IPO

Panel B: Pooled Revenue & Expense Deciles (.1, .3, .5, .7, .9) for firms with IPO by Series C ("Fast IPO" Companies)
$100,000,000 $80,000,000 $60,000,000 $40,000,000 $20,000,000 $0 -$20,000,000 -$40,000,000 -$60,000,000 -$80,000,000 -$100,000,000
.10 Percentile Expens es .90 Percentile Revenues .10 Percentile

.90 Percentile

Series A

Series G

Financing Rounds Prior to IPO

Panel C: Pooled Revenue & Expense Deciles (.1, .3, .5, .7, .9) for firms with IPO after Series C ("Slow IPO" Companies)
$100,000,000 $80,000,000 $60,000,000 $40,000,000 $20,000,000 $0 -$20,000,000 -$40,000,000 -$60,000,000 -$80,000,000 -$100,000,000 Expens es .90 Percentile .10 Percentile .10 Percentile Revenues .90 Percentile

Series A

Series G

Financing Round Prior to IPO

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Relative Percentage of Adjusted R Attributable to (A) All Variables, (B) Company Financial Statement Variables, (C) Company Non -Financial Statement Variables, and (D) Capital Market Variables Panel A: Adjusted R-sq. in Levels
R-sq For All Variables 70% 60% R-sq For Coy. Fin. Stat. Variables R-sq For Coy. Non-Fin. R-sq For Capital Market Stat. Variables Variable

Adjusted R-sq.

50% 40% 30% 20% 10% 0%

-3 -2 -1 0 1 2 3

-3 -2 -1 0 1 2 3

-3 -2 -1 0 1 2 3

-3 -2 -1 0 1 2 3

Event time (where IPO is in Year 0)

Panel B: Adjusted R-sq. (in Levels) Expressed As % of Total R-sq.

% R-sq. For Coy. Fin. % R-sq. For Coy. Non-Fin. % R-sq. For Capital Stat. Variables Stat. Variables Market Variable 100% 90% 80%

Adjusted R-sq.

70% 60% 50% 40% 30% 20% 10% 0%

-3 -2 -1 0 1 2 3

-3 -2 -1 0 1 2 3

-3 -2 -1 0 1 2 3

-3 -2 -1 0 1 2 3

Event time (where IPO is in Year 0)

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Table 5
Summary of t-statistics From Various Models That Include Different Combinations of Income Statement Variables

Pre-IPO
Levels Matching Interpolated Scenario 1 Revenue Scenario 2 Total Costs Scenario 3 Revenue Total Costs Scenario 4 Revenue COS SMG&A R&D 7.22 6.20 Differences Undeflated Deflated 7.30 5.10 Levels

Post-IPO
Differences Undeflated Deflated -2.18 5.11

6.70

11.37

14.11

9.40

10.28

1.77

-7.69

-1.73

2.84 9.03

0.51 12.40

3.58 6.71

2.30 8.81

6.80 -2.09

3.43 -8.16

6.80 -4.76

4.05 1.53 2.52 3.27

3.25 2.08 2.65 7.27

4.55 0.59 4.36 2.55

2.19 2.10 6.57 2.75

8.31 -5.17 -3.30 4.47

3.91 -3.59 -5.96 -2.30

6.98 -2.84 -4.19 0.22

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Table A1
Median Pre-Money Values and Median Amounts Raised for Larger VentureOne Database

Median PreMoney Valuation Round A Round B Round C Round D Round E Round A Round B Round C Round D Round E Round A Round B Round C Round D Round E 5.7 18.7 37.0 75.4 117.0 5.9 13.5 23.9 28.0 36.0 5.8 14.8 29.7 52.2 84.3

1996-2000 Median Amount Raised 3.4 6.6 9.9 13.7 22.5 3.0 4.7 5.0 5.0 4.4 3.0 5.0 6.5 7.8 11.2

nobs. 754 780 715 608 461 3515 2344 1350 753 382 4269 3124 2065 1361 843

non 1996-2000 Median PreMedian Money Amount Valuation Raised 7.2 26.8 39.1 45.2 51.9 5.8 13.5 22.0 28.0 32.9 5.9 14.5 24.4 32.4 38.5 4.9 10.0 14.0 14.3 16.5 3.1 6.0 7.0 6.1 7.0 3.2 6.0 7.0 7.0 7.5

nobs. 284 362 337 315 248 6651 5433 3737 2327 1272 6935 5795 4074 2642 1520

Full Sample Median PreMedian Money Amount Valuation Raised 5.9 21.1 38.0 61.4 86.8 5.8 13.5 22.5 28.0 33.8 5.9 14.7 26.2 40.1 53.7 3.5 7.0 10.1 14.0 20.1 3.0 5.4 6.2 6.0 6.0 3.0 5.7 7.0 7.2 9.0

nobs. 1038 1142 1052 923 709 10166 7777 5087 3080 1654 11204 8919 6139 4003 2363

IPO

non-IPO

Total

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Correlation Between Valuation and Revenue 1 for Larger VentureOne Database

Matching-Pre

Matching-Post IPO Interpolated Valuation

Change in Valuation

1996-2000 Spearman Pearson 0.4176 0.21096 <.0001 <.0001 2107 0.43213 0.23007 <.0001 <.0001 2107 0.4434 0.24579 <.0001 <.0001 1730 0.41722 0.6189 <.0001 <.0001 1032 0.32209 <.0001 189 0.30103 <.0001 189 0.26802 0.0024 126 0.30993 0.0548 39 0.25328 0.0004 0.23767 0.001 0.29159 0.0009 0.16722 0.3089

non 1996-2000 Spearman Pearson 0.3412 0.29001 <.0001 <.0001 2072 0.3737 0.30068 <.0001 <.0001 2072 0.40871 0.5191 <.0001 <.0001 840 0.37764 0.51749 <.0001 <.0001 515 0.37549 <.0001 438 0.37368 <.0001 438 0.2756 <.0001 374 0.26511 0.0014 142 0.20296 <.0001 0.19555 <.0001 0.3564 <.0001 0.2453 0.0033

Full Sample Spearman Pearson 0.35904 0.26781 <.0001 <.0001 4179 0.35845 0.28016 <.0001 <.0001 4179 0.43034 0.4593 <.0001 <.0001 2570 0.39976 0.24063 <.0001 0.0011 1547 0.36237 <.0001 627 0.38679 <.0001 627 0.27791 <.0001 500 0.29983 <.0001 181 0.21048 <.0001 0.20238 <.0001 0.34132 <.0001 0.59208 <.0001

Matching-Pre

Matching-Post non-IPO Interpolated Valuation

Change in Valuation

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MANAGEMENT CONTROL SYSTEMS AND COMPANY PERFORMANCE

EMPLOYEE GROWTH
REVENUE VALUATION

CEO TURNOVER

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Management control systems intensity and employee growth

160

140

120

100 Employees

80

60

40

20

0 1 2 3 Age (1) Lowest intensity (2) (3) Highest intensity 4 5 6

This figure plots average company size over time for three portfolios. Each company in the sample is assigned to one of the portfolios according to its systems intensity in its second year of existence. Each portfolio has equal number of firms. Portfolio (1) is formed with the 33% of companies with lowest intensity, portfolio (3) is formed with the 33% of companies with highest intensity, and portfolio (2) is made up of the rest of firms.

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Budget adoption and company growth (employees)

120

100

Number of employees

80

60

40

20

0 1 2 3 Years since founding Early adoption Late adoption Non-adoption 4 5

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Budget adoption and company growth (revenues)

14000 12000 10000 8000 Sales 6000 4000 2000 0 1 2
Early adoption

3 Years since founding

Late adoption

4
Non-adoption

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Budget adoption and company growth (valuation)

140 120 100 80 60 40 20 0 1 2 3 Years since founding Early adoption Late adoption Non-adoption 4 5

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Valuation (in millions)

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CEO turnover and management control systems intensity

Panel A: CEO turnover and management control systems intensityyear 1

P r e t g o f u d r r p c d f o C Op s io e c n a e f o n e s e la e r m E o it n 60 50 40

30

20

10

0 Group 1 (highest intensity) Group 2 Group 3 (lowest intensity)

Panel B: CEO turnover and management control systems intensityyear 2

P r e t g o f u d r r p c d f o C Op s io e c n a e f o n e s e la e r m E o it n 60 50 40

30

20

10

0 Group 1 (highest intensity) Group 2 Group 3 (lowest intensity)

P r e t g o f u d r r p c d f o C Op s io e c n a e f o n e s e la e r m E o it n

Panel C: CEO turnover and management control systems intensityyear 3

60 50 40

30

20

10

0 Group 1 (highest intensity) Group 2 Group 3 (lowest intensity)

These figures plot the percentage of founders replaced from the CEO position per level of management control systems intensity. Firms were grouped into three portfolios from lower to highest intensity in year 1 (Panel A), year 2 (Panel B), and year 3(Panel C). The y axis is the percentage of founders replaced and the X-axis are the three portfolios from highest (group 1) to lowest intensity (group 3).
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Illustrative quotes for variables potentially affecting management control systems intensity

Variable

Illustrative quotes

Number of employees

And frankly, balance the need to be flexible with the need for getting the right kind of processes in place. So on the one hand, you cant have chaos, but having 110 people in a company and having like IBM-type policies and procedures doesnt make any sense either. So its eternally a struggle, but I think that the companies that probably succeed in developing, have an instinct for when to implement things and what not to. And I think that weve probably done reasonably well, though certainly some things were probably overdue. I think the systems are more important in the scaling period because what works for 20 people wont work for 50 or 200 people, in terms of communication, decision making, etc. So you need the systems to formalize and structure it more. It definitely happened to us, when you couldnt fit everyone into one space and the dynamic shifts and communication gets a lot harder.

Venture-backed

We manage by the numbers in a lot of ways. Everything we do is numbers focused. So, in order to manage by the numbers, you need to have formal reporting structures in place, obviously. The marketing planning process is more formal, because thats what the board requiresyoure going to spend this money, we want to know what youre spending it on and why youre spending it on that. (These systems) were put in through a combination of the then Chief Financial Officer as well as the minimum expectations set by the VCs. So the board itself had a very strong hand in terms of what minimum it was prepared to accept. I just find that you cant get hurt by over reporting to the board. And reporting early.

Managers experience

I think some of it is just something that I've learned or I've developed over the years from experience, things that work. He came from McKinsey and he was a very process oriented guy. So thats when the process began I would say. A lot of small companies don't have budgets till very far along but its just unthinkable not to have them from my point of view so that's probably just one that I brought. Let's have budgets, let's get more formal about tracking capital expenditures. Some systems expertise you import when you import the right people.

Founder replaced

Originally the sales organization was run by one of our founders who was a very, very young guy like 22 at the time or something. But that wasnt, he just didnt have a lot of experience running this type of organization and putting this kind of systems in place. And then eventually we ended up having an experienced VP of sales and marketing join who then implemented kind of his vision of things.

Past prerevenue stage

So there is a clear need for a formalized policy on communicating with each other. And also because we are getting closer to commercialization, there is a need to have a better understanding of our cost structure, which needs a very formalized approach. Theres no need to do a product profitability report because were not shipping product. So part of where I said I think one of our biggest weaknesses was lack of marketing information and marketing analysis was that we didnt have the reporting tools.

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Overview
1. 2. Financial systems are one of the first systems adopted in most early-stage companies Budgets are the first of the financial systems to be adopted. Not withstanding the heavy criticism of budgets & budgeting, they clearly do pass a market test in early-stage companies. Companies adopting systems at early stage have faster growth. Alternative viewpoints on causality. No blue-print of systems rollout that is followed. Multiple factors affect the rollout sequence
Specific line of business (Biotech bring in revenue systems after lengthy delay) External parties (Venture capitals, R&D partners, etc) Experience level of CEO(s)

3. 4.

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