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Accounting for unicorns

Aldie P. Garcia Assurance Managing Partner, PwC Philippines 15 Jun 2018

hilippine startups are beginning to take center stage. Our very own innovators and disruptors placed the country in the regional and global tech and innovation map. Several incubators and accelerators united to help round up the country’s startup ecosystem.

Even the public sector is chipping in. Laws being enacted and proposed aim to make the lives of startups and entrepreneurs easier. Incentives are also being legislated to help ease the birth pains of startups and hopefully launch more of our very own unicorns.

But what are unicorns? And how do you hunt them? A unicorn, in the world of startups, refers to a privately held startup company currently valued at over US$1 billion.

Reference was made to the mythical creature to highlight both the statistical rarity and uniqueness required to be successful. Some of the better-known super unicorns include Uber, Didi, and Airbnb. In 2017, the Philippines hit a significant milestone when one Filipino startup, Revolution Precrafted, achieved unicorn status. It became one of the fastest, if not the fastest, to achieve that status in Southeast Asia, according to Tech in Asia media startup site.

The reality on the ground, however, is that for every unicorn, there are hundreds, even thousands, of startups aiming to join the club. Their key challenge remains the same –funding. In the 2017 Philippine Startup Survey conducted by PwC Philippines, 88 percent of the respondents said capital requirement is their top challenge when starting their venture while 81 percent said lack of adequate financial resources is their primary constraint in pursuing further innovation. In the same survey, 94 percent said they are planning to welcome an investor in the next three years and 59 percent consider financial capacity as the key criterion in looking for potential investors.

Funding trickles down in different shapes and sizes. For each funding round, startups need to wrestle with three decision points: source, purpose and accounting. I’ll let the innovators and disruptors worry about the pitch and the burn and take care of the source and purpose, respectively. This column will tackle accounting for startup funding.

Following the golden rule of double-entry bookkeeping, for every funding received, startups need to account for the corresponding debt or equity. Firstly, let’s get debt out of the way. This refers to conventional funding similar to how banks lend to its customers.

The funder, called creditor, expects full repayment of the principal plus interest. So the startup needs to recognize a liability in its books. This is the less sought-after type of funding precisely because during the early stages of the venture, the founders would want to pour the entire fund into the startup rather than spend for interest payments. Founders would rather focus on the platform, the technology, and the business model instead of having to worry about debt servicing.

The more sought-after type of funding is equity. By official definition, Philippine Accounting Standard (PAS) No. 32, Financial Instruments, provides that an equity instrument refers to any contract that evidences a residual interest in an entity’s assets after deducting all of its liabilities. This is where the funder, called an investor – angel or otherwise – will give fund to the startup in exchange for a fraction of ownership in the venture. They are owners, and not creditors. They share in the risks and rewards associated with the startup. There are two types of equity shares: 1) Ordinary or common shares, and 2) Preferred shares. Preferred share is the name given to any share issued that has some preferential rights in relation to ordinary shares. These preferential rights vary greatly but normally refer to the right to a fixed dividend. They could also refer to the right to participate in the distribution of the entity’s assets.

Classification of startup funding is not always straightforward. Contract terms can be so complicated that accounting becomes doubly confusing. So much so that a good chunk of PAS No. 32 is dedicated to presentation and classification to try and address the ever-evolving features being attached to debt and equity instruments. Preferred shares for example, while generally classified as equity, can be issued with different features that would trigger debt classification. A mandatorily redeemable preferred share, with rights to a fixed dividend rate, is required to be presented and classified as debt rather than equity.

In the same manner that an innocent-looking loan from a creditor, if issued as convertible, can be classified as equity or as a compound instrument with both debt and equity components, for which split accounting should be applied. All these in the name of sweetening the funding deals.

Needless to say, accounting for startup funding is complex. But nothing compares to the complexity of looking for new ways to solve an age-old pain. And that’s what our unicorn hunters have been doing, powered by technology and driven by entrepreneurial spirit. Cheers to those that make up our growing startup ecosystem. To the government, may you consistently champion the concept of inclusive innovation and implement a system of support for our startups nationwide. To our incubators, accelerators, funders, and investors, may your generosity continue to flow and bridge our startups to much-needed resources, financial or otherwise. And finally, to our innovators and disruptors, may the fire in you never die down. May you find inspiration in the thought that the whole country is rooting for you.
Happy hunting!

This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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Aldie P. Garcia

Aldie P. Garcia

Assurance Managing Partner

Tel: +63 (2) 8459 3078

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