The narrative of promising startups encountering roadblocks leading to failure or sustainability challenges is becoming increasingly common, raising concerns about the high rate of startup failure. With a critical analysis of recent such incidents, I believe this highlights the crucial necessity for effective management, specifically through the implementation of robust internal control systems. Internal control systems work as a backbone of a business, mitigating risk factors and steering organisations towards long-term success in an ever-changing startup ecosystem.
This article serves as my present to the startup ecosystem for the first quarter of the year, aiming to underscore the pivotal role of internal control systems in the startup landscape. It sheds light on how these systems contribute to balance, fortify strategic planning, and act as attractive magnets for external investment. Simultaneously, it emphasizes the indispensable role of internal control systems in propelling startup growth and ensuring sustained success.
Empirical studies have highlighted the critical role of internal control systems in the life cycle of early-stage startups, particularly emphasising the importance of financial, strategic, and human resources internal control systems in attracting external financiers. According to a Harvard Business Review article, startup failures are typically caused by founders’ inability to engage suitable stakeholders and their hasty pursuit of prospects without necessary validation. This emphasises the critical role of effective management, particularly through structured internal control systems, in guiding decision-making and resource allocation. Other literature on the evolution of internal control systems in early-stage businesses supports this stance, indicating a positive association between control system adoption and startup growth.
According to the Committee of Sponsoring Organizations of the Treadway Commission (COSO) the three main objectives of internal control are to ensure the operational effectiveness and efficiency, internal and external financial and non-financial reporting as well as adherence to laws and regulations to which the entity is subject. The COSO Framework delineates that in an effective internal control system, five components synergistically work to support the achievement of an entity’s mission, strategies, and related business objectives.
Key Components of Effective Internal Control Systems
Control Environment: The control environment establishes the foundation for an organization, shaping the control mindset of its employees. For startups, cultivating a robust control environment entails fostering a culture centered on integrity, ethics, and accountability. This encompasses a commitment to internal control by leadership, transparent communication of expectations, and the definition of organizational structure and responsibilities.
Risk Assessment: Risk assessment involves identifying and analyzing potential threats that could impede the accomplishment of business objectives. In the context of startups, it is imperative to assess risks associated with market volatility, financial stability, and operational challenges. A thorough understanding of these risks enables the organization to formulate strategies for effective mitigation or management.
Control Activities: Control activities encompass the policies and procedures implemented to ensure the execution of management directives to mitigate risks. In the startup realm, control activities may involve the establishment of financial controls, segregation of duties, and the integration of technology to automate processes. These measures are designed to proactively prevent or detect errors and irregularities in the startup’s operations.
Information and Communication: Information and communication involve the seamless flow of pertinent information throughout the organization to support effective internal control. For startups, this entails timely and accurate financial reporting, clear communication of policies and procedures, and ensuring accessibility of information to relevant stakeholders. Effective communication is essential to align everyone in the startup with the organization’s objectives and to clarify their roles in maintaining internal control.
Monitoring Activities: Monitoring activities revolve around assessing the ongoing effectiveness of internal control over time. Startups must consistently evaluate and enhance their internal control systems to adapt to changing circumstances. Monitoring activities may encompass ongoing management reviews, internal audits, and periodic assessments of the effectiveness of the internal control framework.
In essence, there exists a direct correlation between objectives (what startups strive to achieve), components (representing what is required of startups to achieve the objectives), and the organizational structure of the entity. This interconnected relationship forms the backbone of a startup’s approach to internal control, ensuring a comprehensive and adaptive framework for achieving success.
Requirement for Effective Internal Control
An effective internal control system plays a pivotal role in mitigating the risks associated with failing to achieve objectives to an acceptable level. This mitigation is relevant across the three categories of control objectives, necessitating the presence and proper functioning of each component and relevant principle. The following conditions must be met for the system to be considered efficient:
Presence and Functioning of Components and Principles:
• Presence signifies the determination that components and relevant principles exist in the design and implementation of the internal control system to achieve objectives.
• Functioning pertains to the determination that the components and relevant principles persist in the operations and conduct of the internal control systems, ensuring the achievement of specified objectives.
Integration of Five Components:
• The five components must operate in an integrated manner, collectively reducing the risk of not achieving an objective to an acceptable level.
• Operating Together refers to the determination that all five components synergistically function to achieve the objective. The interdependence and multitude of interrelationships and linkages among the components, especially the interaction of principles within and across components, are crucial for this integration.
Therefore, in the presence of a major deficiency concerning the presence and functioning of components or relevant principles, or if there is a lapse in the integrated operation of the components, the organization cannot conclusively assert that it has met the requirements for an effective system of internal control. The interconnected nature of these components and principles underscores the importance of their collective presence and proper functioning in ensuring the efficacy of the internal control system.
Building Control Systems from Day One
Multiple hurdles and uncertainties exist during a business’s fragile initial phase or inception stage. Many startups fail prematurely due to a lack of solid control systems at this vital stage. The establishment of effective control systems from the outset is imperative for startups, functioning as a guiding compass that provides insights into the inner workings of the business, aids in resource allocation, and facilitates the achievement of goals. These control systems encompass various aspects, including financial, operational, human resource, and strategic controls, among others.
The financial controls aim to assist startups in managing their money, including budgeting, cash flow management, and financial reporting as well as help startups make better resource allocation decisions and identify areas for development. Startups also use operational controls to manage their operations, which include manufacturing, inventory management, and quality control while enhancing their processes and increasing efficiency. With human resources, controls assist startups in managing their recruitment, training, talent management, and performance management which helps startups in forming a strong team and creating a favourable work environment. Additionally, strategic controls assist startups in aligning their actions with their strategic objectives, ensuring that the firm is on track to meet its goals, identifying areas for improvement, and making data-driven decisions. The implementation of these control systems is particularly crucial during the initial stages of a startup, as it establishes a foundation for effective governance and decision-making.
These controls stem from the below control system parameters for startups to consider:
Output control: This approach closely monitors measurable results, focused on meeting predetermined targets. For instance, a manufacturing company that uses output control has particular goals for order processing time, packaging precision, and delivery speed. By attentively monitoring these indicators, it assures efficient order fulfilment while continuously improving performance.
Behavioural control: This regulates behaviours and assesses employees’ conformity with company goals and values in their daily activities. Consider a startup that implements a control measure by recording discussions between its customer service representatives and clients during transactions. This monitoring assures respectful, sympathetic communication in line with the company’s customer service ethos
Concurrent control: This is distinguished by the ability to address issues as they arise, spanning production, inventory, and quality control, ensuring seamless organisational operation.
Feedback control: This system responds after an event, assessing finished projects against organisational standards to shape future plans.
Challenges in Implementing Control Systems for Startups
The implementation of control systems within startups often encounters various challenges as follows:
Limited Resources: Startups frequently struggle with constrained financial resources, making it challenging to invest comprehensively in control systems. This scarcity might hamper proper planning and resource allocation, potentially impeding the company’s growth trajectory.
Resistance from Employees: Employees may perceive control systems as a means of exerting undue pressure, leading to resistance and dissatisfaction. Overcoming this resistance becomes pivotal for the effective implementation and maintenance of control systems.
Magnitude of Change: The introduction of a new control system necessitates significant cultural and process-based shifts within the organization. This can be particularly challenging for startups, which are known for their dynamic and rapidly evolving work environments.
Complexity: Control systems often entail intricate components, such as financial planning, risk assessment, and performance metrics. The complexity involved can pose difficulties for startups in implementing and sustaining these systems effectively.
To address these common hurdles, startups can adopt the following strategies:
Prioritise Essential Systems: Concentrate on implementing fundamental control systems aligned with the company’s goals instead of aiming for a comprehensive system from the outset.
Train and Educate Employees: Provide comprehensive training and education to employees about the control systems, emphasising their benefits and contributions to the company’s success.
Engage Stakeholders: Involve critical stakeholders—employees, customers, and partners—during the implementation phase to ensure the relevance and effectiveness of the control systems.
Regular Review and Adjustment: As the company evolves, periodically review and adjust the control systems to accommodate new challenges and opportunities, ensuring ongoing relevance and efficacy in managing the organisation.
By tackling these challenges strategically, startups can successfully implement and maintain control systems that significantly contribute to their long-term success and sustainability.
Conclusion
Effective control systems are critical in the startup environment as they serve as the foundation for successful entrepreneurial ventures. As the new year has begun, startups must understand that as control systems are essential and as businesses expand, their control systems must evolve in tandem, responding to changing requirements. Despite implementation problems, prioritising critical systems, involving stakeholders, and encouraging agility can strengthen operational foundations. Finally, control systems support long-term growth and risk management rather than hinder it. Nurturing solid control systems from the start is not only beneficial to the entrepreneurial journey but also necessary for realising and maintaining startup potential.
Author
Emmanuel Kundo is a Tax Practitioner, Business Strategist and Policy Analyst. He is a Certified Financial Modelling and Valuation Analyst, a Certified Environment, Social, and Governance (ESG) specialist, both by the Corporate Finance Institute and holds a BSc in Accounting from the University of Professional Studies, Accra.
