Feb 1 2008

Do Venture Capitalists Demand Audited Financials?

Q:  Do venture capitalists require audited financials from the companies they’re considering for an investment?  Will “reviewed” financials suffice?  For that matter, how do acquirers think about audited financials?  Will they help speed an acquisition or is it overkill?

A: (From guest writer, our partner, Chris Wand). 

We have a requirement that all of the companies that we’ve invested in get full year-end audits from an audit firm we’re comfortable with.  It doesn’t necessarily have to be one of the big national firms (such as PwC, Ernst & Young or KPMG); in many cases we’re comfortable with a reputable regional firm with strong capabilities and resources.  However, a small shop with a handful of people or a solo practitioner isn’t like to make the cut from our perspective.

Most entrepreneurs who have grown their business beyond a basic startup stage (i.e. they’re generating more than nominal revenues and have more complex or significant operating expenses) will find it helpful to have audited financials when talking with venture capitalists, since that just takes the entire issue off the table.  However, not all venture capitalists will require audited financials before investing in a company (even though virtually all venture capitalists will require their companies to be audited after the investment).

Ultimately it’s a judgment call as to whether we (or any other venture firm) would require audited financials before making an investment.  If it’s a small, early stage company with a handful of employees, a relatively low expense base and nominal revenues, we’re probably not really valuing the business (and hence our investment in the business) based heavily on the company’s historical financial metrics, so audited financials aren’t that important to us.

On the other hand, if a meaningful part of the valuation dynamic of the business is the company’s historical financial metrics (i.e. the company is arguing for a certain valuation based on market multiples and the company’s revenues), then we need to make sure that the financials are properly presented in order to get comfortable making the investment.  The same could probably be said if a company had weird expenses (i.e. issues of capitalizing vs. expensing certain expenses, etc.) but that’s less of a specific concern for us given the types of businesses we invest in and the fact that we view cash outflows as more indicative/important than expenses (using the accounting meaning of that term) for early-stage companies.

As for being prepared for an acquisition, you definitely want to have audited financials before you embark on an M&A process.  We find that very few acquirers (and certainly not large public acquirers) are eager to acquire a company without seeing audited financials before signing the deal.  While I’m sure there are exceptions, it’s generally too significant of a diligence item for an acquirer to overlook.  So it becomes a question of whether you want to get your financials audited now or whether you want to be under the gun getting an audit when you’re in the midst of an M&A process.

If you think an M&A process is likely at some point in the near-to mid-term, then you should get audited financials rather than reviewed financials, since again that keeps it from becoming a distraction (at best) or a barrier (at worst) to a deal.