Startable – Healy Jones’ & Prasad Thammineni’s Blog

I was pretty surprised at the recent news that Canopy Financial was cooking their books. Sure, early stage investors don’t usually conduct much financial diligence, because early stage investments are not usually made on the basis of historical financial performance and pre-revenue technology development type companies don’t really have a ton of meaningful data in their historical financial statements anyway.

But growth investing is a different story. Growth investments are made on the basis of financial performance, both projected and historic. Most growth investors insist on having a formal audit, paying for a quality of earnings analysis from an outside accounting firm and have long, painful conversations with the company’s accounts. And in brokered deals, where an investment bank is involved, the ibank is assumed to have conducted their own due diligence – which includes at least one conversation with the auditors.

I know this because I was a growth investor, early stage investor, and (I’m loath to admit it because it’s so uncool these days) a baby investment banker who worked on some growth venture deals.

When I was with Summit Partners, we had pretty long, boring conversations with both the company’s auditors and the outside accounting firm we brought in to do a quality of earnings analysis. As the junior person, I usually led the process, but the entire deal team was involved in conversation with the accountants. The head partner was the person who authorized the couple hundred thousand dollar quality of earnings analysis. This analysis was conducted by an auditing firm that WE had a relationship with, not the company. I might have drafted up the list of questions we asked, but the partner on the deal was very much the guy asking a lot of the questions at the accounting firm. And he also was the person who had to present our accounting diligence to the investment committee. Note that this committee wasn’t a rubber stamp committee – they asked annoyingly deep questions on specific numbers. A number of times we had to go back to the company and auditors to really figure out the answer.

And at the investment bank, we didn’t just check the box if a company had an audit. We called the head auditor and spoke about the audit. When was it conducted? How long did it take? Was there any doubt that the company had the cash and revenues presented in the audit? Any parts of the company’s numbers that were potentially controversial, or did the company take aggressive recognition tactics anywhere in their numbers?

But there may be something that happens when investors get lazy. The audit homework might fall to the most junior person. But even then, you’d expect that this person would be pretty competent and would follow standard list of questions designed to at least ensure a good conversation with the auditor. At Summit, a huge portion of our mandatory investment memo was financial diligence. It usually was 10 to 15 plus pages of analysis, and included the audit and quality of earnings analysis and notes from the conversations with the auditors. It was a pain in the butt, but it was set up so that everyone knew what had to be done and the partners could do dives into the numbers during investment discussions.

Or, perhaps the company and investment bank were running a “rushed” process. “Hurry up and invest or else the deal will go to someone else!” So maybe in the fury of a quick-execution deal the audit diligence never got done. Maybe the faked audit letter was enough, and the investor assumed that the investment bank and company’s audit committee had done their job and confirmed that the company’s books were legit. With the growth numbers that Canopy claimed (I think I heard revenue growth from $9 million to $60 million the next year?!?) I can understand how an investor could get pretty worked up about not losing the deal. On the other hand, it’s really not that hard to arrange a conversation with the auditors. They realize the importance of speaking with a company’s investors, and go out of their way to make time. And, while ideally you’d spend the four weeks it takes to do a quality of earnings analysis, if you are rushed a good talk with the auditor can go a long way. A simple question such as, “hey, have you completed an audit for the time period xyz” might have been helpful here.

Of course, there is also the audit committee from the company’s board of directors. Although I have noticed that the audit committee usually gets chaired by the outside director, not one of the professional investors. This is because it’s a pretty painfully boring job to have. And so, the person who would probably do the best job, an investor who has been on numerous boards, typically isn’t the audit chair and it is usually the person with the least board management experience. But still, someone on the board probably might have noticed something was wrong.

I don’t know anything about the Canopy situation other than what I have read in the news, but it does blow my mind. Spectrum Equity has a reputation as a quality shop, and FT Partners is a pretty decent fin tech investment bank. Nobody’s due diligence is perfect, but financial statement diligence is such a basic blocking and tackling piece of diligence that you’d think would have been conducted on a $62.5 million growth investment. It’s just a strange situation.