Do VCs require regular audits for startups they invest in?

QUESTION:

I heard VCs and other investors typically require regular audits of the company’s finances. This can be expensive — around $20k to $50k. Is this true and what should a startup do about it when negotiating with an investor?

ANSWER:

by Charles Swan at The Virtual CFO

It is negotioble for pre revenue start ups. However, as the company, and the investment matures, aduits are desirable, and probably mandatory. You will definately need one prior to a second round, unless you are pure R&D.

Audit fees for attractive start ups can be very negotiable, particularly in today’s environment – as low as $5k from national firms. However, there are usually long term committments required, so read the proposal and engagement letters closely.

Good luck!

ADDITIONAL ANSWER:

Ethan Stone

Ethan Stone

by Ethan Stone, Stone Business Law

First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.

VCs generally require annual audited financials. This might be negotiable for a very early-stage company with some VCs, but it’s usually not worth fighting about. What is worth negotiating is the opening requirement to use a “nationally recognized” firm to do the audit. Try to get them to agree on a regional firm that is very reputable (it’s much better if they audit some public companies) but less expensive.

Ask the VC which firms they would find acceptable. If you’ve already been audited, of course, the VCs can inspect the quality of your auditors’ work. That’s a good idea if you already have a history of operations and revenues, but overkill otherwise. Bear in mind that the VCs are putting up the money for the audit and they want you to be economical as much as you do. So requiring audits is not merely a CYA move for the VCs (although it is that). It’s also part of their exit plan and, as such, it’s part of your exit plan, too. The two principal exit mechanisms – a sale or an IPO – both require credible audited financials. So even if you succeed in convincing a VC to skip audits or to let you use a non-credible firm to save money (unlikely), it’s likely to be false economy. You’ll spend much more than you save when you decide to sell or go public and realize that you have to hire a serious firm to clean up several years of financials in a hurry.

Comments & Advice:
  1. Larry Davis says:

    One of the great misconceptions about the audit process is that the longer you wait after year end, the easier it is to complete the audit. For example, if you begin today to have your financials audited as of 12/31/09, you certainly know whether or not receivables are collectible in that you’ve had an entire year to collect them, right? This part is certainly true, but if there are complexities to your business (and most tech companies have at least one complex accounting issue), the further you get from year end, the more difficult the audit becomes. Why? Because your accounting department has turnover, and they are focused on today’s issues, not those of 2007 and 2008. Thus, when the auditors start to inquire as to why you took a certain position on a technical issue, no one remembers why.

    It is far more cost effective as well as a real time saver to have your audit conducted a few months after year end.

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