An Audit Is Good For You (Honest)
There is a funny ritual in board rooms when it comes time to determine which board members will go on which board committees. I have seen the same pattern almost every time on every board I have ever been on.
“OK,” intones the CEO hesitantly. “It’s time to select committees. We have the compensation committee and the audit committee. Who wants to be on audit?”
Smirks and eye rolls ensue. A deferential kabuki dance begins. “Well, I’d be pleased to take compensation even though I know it’s a lot of work,” begins the largest shareholder, staking their claim on the juicier post. “But if you prefer comp, I suppose I could take audit.”
Every VC worth their salt knows that the compensation committee is where all the power is — setting the CEO’s compensation, evaluating her performance — whereas audit committee is a snooze. Reviewing revenue recognition policy, discussing the finer points of GAAP and interacting with auditors is less fun than a visit to the dentist. And, besides, in the early days when there is little revenue to recognize and the numbers are too small to merit much debate, there is little reason to even form the audit committee and bother with the expense and time of conducting an audit.
Or at least that is the conventional wisdom. In recent years, I have changed my views. Serving on the audit committees of a venture-backed startup is no longer rote but rather a central and strategic function. Further, I think entrepreneurs should embrace going through an audit rather than holding off as long as possible — which is the typical modus operandi for startups in the first few years. Let me explain (as succinctly as possible, before I put you to sleep since this topic is not known to be particularly scintillating !).
In a private company, the audit committee’s purpose or charter is typically:
- hire the auditors and oversee their work, including reviewing the financials
- recommend monitoring procedures to improve operations
- deal with any complaints associated with the financials or controls
- adhere to any relevant compliance matters
The audit committee is thus where the “rubber meets the sky”. Entrepreneurs are dreamers and optimists, always looking to the future. Audit committees are evaluative and grounded in what actually happened, not what might happen. That is why the audit committee’s role becomes so central at the time of exit. In either an IPO or an M&A transaction, suddenly everyone is focused on financial results and controls and what actually happened and how it was reported and accounted for. If entrepreneurs and boards took the audit committee more seriously from inception, they would save themselves a lot of heartache at the time of exit, never mind avoid some of the classic scaling pitfalls when operations get sloppy.
Let me give you one painful example I recently experienced. I served on the audit committee of one of my portfolio companies. The company was scaling fast and we found ourselves in the enviable, yet still problematic position, of many scaling companies: our finance and operations team was too thinly staffed, our VP of Finance was a bit over their head and we were scrambling to bring in a more senior finance and operations executive. Because I was busy and sitting on a lot of boards and committees, and because I trusted that the CEO and VP of Finance were on top of things, I was not particularly worried about the fact that our audit seemed to be delayed. No alarm bells went off when the typical audit period of a private company (May, June, July) went by without the audit committee being called to convene and review the completed audit.
When the new head of finance showed up and finally dug into the audit process, he discovered that we had inappropriately accounted for some of our transactions. A company we thought was EBITDA positive suddenly turned negative and our accelerated customer acquisition was proving to be unprofitable. We caught the problems in time to hit the brakes, but I know that if I had been more proactive in my role on the audit committee, we could have mitigated the impact.
Mistakes like these happen in good companies run by good people because everything is moving quickly, everyone is spread thin and everyone is focused on the next product release, the next deal, the next quarter, the next year and the next valuation inflection point. The audit process is that point in time where you bring in skeptical outsiders to slow things down and look backwards. Immersing yourself in that process is a valuable function for a board and any entrepreneur — and an underappreciated one.