8 Questions to Ask Before Auditing Your First Venture Capital Fund

By Kristie Domzalski , VC Ops Specialist at Strut Consulting

It’s the most wonderful time of the year: Time to cozy up around the fireplace, sip hot cocoa, and... prepare for your audit. Yes, it’s audit season! While you may not be feeling jolly about it, going through the audit process is essential to ensuring your portfolio companies are valued fairly, and it provides you with credibility in the eyes of your Limited Partners (LPs).

We’ve gathered the most common questions to think through while preparing to audit your first venture capital fund. Read on to find out how to get your ducks in a row.?

Do I need an audit?

TLDR: Maybe ???? - either your LPA requires it, or an LP requires it.

The need for an audit is completely dependent on your Limited Partnership Agreement (LPA). Generally you can find this in the “Financial Accounting, Reports and Meetings” section. The LPA will say if your books and records need to be audited, and if it needs to be completed by a certain date. Standard practice is for audited financial statements should be available to your LPs within 120 days after the close of the Partnership’s fiscal year. As long as your fund is considered an exempt reporting adviser (ERA), you are not legally required to complete an audit.?

If your LPA does not require an audit, here are a few reasons you may still want to do one.?

• You want 3rd party assurance about the accuracy of your financial statements.
• You have an LP that has required an audit in their side letter.
• You are preparing to fundraise from institutional LPs.

What is the purpose of an audit?

The purpose of an audit is to provide reasonable assurance about the accuracy of the financial statements and that they are presented in accordance with Generally Accepted Accounting Principles (GAAP). The audit will ensure that financial statements are free from any material inaccuracies potentially caused by error or fraud.?

What are the auditors looking for?

The audit procedure is designed to identify what the users of the financial statements—your Limited Partners (LPs)—would focus on, and test for accuracy. This includes:

• Making sure that your valuations are reasonable.
• Confirming that your investments actually exist and are in line with the legal documents.
• Identify and address any key risk areas.
• Ensure accuracy of income allocations, contributions, and distributions.
• Ensure disclosures are correct and straightforward.

What entities should be audited?

Limited Partnership (LP) entities.

How much should I pay for an audit?

The answer nobody wants to hear: the cost of the audit depends on the volume and complexity of your portfolio, the number of LPs, and the level of experience and area of expertise of the firm. Shop around, but know that firms with little experience in the VC space can extend the process or add challenges, so you’ll need to consider this when weighing the various prices.??

What should I do to prepare for an audit?

Keeping these things in mind throughout the year will make your audit process smoother:

• Avoid entering into deals without information rights as much as possible.?
• For all new rounds of financing, request closing documents, even if you are not participating.?
• Ensure that you are reviewing the financial statements regularly, even if your Fund Administrator is preparing them.
• Keep track of debt instruments (SAFEs, convertible notes, and warrant conversions) and collect documentation.
• Create a valuation narrative. This is simply a document that details why you are valuing a company a certain way. (Ex. We have marked our value to the price of the most recent round closed on [DATE] at [PPS]. This price values our interest at [VALUE].)
• Ensure you are keeping a well organized file management system (eg. Box, Google Drive), so that you can easily and quickly find and provide your auditor and/or fund administrator the documents and information they need.
• Run an independent analysis of the carried interest calculation. Make sure this aligns with your fund admin.
• Keep a list of up to date contacts for your portfolio companies. This will be helpful when sending out audit confirmations, or if you need to request additional company details.?

Whose job is it?

If you have a fund administrator, you can expect them to do much of the heavy lifting. However, there are a few things that the GP/Operations team needs to focus on:

• Establish a timeline, and ensure things are moving along.
• Align with your fund administrator on responsibilities.
• Have a clear understanding of controls and policies in place.
• If you don’t have one already, establish a valuation policy.
• Ensure that you are reviewing financial statements throughout the year.
• Be available for valuation questions.

What are common issues found by auditors?

You will find that most of this information is similar to the items listed in what to prepare for an audit. Any issues you run into will slow down the audit process, so it is best to work them out with your auditor as early as possible.

Valuation

• No support for valuations (purchase agreements, articles of incorporation).
• No process for getting updates from portfolio companies.
• Recent rounds that you are not aware of.
• Convertible Note or SAFE conversions are not reflected.
• Stale investments; ensure there is no deterioration of the company. (Was the last round over 12 months ago? When did you check in last? What is their cash balance?)
• SAFE/Convertible Note mark-ups. A new SAFE or Convertible Note at a higher valuation cap is not sufficient evidence for a valuation change, however, it could be an indication. If you think a valuation change is warranted, identify other KPIs that would support this, such as increased revenue.

Equity

• LP allocations are done incorrectly. Side letters are not followed.
• Errors in income allocations. These are often found as a result of uncommon terms, such as waived management fees for specific LPs.

Auditing can feel daunting, especially as a sole GP. But addressing the potential pitfalls early on can save you lots of time and money down the road while preserving trust with current LPs and building credibility with future ones. If you’re feeling overwhelmed after reading this, reach out to the experts at Strut so we can help make your auditing season merry and bright (and stay tuned for more best practices!).

This article was originally published at strutconsulting.com.