A version of this article was previously published in the September 2018 edition of the Los Angeles Business Journal.
It’s understandable why emerging technology companies often delay conducting financial statement audits. Audits typically aren’t required, often take significant time and resources, and can distract from a company’s priorities—product development, sales, and fundraising.
Nevertheless, operating without an audit can create barriers to growth for companies of all sizes—especially in an environment where venture capital and private equity activity are increasing and more funders are willing to invest greater amounts at all stages of a company’s lifecycle.
Following are three compelling reasons why tech start-ups should invest in an audit.
Strengthen Your Negotiating Position
Early stage companies live and die by their funding, depending on cash infusions to staff up their engineering and sales ranks, build successful products, and work toward an exit. Investors look for businesses with attractive annual recurring revenue, a management team that knows how to build the company, and a strong potential for valuable ROI.
For a venture capital or private equity investor taking a minority stake, an audited financial statement lends a level of credibility that goes beyond what they’ll get by looking at bookings. For buy-out or a major strategic investor, the audited financial statement is typically the point of entry.
In fact, a company positioning itself for an acquisition or major investment may need three years of audited financials once the due diligence process comes around. If financial records aren’t accurate or in accordance with United States generally accepted accounting principles (GAAP), a company puts itself at risk for potentially significant adjustments arising during the suitor’s due diligence process. A company with audited financial statements tends to incur fewer issues related to accounting records and reported balances during diligence. A smoother and faster diligence process may also increase the likelihood of the close of funding.
Companies with audited financial statements can be in a position for better negotiations and stronger outcomes—while those without could face significant barriers to exit.
Assistance During Diligence
While not in scope for the standard audit engagement, a strong relationship with your auditor lends itself to another opportunity to assist management with investor inquiries of audited financial results during the diligence process. As a knowledgeable business consultant, an existing audit relationship can be leveraged into assisting management in responding to questions related to accounting positions and results during periods under audit. When institutional funds or large strategic investors need deeper explanations, it’s a good idea to have an experienced advisor on your side.
Identify Lagging Problems
An audit can also unearth issues in the business that can create problems in the future.
One area that often arises for emerging technology companies is a messy capitalization (cap) table. Often tech start-ups receive funding which they aren’t sure how to value and report. Through the review of subscription, warrant, option, and other such documents, auditors can assist management in evaluating the completeness of the cap table and the proper recognition of equity-based transactions in accordance with GAAP. Having an accurate cap table provides management with the confidence to present it to and discuss it with their investors and also can create confidence in a new investor seeking to fund the company.
Also, an audit could identify changes in revenue recognition from management’s internal records, that may impact valuation models and risks to an investor. With changing revenue recognition criteria on the horizon—effective for most private companies on January 1, 2019—the timing of how a tech company recognizes revenue from customer contracts could change significantly from current models. Having a business advisor on the company’s side is imperative to a smooth transaction.
Improve Your Business Outcomes
Conducting a financial audit isn’t the same thing as filing a tax return.
An experienced auditor can uncover what the company is doing in terms of financial results regarding booking and recognizing revenue or accounting for complex cap table transactions. While audits are historical in nature, they also provide future-focused benefits in the form of process and control improvements, which may allow management to manage the business more efficiently and effectively. Improving process and internal controls can help a company improve the reliability of financial statements and stakeholder confidence.
Audits aren’t for every company. But for growth companies planning to look fundamentally different three-to-five years down the road, or actively looking for long-term, large-scale financial partners, getting started on an audit early can attract the right investors, reduce risk, and position the company for strong negotiations and better valuations.
We’re Here to Help
For more information about whether an audit is right for your business or to get started with the process, contact your Moss Adams professional.