This last couple of weeks I’ve been working on a due diligence team looking at a potential investment. As the only accountant on the team it can get pretty lonely.

In September Noam Scheiber of the New Republic published an interesting article on how due diligence really works for a great many early stage investors.

Noam Scheiber article

According to Mr. Scheiber, Seth Bannon was in his late 20s, had the requisite beard…and raised $3 million for his startup from Y Combinator and a number of angel investors. Somehow – when no-one was looking, he managed to rack up liabilities for $500,000 in unpaid employee source deductions, $100,000 in legal fees and a $90,000 penalty to the IRS.

Seth Bannon with requisite beard
Seth Bannon with requisite beard

For the most part my colleagues don’t get the idea of financial due diligence. First, they don’t seem to think there is any point in getting financial statements reviewed by a professional accountant. A good deal of the information investors should be looking at is contained in a properly prepared set of financial statements.

Even if you’re going to end up valuing the IP, and ignoring the operations for the most part, it is comforting to know that someone has done some work to substantiate assets and liabilities – so investors aren’t later ambushed by undisclosed liabilities or option agreements that might put the corporation’s status as a CCPC or an eligible business corporation at risk.

The last 2 companies I’ve looked at have had financial statements prepared by the same firm of public “accountants”. In spite of a fairly complex (for a startup) capital structure, neither company had even prepared notes to the financial statements. As a professional, I typically find as much of interest in the notes as I do in the financials.

In both cases there were operations in 2 or more countries and the accountant was really a bookkeeper with little or no training in accounting. Admittedly he is a university graduate and has a Phd from Cambridge in something or other – if his website can be believed.

My point is, if I am performing due diligence on an early stage company I don’t really have time to perform due diligence on the financial statements as well.