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December 03, 2009

Trust, But Verify

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A lot has been written in the last week about the scandal at Canopy Financial, a venture-backed, high-flying start-up that attracted $75 million in capital at increasingly higher prices from top-tier firms, only to come crashing down in a dust of rubble and fraud.  The VC community suffered a very similar scandal at Seattle-based Entellium last year, but few reporters seem to remember that one, perhaps because it wasn't located in the heart of Silicon Valley as Canopy was.


Many of the VCs I’ve spoken to are frankly not surprised that these kinds of fraudulent schemes could have occurred.  In truth, our industry is built on a trust model.  We do our best to conduct due diligence on the team, market, strategy, technology, but at the end of the day many of these investment decisions get made in short periods of time (30-60 days) with incomplete information, particularly when a deal is competitive.  Bandwidth-limited general partners and frenetic CEOs are under pressure to move fast and get things done, leading to rushed, sloppy work to secure the deals.


Perhaps the Canopy Financial case study will finally force VCs into an approach akin to Ronald Reagan’s “Trust, But Verify” policy when it came to dealing with the Soviets during the Cold War.  Prudence wins out over blind trust.


Here are a few specific examples of things VC boards should do, and management teams should openly encourage:

1)    Audit Committee.  Many VC-backed companies don’t do audits until a certain point of maturity to avoid costs and distractions, but certainly a company reporting more than $10 million in revenue should have formal audits.  Further, the audit committee should meet with auditors on an annual basis without management in the room.  This helps ensure that the necessary controls and independence are in place to catch any funny business.  I don’t know what happened at Canopy, and reports that the SEC has accused them of falsification of audit statements sounds extraordinary, but in any event the KPMG senior auditors should have been meeting directly with the audit committee board members, without management present, to sniff out any improprieties.

2)    Role of the CFO.  More than any other management team member, the CFO or VP of Finance must feel accountable to the board directly.  Many CEOs are sensitive to their management team interacting directly with their board.  Board members often view this behavior with suspicion as a sign of an insecure CEO who has something to hide.  This shielding of communication must not be allowed, particularly in the finance function.  CFOs should be interviewed by board members and hired with an acknowledgement that they have an explicit duty of loyalty to the shareholders that requires them to be in direct communication with the board members.  Board members, particularly audit committee members, should go out of their way to interact directly with the CFO so that there is a comfort in communication.  I don’t know the situation at Canopy, but an environment must be established to encourage whistle-blowing.

3)    Board only session.  Too few boards meet, confer and operate as a working unit without the CEO.  Meeting in board-only sessions without the management team allows for a more robust discussion on some of the most important issues a board needs to deal with – including CEO performance, compensation, and general alignment of feedback on strategy and operations.  Additionally, if board members have the freedom to confer without the CEO in the room, it can lead to sharing observations about suspicious behavior that may allow joint problem-solving rather than information silos that may lead board members to conclude everything is fine and their particular observation or concern is an outlier.


These three measures are a few I’ve tried to implement throughout our portfolio.  I’m sure others out there can come up with more.  The subtle point is that CEOs need to get out in front of this rather than have their board impose these things on them in a forced fashion.  Like on many critical issues, CEOs need to be ahead of their boards and leading them towards good governance, not dragging along behind them.


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Couldn't agree more with your recommendations and the philosophy of "Trust but verify." Great companies, startups or otherwise have exactly that type of leadership.

What doesn't make sense to me is your last point that, "CEOs need to get out in front of this rather than have their board impose these things on them in a forced fashion." It would seem that the "CEO being out in front of the board" is exactly was caused the Canopy, Entellium and other frauds. It needs to be the board that is "out in front." Perhaps you meant to say Chairman (since in most startups they are the same person) but not the CEO, right? Having the CEO (management) be leading the anti-fraud efforts (of management) seems to be recommending a lack of check and balances.

Good clarification, Furqan. I mean that the CEO needs to encourage the board to step up to their responsibilities and duties rather than make it uncomfortable for them to, say, meet with the CFO seperately.

Makes a lot of sense. CEOs also need to be proactive about hiring CFOs. I was surprised to see that almost half of tech startups with up to 3 rounds of VC funding don't even have a CFO.


I was formerly part of a well funded startup which went bankrupt due to CEO's misconduct. I can tell you from first hand that your suggestion is worthless. Most CEO are hire by VC (from their own network of friends) in startups. VC do not like to admit they screw up in selecting the CEO. Most boards are typically make up of members of VC firms. The board like to hide their mistake rather than take action and hurt their reprutation. Most VC are elitist, so they believe they are smarter than than everyone else. As con artist will tell you, such attitude makes perfect target for a con because people who think they are smarter do a better job at CONvincing themself that their decision is never wrong. If Microsoft had VC invest in the early startup days, the VC board would have put a CEO with a HBS degree (not dropout like Bill Gate) and a PHd from MIT as CTO in the running of the company. VC board are more interested in jazzing up the image of the investment. You see the purpose of the board is to oversee the management for the good of the company, but VC board will oversee for the good of their reputation first before worring about the long term good of the company (VC will exit in less than 5 yrs). The best VC board member I ever met was an arrogant jerk, he challenge every decisions. His introductory to other VC on the board was very interesting. He basically told them that he is here to ensure we make money for the company and not here to make friends (with other VCs). He once told me that VC who acts nice are the one I should avoid, because they are more interested in networking and making contact than doing the right thing. I hope I am not hitting too close to home.

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