Many venture firms conduct annual audits of their funds. If you’re a first-time fund manager, you might be getting ready to undergo your very first fund audit. To prepare, you’ll want to know how the process will unfold, including the timeline, what auditors look for, and what documents you’ll need. It’s also helpful to have an understanding of why audits are conducted in the first place.
The purpose of a VC fund audit
The main purpose of a fund audit is to confirm that the fund’s general partners (GPs) are operating in accordance with the fund’s limited partnership agreement (LPA), and that the fund’s financials reflect this compliance. A clean audit is one that doesn’t turn up any surprises: It reassures the fund’s limited partners (LPs) that the GPs are managing the fund as agreed.
A second purpose of an audit is to confirm the fund’s valuations of its portfolio companies, as well as the fund’s ownership position in them. Limited partners evaluate fund managers on the strength of their returns—but venture funds don’t typically generate returns until one or more of their portfolio companies is acquired or goes public. In the absence of such revenue, VCs instead report the estimated value of their fund assets to their LPs. An audit assures your fund’s investors that a neutral, third-party accounting firm has confirmed not only the fund’s financial statements, but also its assessment of its own success.
When are audits necessary?
Most venture funds go through audits either because it’s required by law or because at least one LP requires it as a condition of their investment.
Audits required by law
The U.S. Securities and Exchange Commission (SEC) is a government agency that regulates the venture capital sector. U.S. securities law requires people or firms that manage money for other people to register as investment advisers. However, the SEC’s definition of venture capital funds exempts certain VC firms from registering. This exemption lets them skip some regulatory procedures required of registered investment advisers, including audits. If a fund no longer meets the criteria for exemption, the entity managing it—usually the fund’s management company—must register as an investment adviser and begin conducting regular audits. The SEC also requires that any fund formed by a registered investment adviser (RIA) conduct an annual audit. Your firm’s legal counsel can help you determine whether your firm is exempt from registering with the SEC as an investment adviser.
Audits required by investors
Many venture fund LPs are institutional investors that manage money on behalf of organizations and groups, like foundations, public pensions, and health care systems. These LPs want fund audits for two reasons: First, they’re typically pretty conservative investors. Audits can bring greater transparency to riskier private assets. Second, because they answer to their own management boards, institutional LPs need to be sure that GPs are executing on the investment strategy that they signed up for. Regular, required audits are a way for LPs to show fiduciary responsibility to the groups whose money they manage.
Do you need an audit?
First-time funds without institutional LPs often decide to forgo the expense of an audit when they aren’t required by law to conduct one. Exempt funds in their earliest stages, such as those in their first or second year of investment, may also skip the process, so long as none of their LPs have required one.
However, annual audits are increasingly common across the VC ecosystem. Even when they’re not required to audit, fund managers often conduct one anyway—especially if their firm is looking to create a new fund. That’s because audited financials show current and prospective future investors that your accounting, valuations, and controls are in order. Larger, more prestigious investors use audited financials to perform in-depth due diligence on firms they’re thinking about working with—so VCs will sometimes start auditing their previously unaudited, exempt funds when they’re raising their first institutionally backed funds.
The timeline for venture fund audits
- July/August: For funds whose fiscal year ends on December 31, audits generally begin in January and occur on an annual cycle. As a fund manager, you’ll need to start evaluating prospective auditing firms in July or August if you want to have your fund audited in January.
- Start of Q3: Ideally, you’ll contract an auditing firm by the start of Q3. Your auditor’s interim testing will typically begin in the third quarter. This is a preparatory phase of the audit cycle, when auditors begin reviewing your fund’s cash-related events—things like capital calls, distributions, and investment purchases and sales. Interim testing gives your auditor a head start on making sure your financial reports can be issued on time.
- During Q3: During Q3, your auditors will also send a “provided by client” (PBC) list, which itemizes the documentation you’ll need to send them. As the GP of the fund, it’s your job to assemble and prepare these documents for your auditor’s inspection. This might sound simple, but it can become a serious burden for fund managers who lack the support of a fund administrator.
- Q4: Investment valuations are tested closer to the end of the year, because the fair value of your investments should be dated December 31 if your fund follows the calendar year.
- Q1: Audits usually begin in January.
What do auditors look for?
To evaluate your fund’s compliance with its LPA, auditors examine its documentation and records. They look at invoices to make sure you’re only charging your LPs for permitted expenses. They also confirm that bank balances, transactions, management fees, capital calls, and distributions are all accurately recorded.
Auditors also confirm that a fund’s ownership positions in its portfolio companies match those companies’ records—in other words, that you have invested what you say you did. To do this, you’ll need to provide updated cap tables from each of the fund’s portfolio companies. After confirming ownership, auditors then look at how the fund calculated each portfolio company’s valuation. This can reveal misleading or inaccurate representations of a fund’s performance, or incorrect calculations of its portfolio company holdings.
Auditors follow U.S. generally accepted accounting principles (GAAP) or the international financial reporting standards to value investments. These guidelines create consistency for how assets are valued across the VC industry. However, since the guidelines permit some flexibility, VC firms benefit from having a clear valuations policy that outlines to auditors how they value their assets.
You and your auditor might disagree about the approach you took for establishing the valuations of some of your assets. That’s because there are several different methods VCs use to establish company valuations. One common method calculates the fair value of investment holdings according to the company’s most recent primary financing, while other methods do so through comparisons to recent IPOs or acquisitions of similar companies, or through more complex formulas that account for investor liquidation preferences. Depending on the type and stage of the investments in your portfolio, your auditors may prefer a different valuation model than the one you used.
What auditors will need
Documents auditors need from your fund include:
- Fund formation documents, including the LPA
- The fund’s operating agreement and partner agreements
- LP subscription documents and side letters
- EIN letter
- Article of incorporation
- Statement of assets, liabilities, and partner’s capital
- Statement of changes to partners’ capital
- Bank account and brokerage account statements
- Schedule of portfolio investments
- Service agreements with third parties
- Expense invoices, including those for the fund’s auditor, tax provider, fund administrator, and other outsourced professional services
- Statement of cash flows, i.e., a record of all money movement into and out of the fund, including investment fundings, investor capital calls and distributions, carried interest, and expense payments.
Auditors will use these documents to validate that all transactions have occurred and that your accounting books are accurate.
Portfolio company documents
Documents auditors need to evaluate portfolio investments include:
- A spreadsheet of contacts for each portfolio company, including their name and email address
- Updated portfolio company cap tables
- Most recent financials for each portfolio company, dated as close to year-end as possible
- Financing documents related to the most recent round of financing for each portfolio company
- Balance sheets
- Revenue reports
Throughout the audit, your auditors will continue to request any information and documentation they think will help them gain insight into a portfolio company’s finances and stress-test the fund’s own ASC 820 valuation of its interest in the portfolio company.
How Carta helps you through audit process
Providing all this evidence of fund and portfolio company performance can be a huge time suck for GPs. If your fund is administered by Carta, we can simplify the process, and help save you time and stay efficient.
Working with the audit team
Carta coordinates with the fund and audit teams to make sure everyone is on the same page about document delivery timelines. Our team works with you to fulfill open items on the PBC list and prepares investment and investor confirmation letters as needed.
Carta’s software lets you add groupings to your statement of investments, among other detailed information you may wish to include in your audit documentation. The Carta fund administration team can generate your fund’s annotated quarterly financials with just a few clicks. Carta also provides your audit team with access to your fund’s general ledger, and is the first point of contact for any additional support your auditor needs.
Coordinating with portfolio companies
To keep you ready for client audits, your fund can use Carta’s investor services platform to collect updated portfolio company financials. If you have portfolio companies that use Carta for cap table management, they can authorize permission for you and your designated Carta fund administrator to access their cap tables and other financial information, to make the process even smoother.
Secure document sharing
Carta fund admin software also creates connectivity in your fund’s general ledger: Auditors can click on a number in the ledger and trace the figure back to its original source. This in-app document trail allows auditors to self-serve the documents they need, without having to request and receive them over email or a cloud server. Features like these help to minimize the number of documents you need to find, update, and send to your auditors. They also provide greater information security by reducing the amount of sensitive information you need to send by email or cloud server. This increases information security while giving auditors independent and convenient access to documents whenever they need them.
To learn more about how Carta can help your fund conduct smooth fund audits, contact your fund administrator. If you’re new to Carta, get in touch with the fund admin team.