Okay, I’ll say it. Something stinks here, and it’s not just the smell of cooked books at Entellium. The incredibly simple scandal over there is sending shockwaves through the Seattle startup community. How did this happen? What does this mean for the rest of us?
Here’s how it happened: 1) People lied. 2) Nobody checked up on them. Easy as pie.
Now, I’m new to this startup thing, I have always admitted that. So I was shocked that this could have happened. I mean, this scam was not a complicated one – as far as I can tell from the charging documents, there were no complicated offshore accounts, no elaborate shell companies to hide funds, nothing like that. There was stated revenue that was GROSSLY out of line with actual revenue. That’s all. Just simple lies.
Simple lies should be fairly simple to uncover. So I asked what I thought was a simple question on the STS list. Didn’t anyone check?
Bill Bryant was quick with an answer:
“A Board would never "check bank statements"; they rely instead on management reporting. Investors have information rights but these generally only extend to "financial statements" (which is management's representation of the underlying contracts, bills, bank statements and the like) and not to the source documents themselves.
I've been in several hundred board meetings over the past nearly 20 years and not once has a Board ever had access to, or reviewed, bank statements or similar source documents. At the end of the day, an investment in a firm is predicated on trust & integrity.”
I’m sorry, that’s kind of silly. As I told Bill, I’d love to live in the world of “trust & integrity” when it comes to business and financial practices, but, I dunno, I’ve been watching the news lately, and that doesn’t seem to be working out very well for any of us.
In response to Bill’s comment, Pascal Stolz pointed out:
“I would offer that a Board has a general common sense approach to the situation in a business and there are things that flat out would come out as an outlier:
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Why a company with a “reported” revenue of $5M needs to raise money? The answer is simple, there is a shortfall of $4.5M…
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As reported to the Board (to justify the short fall) the cash burn reported is such that user/customer acquisition costs would be completely out of whack.
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Hence, someone would ask the question: how do we reduce that cost.
It should not take 4 years to figure out…”
Apparently Brian Myers agrees with Pascal:
“With the claimed revenues being so far above actual, simply checking the bank statements would raise huge red flags. (2006: $580k actual vs claimed $4 million) It wouldn’t take a full audit to discover this; even an internal controls review would reveal the red flags.”
Needless to say, conversation quickly turned to independent oversights & audits. That is a scary thought to many, mostly just because of the cost. A thorough audit can be expensive – 10’s of thousands of dollars.
But popular opinion seems to be that such an audit wouldn’t be required unless a company had revenues of $1M or so and was raising cash for growth. (Had to laugh when Bill Bryant said that until that point, the only thing to look at on the books are expenses. Truer words were never spoken.)
Typically, the cost of such an audit would fall on the company seeking funding, and that can sound like a lot of cash. But let’s put it in perspective. Entellium raised over $50 Million, an audit was likely to cost about $40 thousand. Audit costs relative to capital – seems like a good investment to me. Especially if it keeps you out of jail.
Or, you could look at the cost of the audit relative to the cost of YOUR investment as a VC. Is the audit cost worth it? I dunno. There were millions of dollars lost, that buys a lot of accounting services. It doesn't seem like a lot of money to spend in order to avoid losing a whole lot more money.
It really just kind of irks me, on a lot of levels.
First of all, lying just plain mean and stupid. I know that isn’t exactly profound, but the truth is exactly that simple. Don’t do it, it’s wrong.
It’s easy to say, “hey, what’s the big deal, they got what’s coming to them.” Well, here’s the big deal. I can name at least a dozen really good startups in Seattle right now, with ethical partners, solid business plans, honest (if not impressive) books, who could really use investment to grow successful companies the slow, steady and honest way. That $50M that was swindled out of investors could have been invested in good companies.
Whatever, the honest amongst us will keep being honest. (And there are FAR MORE of us out there who are honest, we just don’t make the news.)
Brian Myers has some great advice about what we, as entrepreneurs, can all be doing:
“Executives already know the need to build trust by providing transparency and verification. The lesson, or opportunity, for startup executives is to take that to heart.
I’ll use an example other than financial. In every investment the VC asks whether the company has non-disclosure agreements and invention assignment agreements with all the employees and contractors. Every exec team should know the question is coming. The best answer is, 'absolutely, here is a three-ring binder with copies of every one of them.' Contrast the confidence that answer instills with 'well, we think so, but maybe not all. We gotta check and get back to you next week.' Excellence = confidence and trust = higher valuation and higher exec team compensation.”
Good call, Brian. There is just no excuse here. Not on behalf of the liars, and not on behalf of the investors. This shouldn’t have happened.
And on that note, I’ll give David Gellar the last word:
“No excuse on the accounting mess there. Clearly people in accounting would have known. And, again, a firm as small as Entellium simply wasn't sophisticated enough from a breadth of products and sales model perspective to be overly complex.
The Ignition partners should be very embarrassed and probably fired.”