Three ways to prevent executive fraud

(Editor’s note: Jeff Bussgang is a General Partner at Flybridge Capital Partners. This column originally appeared on his blog Seeing Both Sides.)

A lot has been written in the last few weeks about the scandal at Canopy Financial, a venture-backed, high-flying start-up that attracted over $100 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 and 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.

Additionally, those on the board (particularly audit committee members), should go out of their way to interact directly with the CFO so that there is a comfort in communication.  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.

If board members have the freedom to confer without the CEO in the room, it can also 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.