The Venture Investors Guide to Financial Due Diligence

Why is due diligence (DD) so important?

Financial due diligence (DD) is an investigative analysis of a company's finances. Although similar to an audit, there are a few differences. While an audit focuses on whether a company's financials comply with accounting and tax standards (such as GAAP or IFRS), due diligence is designed to determine whether the financial reality of a company matches the story an investor has been told.

The common factor for performing due diligence in almost all cases is a need for more transparency, with audit and DD failing to go to a granular enough level to discover issues. This is an important distinction because, in many high-profile private company meltdowns, investors relied on a company audit instead of their own financial due diligence. In other cases, financial DD was outsourced but ultimately still misinterpreted data and failed to spot those mistakes.

The implication of this is massive. According to research from the Association of Fraud Examiners, over US$1.8 trillion is lost annually due to financial statement fraud, with audits catching less than 4% of frauds. In many cases, fraud starts with a slight overstatement of earnings or concealment of costs. These mistakes often compound over time, leading to a continuous cycle of reporting inaccurate financial findings, inevitably leading companies to fundraise constantly to refill the monetary gap.

Businesses can now accurately present and keep track of their finances thanks to gini. This guide will show how gini's financial due diligence automation software can increase returns by dramatically reducing the time taken to analyze a private company. Our tool will also deliver insights and automatically monitor your entire portfolio's financial health.

How easy is it to overlook errors in data?

Even great financial analysts with decades of experience and a keen eye for possible mistakes are only required to identify the most complex, well-hidden, and sophisticated misrepresentations in financial statements. With gini, doing financial due diligence is easy for any investment professional.

Our analytics go down to the journal level and include several indicators that can alert you to suspicious activity - including Benford's Law. The data provided by our analytics are not solely aggregated by month. Therefore it's also easy to identify common patterns of misstatement, including abnormal numbers of transactions being booked at the end of a month.

Furthermore, our expert team offers guidance, support, and insight based on the 300+ companies analyzed using gini software. Gini also provides technical training on accounting and financial analysis for those unfamiliar with some of the more nuanced issues that can be identified with our app.

Companies hire auditors, and although they have fiduciary responsibilities, they often need to be compensated and motivated to do their job. Statistically, audits only uncover 4% of financial frauds and, in many cases, are outdated from a financier's perspective. Also, the audit practice is almost entirely manual and error-prone - with many processes delegated to junior auditors to make it cost-effective.

A more thorough examination of finances is necessary, especially for attracting experienced investors. Gini makes it easy to supplement audited financials with live, granular data. Unlike audited statements, we don't just show you the aggregate totals every month and expect you to trust the auditor's opinion. Instead, we allow you to drill down to the transaction level, using your knowledge of the industry and the company to analyze if the company's transactions match what you expected.

Despite investors having the right to more information, many equity investors are hesitant to ask for detailed disclosure of financials. Although these occurrences are frequent, lenders, such as Wayflyer and Clearbanc, have demonstrated that companies are often very willing to connect accounting platforms to access financing.

As revenue based financing becomes more common, founders have gotten used to linking bank accounts, accounting systems, and payment systems to streamline underwriting. Since many investors, particularly lead investors, have information rights, it is reasonable to demand the same information that a lender is given.

Common misconceptions investors make

"Financials are not important to us at this stage- we invest in founders and visions."

A common misconception investors need to be aware of is placing all their emphasis on the founders' personality and the vision of the said company they wish to invest in.

Unfortunately, in reality, financial fraud is usually common. It often forces investors to keep quiet about malpractice. Financial fraud starts with something small with a plan to fix for the next month, only to compound into something severe and uncontrollable. Furthermore, from working with investors, gini's team of experts has found that fraud is concentrated in the best-performing part of the portfolio, making it even more damaging when calculating accurate returns.

"I'm not the lead investor, so it's not my responsibility."

Everyone should be a responsible steward of LP capital, and non-lead investors are no different. Nobody ever complained about being mis-sold an investment that went up, and poor underwriting process is often a key focus of litigation when things go wrong. Showing that you have detailed financials on file, and investing in technology and process, is a small price to pay to show you have a thorough and diligent process.

"I've hired a big accounting/consulting company to do it for us."

This is great - their work perfectly complements the analytics, similar to what gini provides. A big four accounting company tends to offer buy-side due diligence based on an analysis of the company's existing financial statements and is looking to use trends and ratios to determine the company's strength. However, gini looks at every single transaction and uses an algorithmic approach to detect red flags.

Furthermore, buy-side DD is conducted only at the inception of a transaction, whereas gini provides ongoing analysis and reporting.

Refine your due diligence with gini

Implementing gini for your future portfolio investments

Performing due diligence is easy with gini. The quickest way to incorporate our software is to input the closing condition of your execution deal documents.

Tailoring your final closing conditions with the closing legal team to best suit the purpose of the transaction is essential. Here are some of the closing conditions for reporting access, along with integration requirements:

  • The company shall ensure that all financial records are kept up-to-date monthly (a maximum of one month in arrears) unless agreed otherwise.
  • The company agrees to enter into a service agreement with gini (the form of which is attached here as Annex A) and shall pay all related service charges.
  • The company shall provide continued and uninterrupted access to its Accounting Software to gini and ensure that the integration between the relevant Accounting Software is not terminated before a Liquidity Event.
  • The company gives gini irrevocable permission to share all relevant information collected through its Accounting Software with the Investor.

Implementing gini for current portfolio investments

Although gini is not merely seen as a closing condition, there is a sales process investors can benefit from by getting founders to feel comfortable sharing their data. To yield the best results, transparently communicating an investor's responsibilities to their LPs and emphasizing that this is to automate processes is crucial.

The email sample below is an example of what you can send to your portfolio companies:

"Dear XYZ

As you are probably aware, there have been many high-profile cases of financial fraud in the startup ecosystem, and LPs emphasize ensuring that due diligence and financial reporting processes are rigorous.

To continue to deploy capital to support our portfolio without putting an undue administrative burden on founders, we're working with a service provider who can automate some of the checks our LPs require. These include:

1) Running standard anti-fraud check
2) Automating monthly financial reporting
3) Help us estimate the runway so we can ensure we have enough capital to support you

Complying with this is very straightforward, and we're expecting this to become standard practice across investors as the market adjusts.

Getting onboarded shouldn't take more than 1-2 minutes if you follow the steps outlined here: (insert your personalized gini link) and the gini team (cc'd) is on hand to help with any barriers you may face."

Analyze finances with gini

Our team of experts will ensure you have all you need to get started with gini software. With our onboarding process, you will know the step-by-step guide on analyzing your financial information once the first portfolio companies have shared their data with you to maximize your potential investment with gini. Additionally, we also offer continual training and a set of experienced professionals who can review any company of your choice.

Gini's co-investment

Gini is partnered with Pershing Ventures, a specialist investor with experienced credit professionals. While most venture investors are experts at predicting which companies maximize their potential, Pershing Ventures analyzes companies based on their survivability.

As capital becomes scarce and investors increasingly emphasize the business plan that positions a company as "default alive," Pershing Ventures are willing to share its due diligence work with investors it co-invests with and bear the cost of the gini software package.

This is particularly suitable for investors who want to have an alignment of interest from an experienced investor with extensive skills and experience in financial due diligence.

Cash Flow Forecasting Xero
Ray Wyand, CEO of gini
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The Venture Investors Guide to Financial Due Diligence
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