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Call it the Arthur Andersen effect. The spate of corporate accounting scandals has forced venture investors to tighten scrutiny of their portfolio companies. “Venture capitalists got burned the past few years by taking a lot of stuff on faith, whether it was business strategy or financial statements, but now they’re more focused on accounting issues as they relate to their exit strategy,” said Michael Littenberg, a corporate partner at New York’s Schulte Roth & Zabel. The financial skullduggery has prompted investors to overhaul attitudes toward accounting. The changes — from accounting due diligence to tougher audit procedures — represent a return to more conservative practices, said lawyers and venture capitalists. Even before the recent scandals at Enron Corp., Andersen and WorldCom, the pendulum was swinging toward caution, following a dot-com frenzy that produced many failures and a weak IPO market. Now, with billions in venture capital sidelined, accounting may slow the process even more and make it more costly. “I think it will affect the overall market in that uncertainty, and the corresponding risk premium that needs to be built in when companies are due to go public, have risen,” said Joseph Carcello, a professor of accounting at the University of Tennessee’s College of Business and vice chairman of the auditing standards committee for the American Accounting Association. Carcello said investors will demand a higher return to compensate for additional “information risk” and for the time and expense of more comprehensive audits, he said. Littenberg said venture capitalists have come to him with a larger number of accounting issues in the past three months. In some cases, they are setting strategies for companies preparing to go public. In others, they are buying or selling companies that need accounting due diligence. Except for large or later-stage investments, VCs historically rarely consulted their own accountant or an independent auditor to take on the target company’s finances. “The presumption has been that a company’s outside accountant is careful and has done everything correctly,” Littenberg said. Now, VCs are realizing that “just because there’s an outside auditor doesn’t necessarily mean that outside auditor is right,” he added. For many private companies, the bulk of the concern is over revenue recognition, an abused area in the Internet boom years, said Murray Alter, a New York-based tax partner at PricewaterhouseCoopers. Many private software companies attempted to lure more VC money by inflating revenue, he said. One method in which income is recycled to appear as income involves listing software licensing payments as revenue and then investing an equivalent amount in the customer. At New York’s Rho Ventures, which manages more than $1 billion, changes related to accounting started about a year ago when the Financial Accounting Standards Board came out with tightened requirements on audit committees for public companies. Although not required by the Securities and Exchange Commission, late-stage companies also have an audit committee usually headed by an independent outside board member. Venture capitalists who sit on a company’s board have traditionally paid little attention to the audit committee and avoided taking an active role due to liability concerns. Lately, the reverse has been true, as better qualified members, particularly with strong financial backgrounds, are picked to manage the committee. “Auditors have woken up to the fact that their client is the company and that they damn well better be fully accountable and independent,” said Mark Leschly, a managing partner at Rho Ventures. “You can’t dismiss the audit committee anymore.” He said audit committees are meeting more frequently — quarterly instead of annually — and are communicating far more with investors and executives. Wellesley, Mass.-based Battery Ventures, which manages more than $1.8 billion, has also intensified communication with its portfolio companies’ accountants. When Andersen came under investigation, Battery reviewed all its companies for an Andersen link. “We asked each of the companies to determine whether or not to keep Andersen, and many opted to change,” said Anthony Abate, a Battery general partner. Following the WorldCom mess, Battery is giving particular scrutiny to its telecom investments to ensure the companies follow generally accepted accounting procedures, or GAAP, in letter and in spirit, Abate said. Those rules leave room for interpretation, he pointed out. “Two or three years ago, the rule was, as long as you’re within GAAP, you’re fine,” he said. “Today, you’ve got to be even more conservative than GAAP.” Abate said his firm has disciplined itself to manage its private investments as if they were public companies. “We have to assume that they will go public at some point, so they don’t have to change their corporate ethics when they do,” he said. Most agreed that fraud among startups has been rare, mainly because early-stage companies don’t have much money to begin with. But Harry Edelson, founder of Edelson Technology Partners of Woodcliff Lake, N.J., disagreed, saying that one in 10 of his portfolio companies have had CEOs “who are crooks.” “Very often, you’re thousands of miles away, there’s no SEC looking over the company’s shoulders and sometimes there’s no auditor or the company employs a small accounting firm,” he said. “So you’ve just got to step up the scrutiny.” Copyright �2002 TDD, LLC. All rights reserved.

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