Three Tips to Avoid Fraud at Your Portfolio Companies

In light of the charges of fraud brought against the former president of VC-backed Canopy Financial in December, Jeff Bussgang of Flybridge Capital Partners has some thoughtful tips that VCs can use to try to prevent similar alleged improprieties at their portfolio companies. For those unfamiliar with the Canopy case, we have included a brief overview at the end of this column. –Ed.

A lot has been written in the past month about the scandal at Canopy Financial, a venture-backed, high-flying startup that more than $88 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 to 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 three things VC boards should do, and management teams should openly encourage:

1. Have an Active 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 sound 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. Make CFO Accountable to Board

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.”

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. Board members, particularly audit committee members, should go out of their way to interact directly with the CFO so that there is a comfort in communication. I don’t know the situation at Canopy, but an environment must be established to encourage whistle-blowing.

3. Conduct Some Board Meetings Sans CEO

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.

Additionally, if board members have the freedom to confer without the CEO in the room, it can 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 at Flybridge Capital Partners. 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.

Jeff Bussgang is a partner with Boston-based VC firm Flybridge Capital Partners. He may be reached at jeff@flybridge.com, and you can follow him on Twitter at www.twitter.com/bussgangRecap of Canopy Financial ScandalBy Deborah Gage and Lawrence Aragon, VCJ

The U.S. Attorney has charged former Canopy Financial President Jeremy Blackburn with wire fraud, which carries a maximum penalty of 20 years in prison, a $250,000 fine and mandatory restitution.

The criminal complaint claims that Blackburn allegedly diverted more than $2 million of a $60.5 million investment in Canopy by Spectrum Equity Investors last summer for “personal expenses and luxury items,” including an attempt to use a false bank statement to get a mortgage on a new home in Malibu.

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.”

Separately, the Securities and Exchange Commission has filed a civil enforcement action against Blackburn and Canopy, which has sought Chapter 11 bankruptcy protection.

Blackburn co-founded Canopy in 2004 with Vikram Kashyap, who has stepped down as the company’s CEO, and Anthony Banas, the company’s former chief technology officer. Neither Kashyap nor Banas has been charged in the case. Kashyap issued a statement through his attorney that he was unaware of the alleged fraud and would stay on as Canopy’s chairman.

Canopy makes software for financial institutions and health care companies to better manage health-related spending accounts. It raised a total of $88.5 million in venture capital over three rounds from GGV Capital, Foundation Capital and Spectrum Equity Investors, according to Thomson Reuters (publisher of VCJ).

As part of the round raised last summer from Spectrum Equity, Canopy agreed to provide audited financial statements and said that Blackburn and two other co-founders would sell up to 10% of their shares, according to the complaint. Blackburn sold shares for $1.6 million, while “Individual B” (which the complaint identifies as Canopy’s chief technology officer, but does not name) sold $975,000 worth of shares, the complaint alleges.

The complaint also alleges that Canopy provided a falsified audit to investors that it claimed had been done by accounting firm KPMG. KPMG never audited Canopy’s financials, but it did provide an SAS 70 audit and in March had e-mailed a sample of an independent audit and other documents to Canopy’s chief administrative officer, who forwarded the documents to Individual B, according to the complaint.

The complaint goes on to allege that in April Blackburn sent an e-mail to Individual B saying he would “ghost write a note for you to send to [Individual A] and I re: KPMG today. Remember you’re supposed to be spending time with them today…cool?” (The complaint identifies “Individual A” as Canopy’s CEO, but it does not name the individual.)

Authorities allege that on June 30 Blackburn e-mailed the falsified KPMG audit to Individual A with the subject line “Audit FINALLY Complete.” Individual A in turn forwarded the report to Spectrum Equity and the investment bank involved in the Series D financing, according to the complaint.

Individual B, meanwhile, sent the report to Ridgestone Bank, where he had an account ostensibly to hold HSA funds for a Canopy client, and sent falsified bank accounts to Spectrum, according to the complaint.