What Does an Annual Fund Audit and Tax Reporting Look like for a VC fund?
A brief case study with tactical steps that Graph Advisors took to support a client's annual fund audit and tax reporting needs.
We work with clients of all sizes, mainly VC firms with up to $250,000,000 in AUM. We provide Fractional CFO/COO services allowing GPs to devote as much time as possible to sourcing investments, winning allocation, and raising capital.
One area we provide considerable leverage is in the Q1 sprint to complete annual audit and tax reporting requirements. Below we outline the tactical steps and takeaways from a client and how they benefit from working with Graph Advisors.
Client Overview
Client Fund Size: $40,000,000
Number of Investments: ~25
Audit Deadline per LPA: 120 Days
K-1 Target: 90 Days
Fund Admin: Carta
Considerations:
GPs want more time sourcing, investing, supporting portfolio companies, and engaging LPs
Not a core competency of the GPs and no team member to delegate the management of these projects
Time intensive to coordinate the different audit and tax service providers
Budget consciousness for a $40m AUM Fund
Solution: Work with Graph Advisors
Delivered a Schedule of Investments (SOI) in days instead of months
Worked with fund admin (in this case Carta) to ensure accurate statements
Developed a portfolio tracking system across Q4 to support valuation exercise
Served as point of conduct with audit firm to remain on schedule, delivering on follow-up requests and advising GPs on process and outlook
Managed preparation of tax filings by tax firm (separate from audit) to meet 3/31 internal target for K-1 distribution
If anything below sounds familiar, we should work together
You want someone else manage your annual audit and tax reporting so you have more time to do what you do best — invest
You do not have an in house CFO overseeing and directing the projects
You do not have a GP with experience in fund ops and back office management
Reach out to work with us: www.graphadvisors.com
Detailed Review of Project Components
One of the biggest Q1 priorities for any fund is annual audit and tax reporting. For large funds with ample fees to support in-house tax and accounting professionals, this process is overseen by the GPs but the day-to-day is largely managed by staff. For funds that are not yet large enough to yield fees sufficient for hiring this talent, the GPs are left with few options:
Allocate time each week to drive the process, follow up on requests, track down documents, upload materials to shared folders, coordinate with fund admin.
Delegate the project to a fractional service like Graph Advisors and oversee the process to ensure all deliverables are correct but leave day-to-day to the provider.
The reality is that all funds have some level of annual reporting that must be completed. But every hour that GPs allocate to this “beta” process is an hour not focused on generating “alpha.” It’s important for funds to be clear-eyed about the trade they are making with GP time, and this overview is meant to describe the different components of the annual fund reporting process and support GPs in reflecting on their funds’ approach and where it can be improved.
Of course, if Graph Advisors can be helpful, please contact us at hello@graphadvisors.com, and we’ll set up a brief introduction to listen to what you’re working through and where an extra set of hands can give you the most leverage.
SOI and Valuations
We ended 2023 with a free template and post sharing an End of Year Checklist for funds to work through to make the 2024 reporting process as efficient as possible.
One of the most important components of the annual reporting process is the Schedule of Investments (SOI). This is a list of all the investments in the fund’s portfolio, their current status (active, impaired, dissolved, exited), the cost of the investment, and the current valuation (it can also include things like stage, sector, country of operations, etc., but the primary data points are cost and current value).
Depending on the size of the portfolio, ensuring the SOI is up-to-date and accurate can take time.
The goal is for the unaudited annual financial statements that your fund admin sends to your auditors to be 100% accurate as of December 31.
Why?
Because the valuation of the individual portfolio companies is the key driver in determining the fund’s assets and calculating the funds rate of return.
You’ll want to have confidence in the valuations of your portfolio companies and be prepared to justify those valuations with the documents confirming any recent changes (up round or down round). Additionally, if the company has not had a financing event in the past 12 months, you’ll look to its financial performance relative to market benchmarks to determine if a change in valuation is warranted.
Note: the expectation is that these valuation reviews and updates are completed prior to your auditors receiving the annual financial statement. The auditors are reviewing your work; not doing your work for you.
Fund Financials
Along with the SOI, the fund financials will details funds remaining assets and any liabilities. So, your fund admin will report on expenses (including management fees), capital calls receivable, interest on cash, line of credit, etc.
Because the business of the fund is rather straightforward, the balance sheet and cash flow summary shouldn’t be that complicated, assuming the fund has kept up some basic bookkeeping and quarterly reconciliation processes throughout the year.
Two areas to double-check here:
Management fees — were all management fees paid according to the calculation and timeline articulated by the LPA?
Was the fee calculated correctly based on any LPs who have special economics — including the GP?
Capital calls — are all partners funding capital calls on the same schedule. For LPs who joined the partnership later and may have missed previous capital calls, is their account showing a payable such that the fund can book this balance as a receivable? We find that the “catch up” contributions for this group of LPs can often be missed so it’s worth double-checking.
Portfolio Sampling
Once the annual financials statements are prepared and reviewed, they are submitted to the audit firm. This is where the auditors are doing their work — essentially looking for evidence that everything in the financial statement is accurate and reported correctly.
So, they will:
want confirmation of end of year cash balance directly from your bank
will look for invoices and receipts for expenses that have been charged
will review the LPA and recalculate the management fee to confirm accuracy
ask questions about “material” events subsequent to 12/31 that will need to be reported
finally — importantly — look to confirm the valuations the fund has determined for each portfolio company.
This last point is referred to as portfolio sampling. They will select a meaningful sample of companies from the SOI and request information from those portfolio companies. For any portfolio company whose valuation is greater than 5% of the fund’s total assets, they will likewise request information.
The questions they will ask basically boil down to:
Have you raised capital in the past 12 months
If not, has there been any material change in your business that has caused you to change the valuation of your company (i.e. significant change in revenue, CEO transition, pivot to new market, technology, sector, litigation, debt, etc.)
What was your annual revenue?
What is your projected revenue for the upcoming 12 months?
In addition to this direct outreach, the audit firm will likely conduct a review of publicly available information for the sample. They might review the company pages on LinkedIn and question any updates to CEO leadership. They will also search Pitchbook and Crunchbase to determine if there are any financing rounds that have occurred beyond what is reported in the fund’s annual financials. Given that these platforms are not often accurate or up-to-date, expect to receive a few questions based on the information that will require additional confirmation on your part — either through sharing more recent company investor updates or through a direct verification with the founder.
Here are a few possible outcomes from sampling:
The audit firm’s findings align with your annual financials. No further action required.
The audit firm finds information that is different than what is reported in the annual financials.
If what they find is correct, then the focus becomes on materiality:
The findings are immaterial (i.e. they don’t change the financials statement in any meaningful way).
The findings are material
In both cases, the audit firm may expand the sampling exercise to examine even more information to determine if their finding was a one-off exception or if the finding is representative of a more systemic problem in the firm’s approach to financial reporting
Expanding the sampling can add weeks to the audit process and may lead the fund to miss a key reporting deadline.
Thankfully, in our work with this client, there were no concerns identified through the sampling activity given the steps we took to prepare accurate financials across Q4.
A bad outcome is that the auditors find that the financials are materially incorrect — this would then be reported in the audit letter and would likely raise significant concerns and questions among your LP base.
Controls and Compliance
In addition to reviewing the final product of the fund’s financial workflows, the auditors will also look for evidence of adequate controls and compliance to ethical standards.
Controls
This is fairly straightforward: who in the firm is authorized to make and confirm all financial decisions, and is there evidence supporting that each financial decision was made and/or knowingly approved by the control person. For a small fund this is likely the GP, so the auditors might ask for:
evidence of GP approval of an invoice prior to payment
evidence of GP approval of a set of quarterly financial statements
evidence of GP approval of the schedule of investments
evidence of GP approval of a capital call
Compliance
Again, fairly straightforward:
The fund’s valuation policy was followed in completing the annual financials
The fund has appropriate measures in place to prevent fraud
The fund has collected and maintains accurate records relative to LP subscription documents
The fund has a cyber security policy in place that it abides by
The fund is up-to-date in its regulatory filings and the GPs have disclosed any litigation and/or legal proceedings resulting from an investigation / indictment for criminal misconduct
Federal, State, and Local Tax Filings
In most cases, the audit and the annual tax reporting can be conducted concurrently as tax reporting is primarily focused on realized, completed transactions where the audit firm is confirming the unrealized value of the partnership.
The tax firm will work from the same financial workbook as the audit firm.
Your LPs are most focused on the timing of their K-1s. With our client, even though the LPA didn’t specify an exact deadline for issuing K-1s, we set the target of delivering these to LPs by 3/31. While most investors in private funds will file for an extension on their personal returns such that they have until October, for those LPs who do intend to file by April 15, we wanted to ensure our client was meeting that expectation.
For the LP tax filing, you’ll work with your tax firm to ensure all LP subscription documents are up date and that all LPs have submitted a W-9 or if they are an international LP a W-8BEN (W-8BEN-E for foreign entities).
At this point, the tax firm will largely have what it needs to determine taxable net income and any other deductions the partners can claim.
When the firm sends over its drafts, you’ll most likely have the following set:
Federal Form 1065 and state-level equivalent
Schedule K-1s for the individual LPs and were required based on international investments Schedule K-2s and K-3s
For the GP and the Management Company
Federal Form 1065 and state-level equivalent
Schedule K-1s
For the management company (if it operates in CA or NY), your firm may also deliver Pass-Through Entity Tax that may need to be paid based on whether the management co elected to make quarterly payments through the preceding year.
As the tax firm is not concerned with the valuation of unrealized investments, this is typically a straight forward process.
Where it can become more complicated is in a year where the partnership had a significant liquidity event. You’ll want to ensure the tax firm has all the documents from the time the investment is made as well as the final closing set at exit. Importantly, you may be able to benefit from the underlying company’s QSBS status, resulting in significant tax savings for you and your LPs.
Conclusion
The annual audit and tax cycle require a significant allocation of your firm’s time and attention across Q1. The clients that we’re privileged to work with have made the decision to delegate the day-to-day management of these process to our team at Graph Advisors. If you’d like to explore what that can look like for your fund, please visit us at Graph Advisors and find a plan that works for you.
We hope that this overview has given you some insight into the overall process so you can anticipate what’s coming rather than reacting to each individual request from the auditor or CPA that lands in your inbox.