Bottom Line Business Insights : Maryland Business Lawyer & Attorney : Wagonheim Law Firm : Mergers & Acquisitions & Contractual Negotiation

Guest Blogger: Joel Charkatz, CPA, CVA, CFE

In my prior post I discussed the importance of internal controls as a safeguard of a business’s assets and provided a real life scenario. The case discussed was an excellent example of how a few minutes per month would have saved the company penalties and interest payments to the IRS, untold headaches, and a trip to the precipice of disaster, from which they luckily returned.

I also reported the most recent study performed by the Association of Certified Fraud Examiners indicated the median fraud loss in small business (less than 100 employees) was double the loss in large business. While there may be many reasons for this discrepancy, my experience indicates lack of internal controls is a significant cause of this anomaly.

In the current business climate, many businesses have pared employment rolls, leaving fewer personnel to perform the same or more tasks. As a result, internal controls have taken a back seat to servicing the customer. Even where good solid internal controls were once in place, I generally find the change in personnel has not been accompanied by an evaluation of its impact on the controls of the business.

What can be done? For starters, there are a few simple controls which can be accomplished with very little effort. And whether your business has three or ninety three employees, they will work very effectively.

The first procedure is the simplest – the monthly bank statement(s) should be given to a responsible party, unopened. A responsible party is the owner, owner’s wife or other family member, or someone in the organization that has nothing to do with finance. Typically, we find the owner to be the most credible person for this task. Mr. (or Ms.) stockholder opens the bank statement and looks at each check making sure:

• the payee is legitimate
• the amount is not out of character for the payee
• there are no erasures or other apparent changes on the document
• the authorized person’s signature is legitimate
• the endorsement on the back appears correct
• the address the payment was mailed to is where the vendor is located
• everything else on the document appears to be correct

An additional function would be to compare the check payee and amount directly into the company’s disbursement system to make sure the payee and amount are recorded in sync with the document. This procedure is generally only performed when a question arises, but it is a good idea to spot check, on an occasional basis, a few disbursements.

The key to protecting any business’s assets is internal controls. While small business may see this as a challenge, the fact is the smaller the operation, the easier it is to exert control over the assets.

Joel Charkatz, a Shareholder with KatzAbosch, has served the Maryland business community for more than 40 years. He is Chairperson of the firm’s Business Valuations & Litigation Support Group and a member of the Medical Practice Services Group.  He is also the past Chairperson of the Maryland Association of Certified Public Accountant’s Business Valuation, Litigation, Fraud and Forensics Group. Mr. Charkatz provides a full range of accounting and tax services for clients including business valuation, forensic accounting, litigation support/expert witness, real estate development, management advisory services to closely-held businesses and tax planning.

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Guest Blogger: Joel Charkatz, CPA, CVA, CFE

We hear this phrase over and over. Why? Because it is almost inevitable that when we are called in to investigate an employee embezzlement case, the entire venture could have been caught very early. Once we begin to probe, and determine the fraud was easily discoverable, management sighs and says “If I had only looked.”

Statistics from the Association of Certified Fraud Examiners reflect small business is more vulnerable than large business when it comes to fraud. Why? Because big business “looks” more than small business. The median loss in small business (less than 100 employees) was reported to be $200,000, while the median loss in large business was just $97,000. Because they look.

Really large businesses many times have a Loss Prevention Department. This area’s responsibility is to catch and stop fraud and embezzlement in the company. While they may interface with the internal auditors, they are usually not accountants. Most likely the personnel in this department have investigative backgrounds – either in police work, insurance loss investigation, criminal work, etc. As a result, these folks have a mindset that is much different from an internal auditor, and very much different from the company’s outside CPA firm.

Depending on the size of a business, there are several very simple procedures that can be performed, usually only taking minutes per month. These procedures will uncover most employee embezzlement at or near the outset.

A good example is the fraud we investigated where the bookkeeper embezzled hundreds of thousands of dollars over a period of several years. She was able to cover up the theft by not paying payroll taxes the company owed for its employee withholdings. Of course, when a non-payment notice was received in the mail from the IRS, the mail clerk would give the IRS notice to Sally (not her real name) because it was “tax stuff and Sally gets all that mail.”  The tax notice was hidden from everyone, and the fraud continued.  This resulted in a significant loss to the company, and once discovered, were required to pay taxes, late payment penalties, and interest to the IRS. It almost put them out of business.

This type of employee action would have been discovered almost at the outset except for one mitigating factor. Sally had been with the company for many years and was a trusted employee. Consequently, there were very few controls in place on her position. Were the owner to, once a month, simply receive the bank statements unopened, and peruse the canceled checks, he would have seen the checks payable to his bookkeeper, and discovered the embezzlement in the very early stages. If only he had looked.

One final word….trust is not a control. Just because an employee is trusted does not mean common sense (read internal controls) can be suspended.

Joel Charkatz, a Shareholder with KatzAbosch, has served the Maryland business community for more than 40 years. He is Chairperson of the firm’s Business Valuations & Litigation Support Group and a member of the Medical Practice Services Group.  He is also the past Chairperson of the Maryland Association of Certified Public Accountant’s Business Valuation, Litigation, Fraud and Forensics Group. Mr. Charkatz provides a full range of accounting and tax services for clients including business valuation, forensic accounting, litigation support/expert witness, real estate development, management advisory services to closely-held businesses and tax planning.

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A few weeks ago, I discussed several different methods of financing a new business or providing for the ongoing capital requirements of an existing business (click here to read the blog). I touched on the difficulties inherent in trying to get bank or venture capital (“VC”) financing, and promised to discuss those issues further in a future blog. Not one to break a promise, this is that blog.

Let’s start with bank financing before we get to VC financing.  I’ll be blunt: generally speaking, most start-ups aren’t bankable (meaning they’re not good candidates for a bank loan). Banks tend to require an operating history, several years of audited tax returns, net operating income at a specific multiple of the anticipated debt service, accounts receivable or hard assets that can be pledged as security, and spectacular credit scores by the principals. Not to mention personal guarantees. If your company (or you, as the case may be) isn’t/aren’t able to produce most or all of these things, guess whose house is going to be mortgaged as collateral on the loan (assuming you’ve got equity in your house)?

That said, there are certainly lending programs at most banks that are geared towards specific types of startup businesses. Dental and medical practices come to mind, which are bankable for a variety of reasons that are beyond the scope of this blog. However, most new businesses simply won’t qualify for bank financing, particularly in light of the new-found lending conservatism brought on by the latest recession. 

Which brings us to VC, and why your odds of getting VC financing are slim.

Venture capital financing is, for the most part, limited to Silicon Valley technology wonks whose companies can deliver scalable businesses, proprietary technology (i.e., patented or patentable), and a minimum 35% pro forma return on equity with an ironclad exit strategy in 5 years or less. In other words, unless you’ve got a biotech, software, or alternative energy company with a defensible patent (VCs hate competition), you’re unlikely to be attractive to a VC firm.

Additionally – and I can’t overemphasize this – VCs are looking for stellar management whom they trust implicitly. The way they get to trust you is by knowing you. And the way they get to know you is by being introduced to you by someone they already trust. So if you’ve got a couple Wharton MBAs and a Stanford electrical engineer with 4 fuel cell patents to his credit on your executive management team, and you know a guy who works for Draper Fisher Jurvetson, congratulations! You might actually stand a chance of getting a VC firm to actually read your business plan. Continuing the theme, it also wouldn’t hurt if you’ve run and successfully sold or gone public with a previous company. And made lots of money for your previous investors in the process.

Finally, it’s useful to recognize that most VC investments don’t occur at the startup phase, but rather in a later round of financing, and most often in an amount equal to several million or tens of millions of dollars. This means that even if you do eventually get VC financing, you’d still need to rely on the 3 F's in the earlier stages of financing your business. Now, I realize that the idea of getting an infusion of capital amounting to several million dollars from a VC would make the principals of most small to medium sized businesses salivate, but consider this: could you produce a realistic business plan and a full set of pro forma spreadsheets demonstrating to the VCs how you plan to turn an $8,000,000 investment in your construction framing business into a $4,000,000 profit, PLUS return of their initial investment, PLUS a successful IPO or sale of your company, all in 36 months? Probably not. 

The simple math of the matter is that very few people, or companies, will qualify for VC financing. Factor in the sheer volume of business plans and elevator pitches that the typical VC sees and hears in a given year, and the fact that the volume of all VC financing has been severely reduced as a result of the recession, and the odds of a successful VC investment in your company become slimmer still. Which is why I pointed out in my last blog that the most likely source of funds for your business is the 3 Fs.

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