Everyone has a worst investment story that clobbers investing pride and teaches lessons. My cautionary tale of money lost concerns a small-cap wireless infrastructure maker. When I bought shares in 1999 in Vari-L Company, it couldn't miss, what with key products for the exploding wireless and broadband marketplace, patents, profits, accelerating demand, and elite repeat customers such as Nokia (NYSE: NOK). Applying the Rule Maker investing criteria showed that this small cap -- $169 million market capitalization -- really sparkled.

Today, Vari-L's stock is down more than 80% -- having been underwater as much as 95%. Management clearly doctored the financial statements, the president and CEO is gone, and the company hasn't filed an SEC 10-Q since May 2000. Nasdaq delisted the stock, which now wallows on the over-the-counter bulletin board -- the "pink sheets." Oh, the ignominy (a city in Wisconsin near Menominee)!

The lesson? Know your management. Big companies attract the best management, which then operates with all the world watching. There's a reason the Fool staff last week wrote about the importance of great management. 

Rule Maker criteria aren't just for big caps
Though a small cap, Vari-L shined under the Rule Maker criteria, which measure well any potential investment -- big or tiny. Who wouldn't want to buy stock in companies with minimum 10% sales growth, 50% gross margins, and net margins above 10%? I paid attention to Motley Fool Research Analyst Zeke Ashton's excellent September 1999 Rule Maker column about successfully applying Rule Maker metrics to a small-cap software company, Timberline Software (Nasdaq: TMBS). I thought I'd found my own "Mini Maker" in Vari-L.

And what a business! Vari-L had a lock on the market for voltage-controlled oscillators (VCOs). Essential for any wireless transmission, VCOs adjust the wireless signal to a predetermined frequency. The signal is routed back and forth from wireless phone handsets through base stations to the telephone lines. Every wireless phone handset has two VCOs (one for speaking and one for listening), and every base station has more, depending on how many frequencies it's handling.

Vari-L's sales were 70% wireless base stations, 7% new broadband products for fiber optic networks, 6% wireless consumer products, and 17% military components. Recipients of these sales included a long list of all the animals in the whole wireless and broadband barnyard, including Ericsson (Nasdaq: ERICY), Lucent Technologies (NYSE: LU), Motorola (NYSE: MOT), Rule Maker Nokia, and Samsung.

The Rule Maker numbers
Armed with 10-Qs and 10-Ks, I hit the Rule Maker books. Vari-L's sales growth from 1998 to 1999 was a terrific 34%, easily passing the 10% Rule Maker gate. Gross margins of at least 50%? An "A" again, with 55% in 1998 and 53% in 1999. A light decline, but still well over 1997's 52.4%. Its net profit margins clocked in at 14.9% in 1998 and 14.0% in 1999, well beyond 1997's 11.5%. No problem clipping the 10% requirement. It even had cash 2x debt, besting the 1.5x guide.

I skipped the Foolish Flow Ratio, figuring small Vari-L didn't have much leverage over suppliers, but did promise myself to keep an eye on expanding inventories. Vari-L  sported a respectable operating cash flow margin of 12.2%, comparing well with 1999 numbers of 30% for Intel (Nasdaq: INTC), 17.9% for Coca-Cola (NYSE: KO), 8% for Pfizer (NYSE: PFE), and 6.2% for then-Rule Maker Gap (NYSE: GPS).

With revenues growing at 34% and earnings 20%, it didn't seem extravagant to pay a price-to-earnings ratio of 30. I invested for the long-term future of wireless communications growth, at an average price of $22 a share.

The hits just keep on coming
On May 17, 2000, with no warning, the company adjusted 1997 financial statements to reflect overstated income, promising an internal investigation and possible further restatements. A few days later the company announced a record Q1, but then the controller resigned, and a week later the CFO retired.

On July 7, 2000, the company's small local accounting firm resigned, telling the SEC they'd found irregularities. The Nasdaq halted trading in Vari-L's stock, then at $12 per share. On Aug. 8, the CEO and president resigned, and the company soon brought in an interim CEO and the consulting firm KPMG to help investigate.

When September arrived, Vari-L hadn't filed an SEC 10-Q since May 22 and was out of compliance with Nasdaq requirements, so its stock was delisted. Company founder Joseph Kiser and another director resigned from the board, though both stayed on as company executives.

The truth comes out
A week later, KPMG determined that the restatement would reduce stockholder's equity by $30 million to $35 million, due to an estimated write-down of assets and changes in liabilities. This was a big number for a company with total assets of $68 million, and revealed the extent of accounting malfeasance. The company and KPMG expected to complete the audit -- including 1998 and 1999 -- by the end of 2000.

Meanwhile, the company kept breaking my heart. It announced a 22% revenue increase from Q1 to Q2, and a Q3 increase of 21% on top of that. Its first three quarters in 2000 had exceeded all of 1999 by 15%. That is, if you could trust anything the company said.

On Dec. 15, the Nasdaq denied the company's relisting petition. Two days after Christmas, the company gave shareholders a stocking filled with coal, delaying any restated financials to January 2001. Not only that, but KPMG would be unable "to provide audit opinions for periods prior to June 30, 2000," because the company and KPMG "concluded that no amount of reconstructive accounting could overcome the conditions that existed prior to [then]." Anyone still in denial?

This just in
The company this morning announced restated but unaudited financial results through Sept. 30, 2000, showing a most-recent quarter loss of $0.03 a share. For FY 1999, Vari-L now owns up to a loss of $0.16 a share, versus its pre-debacle profit of $0.57 a share. Revenues did indeed jump as previously reported, but gross margins were 47% -- not 53% and up. The extent of the accounting damage becomes clearer.  

The stock, with a 52-week high over $40, has dipped as low as $0.87 and is now back just above $3.  

How can investors avoid this?
While I have no conclusive evidence that this happened at Vari-L, the temptation to cut corners and overstate assets and cash must be substantial for people who've toiled closely together for decades and turned a private military contractor into a public commercial success in an exploding market. That said, one red flag could've been that the company founder's sister -- with no discernible qualifications -- served on the board.

Buying big, established companies is no protection against this, but there are many more people watching Rule Makers such as Intel, Cisco Systems (Nasdaq: CSCO), and Microsoft (Nasdaq: MSFT). They can hire the world's best management talent, people who are then scrutinized relentlessly by analysts, the media, and their own employees. This is not insurance against accounting malfeasance -- as Lucent has shown -- but people behave differently under brighter spotlights.

I'm still holding my Vari-L shares. But before I invest in another small cap, I'll spend a lot of time studying the Fool's Small Cap Foolish 8 strategy, and questioning long and hard whether a Rule Maker might just be the best place for my money.

Do you have a "worst investment" story? (C'mon, we all do.) Come share it and learn some valuable lessons from others' mistakes on our My Dumbest Investment discussion board.

Before closing today, I have an important request: If you haven't already, please take a few moments to give the Rule Maker managers your feedback (even if you're a first-time reader!) in our Rule Maker Customer Satisfaction Survey. The results from this survey will help the port managers create a Rule Maker future that's sweeter than the present. And thank you to those of you who've already responded.

And finally, Microsoft reported earnings last night that matched analysts' lowered estimates. The company was cautious in its guidance for earnings over the next few quarters, but the market rewarded the company anyhow, sending the shares up today, based on the lack of any further negative guidance. Here's the full story on Microsoft's Flat Q2.

Fool On!

Tom Jacobs -- TMF Tom9 on the discussion boards, licking his wounds