In his recent bankruptcy proceeding filing, John Ray III, the new CEO and Chief Restructuring Officer at FTX, minced no words:
I have over 40 years of legal and restructuring experience. I have been the Chief Restructuring Officer or Chief Executive Officer in several of the largest corporate failures in history. I have supervised situations involving allegations of criminal activity and malfeasance (Enron). I have supervised situations involving novel financial structures (Enron and Residential Capital) and cross-border asset recovery and maximization (Nortel and Overseas Shipholding). Nearly every situation in which I have been involved has been characterized by defects of some sort in internal controls, regulatory compliance, human resources and systems integrity.
Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.
All of which raises a very straightforward question, “could this have been avoided?” There were many sophisticated investors around the table who arguably should or could have seen “red flags.” What are some of these “red flags?” Before we dive into a detailed list, there are three important qualifications:
- The presence of one or two of these things are in no way a guaranteed sign of fraud or malfeasance. However, the more of these you see present in a young private company, the more concern you should have.
- There is always a small probability that a situation could have 100% of these characteristics, and still be legitimate. The odds are quite low, but it is possible.
- Most importantly, there is a reasonable probability that the absence of standard governance guardrails and constraints actually enables reckless behavior. With such guardrails in place, the company may have evolved in an entirely different direction, which would have been better for both founder and investor alike (especially vs. absolute failure).
With those caveats, here are a group of things to watch out for if you want to avoid such situations. Corporate malfeasance is an ugly game that is best avoided.
1. “Letting the Good Times Roll”
It’s no coincidence that Enron happened in the late 2000 and that FTX occurred in 2022. Extended, frothy bull markets are a breeding ground for unwarranted corporate behavior. When markets are soaring, speculation increases and as a direct result so does risk. Also, when everything appears to work, investors are more willing to suspend belief. As it was with crypto, sometimes this leads to the development of “new investment rules” that crowd out traditional norms. Lastly, in a heated market, investor competition increases which leads to more investors being willing to “take what they can get” when it comes to governance. As an investor, when the environment is “frothy” you are much more likely to run into these problems. But ironically this is also the precise time when raising concerns will make you look like a washed up veteran who is unable to adjust to the new “realities.”
2. The Lack of a Legitimate Board
Delaware law requires a board of directors, and these directors are tasked with a “fiduciary duty” to look after the best interest of the corporation. As such, the task of governance falls squarely on the shoulders of the board of directors. FTX is an extreme case where there was no traditional board. But there are many cases where the role of the board of directors is heavily compromised or virtually nonexistent. Filling a board with friends is one way to do this. Filling a board with people who lack experience in private company development (i.e., Theranos) is another. The real question is, “do the founders or operators understand the role of governance and embrace it, or are they trying to intentionally undermine the very notion of governance?” If it is the latter, you have a problem.
3. Super-voting (Dual-class) Stock
These days, many technology companies have deployed a dual class stock structure as part of going public. As a result of many technical voting requirements, this can be rationalized as a way to make operating the company smoother and simpler. However, when this technique is used from the earliest stages as a company, you can create a situation where the entire board can be replaced at the whim of a single shareholder. It would be unreasonable to expect board members in such a situation to provide appropriate oversight.
4. Aversion to Audits
As the bull market raged on from 2015 to 2022, it became quite trendy for venture capitalists to waive the requirement for an annual audit which is embedded in almost every standard Series A term sheet. This relaxation of governance norms is consistent with the “bull market” argument in point #1. No investor wants to lose a deal over an audit requirement. At least for companies generating meaningful revenue, investors should look to have an annual audit with one of the Big Four accounting firms, or one of the more reputable smaller firms like Grant Thornton. Learning how to meet and perform an audit is part of “growing up” as a company. Some founders unfortunately have an explicit aversion to audits. From their POV, they view this step as unnecessary and bureaucratic. The problem is auditors are the “referees” in business. Insisting on running without them is the equivalent of trying to rewrite your own rules.
5. Unique Financial Data Presentations
Related to the point on audits, some companies will insist on presenting corporate data in a way that is (a) inconsistent with traditional corporate accounting, and (b) impossible to square with traditional accounting. Many times, this involves creating a whole new language around unit economics specific to that company. There are also frequent claims of being “profitable” on some definition of “margin” that is specific to the company. Building a unique set of financials can be a reasonable way to use cost accounting to help drive key OKRs. That said, taking this too far can result in an illusionary business narrative that allows one to claim business success where there is not any. Interesting that some public companies continue to do this.
6. Who is Corporate Counsel?
Silicon Valley (and most large US cities) are full of lawyers who have ample startup experience. Having one of these individuals and their firms help guide your company can be crucial to the company’s success. They bring both the natural learnings of best practice by seeing many different previous examples, as well as an understanding of what defines best practice governance. In addition, their reputation will help ensure that investors know the company has the benefit of their experience and advice. The more “atypical” a company’s corporate counsel, the more concerned one should be.
7. Odd Corporate Location
The more atypical a corporate location, the more one should be concerned. Island nations are known for serving as tax havens, but they also can have more lackadaisical business regulations. All things being equal, this should clearly be viewed as non-optimal from a governance perspective. Without naming names, some U.S. states have a reputation for being more forgiving of low-grade business malfeasance. This does not mean that all businesses in a location like this are “bad,” but it still belongs on the checklist.
8. Large Secondary Transactions
Secondary transactions have become commonplace in venture-backed startups, especially as the company moves to Series C or beyond, and in situations where the time to liquidity may be further out than previously expected. There are many good arguments why allowing the founder to take “some of their risk” off the table is good for the company, and as a result it is common to see $1-5mm early liquiduty for founders. However, when $5mm becomes $50mm or many hundreds of millions you are dealing with a different beast. You never want to be a buyer in a pre-public round where the person you are negotiating with is a very large seller. You should assume they know something you do not.
9. Overlapping Corporate Interests
Off all the checklist items, this is the one that is an absolute non-starter. No one operating a venture backed startup should be simultaneously running another corporate entity that has overlapping interest, competing interests or even potentially competing interests. The standard should be the appearance of impropriety. The potential for bad behavior is simply too great. If there was a recipe book for corporate fraud, this would be the first chapter. Just say no. Plain and simple.
10. Everyone Falls For It
The most dangerous scenarios are the ones where the company is claiming a significant paradigm shift. Founders, employees, and investors intent on disrupting the status quo start believing in a new reality even in the absence of empirical evidence or actual results. It’s one thing to be a successful startup, but it’s quite another to claim to be rewriting the rule book for a whole category of business, with seeming immunity to the fundamental laws of business reality. The investors believe, the press believe, and the politicians believe. In such a world, an incremental investor has zero reason to doubt the legitimacy of the organization because 100% of their data suggests the exact opposite of fraud or incompetence — it is held up as a shining beacon of success. Be wary of the situation that is “too good to be true.” It often will be.
There are undoubtedly sound reasons why a company may adopt one or two of the items listed above for legitimate reasons that are unrelated to corporate misbehavior. That said, if you start to see three or four, maybe five of these items present, you have a much higher likelihood of a problem. Equally important, allowing a company to operate in a way that condones or encourages bad governance may actually be the root cause of future poor corporate behavior.
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