👀 Too Much FOMO, Too Little Audit: The Ultimate Recipe for Startup Frauds
There's a connection between the insane rise in startup valuations and the rise in the number of startup frauds: a lack of due diligence. Here's why that is happening.
The media holds immense power: it can make or break a company with just one article.
Don't believe us?
Well, the DHFL scam was exposed by CobraPost, the FTX fraud came to light after an investigation by CoinDesk and the Theranos scam unravelled in a Wall Street Journal exposé.
But why are investors, venture capitalists, and auditors failing to uncover what the media can?
How did these billion dollar startups keep fooling so many smart people? To understand this let's look at the FTX story.
🕵♀️ The FTX Story
FTX is a crypto exchange founded by Sam Bankman-Fried (SBF), an eccentric billionaire founder, who was hailed by everyone as the next Warren Buffett.
But before SBF built FTX, he created a crypto trading firm called Alameda Research, which functioned like a hedge fund* but for crypto.
Now, these two businesses should have remained independent of each other to prevent conflict of interests.
But they didn't. Simply because of FTX's unique accounting practices and its invention of the FTT token.
Back in 2020, crypto tokens were in fashion so, FTX launched its own token FTT. Now, this token didn't trade on the market like other crypto tokens. It just gave users discounts on their trading fees.
And Alameda owned a lot of these tokens (as revealed by a CoinDesk report). This made people suspicious of how closely related these entities were.
Crypto investors suddenly started worrying about the safety of their FTT tokens.
Then came the final blow that broke the house of cards built by FTX: Founder of Binance (the world's biggest crypto exchange) announced that he was selling his FTT holdings due to an ongoing feud.
What next? FTX investors began selling their FTT coins and cashing out of FTX. But FTX simply didn't have the money to pay them all.
Result? The company has gone bankrupt (thanks, Alameda).
You see, Alameda was using these FTT coins as collateral to borrow huge amounts of money from FTX. When the value of FTT fell, there was a margin call but Alameda didn't have enough funds to pay back the money it had borrowed.
So, both companies were now out of money.
Looking back, a couple of things jump out for us:
First, a crypto exchange should always have enough money to return to users should they ask for it. So, why did investors fail to ensure that FTX maintained this?
Second, why was no one monitoring FTX and Alameda's transactions?
Third, why did investors blindly believe a company whose business depended on an imaginary coin?
And these weren't gullible retail investors who could possibly be fooled easily.
Here, look at FTX's investors:
What's worse? These investors also hired some world class consultants and auditors like Bain & Co. to make sure that their investments are protected.
So, what went wrong?
That's a million dollar question and the answer is: FOMO.
😱 The FOMO Story
Over the last few years, some spectacular startups have come up and boomed, like Amazon, Uber, Airbnb, Netflix, Facebook.
All within just the last two decades.
Now, VCs don't want to miss out on the next Uber or Facebook.
So, they're putting money in whatever startup they feel will make it big.
And thanks to low interest rates at the time, which led to high liquidity, these VCs had a lot of money. So, they were raining it on the startups that promised them the moon and stars.
But why did their due diligence teams not ring any alarm bells?
Well, there was just no time. All these VCs were competing with one another to discover the next big thing and milk the next cash cow.
Turns out what most of them discovered was the next big failure.
In the case of FTX, they even failed to notice some huge red flags.
For instance, they allowed Bankman-Fried to hold majority control of FTX and not appoint a board of directors.
This has come back to bite them. Not just VCs, this has also left auditors unmotivated and dissatisfied.
Auditors entered this space to make a difference but just end up ticking boxes that their bosses want to.
Not to say all auditors are not doing their job. Deloitte had recently refused to sign Byju's financial reports because of financial irregularities.
But more often than not, due diligence isn't all that diligent anymore.
In fact, all of the Big Four firms have now been pulled up for some or the other auditing issue. And this could get worse in the future. How?
You see, EY is currently splitting up its audit and consulting arms. This could considerably weaken the audit firm. And a weaker audit firm could cause audit and due diligence failures.
Other Big Four firms are also expected to follow EY's path: a move that could weaken the entire industry.
But until that happens, the auditing industry could see a boom. With investors realising the importance of due diligence, auditors could be in fashion again.
And this could bring down the insane valuations of some startups.
Let's hope that these series of failures brings forth a future with saner startup valuations and lesser frauds.
Nonetheless, we're here for you to uncover all scams and frauds :)
And if you want to get your company’s due diligence done or build a career in due diligence, contact us and we can help you out!
🤓 Noob's Corner: Hedge funds are pooled investment funds that use complicated investment and risk-management techniques to ensure high returns on investments.
⚡ In a line: VCs were skipping due diligence, which led to a rise in startup frauds and valuations and this could get worse soon.
💡Quick question: Do you think VCs will only be diligent till there is a liquidity crunch?
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