Sadaf Sultan, Founder of Finprojections, and Jeremy Au analyzed the eFishery financial scandal and discuss broader issues of financial fraud in startups. They talked about why eFishery was appealing to investors and how the fraud unfolded and shared their insights into detecting fraud effectively. They explore the challenges faced during investor due diligence, overlooked warning signs, and practical suggestions for strengthening investor safeguards.
1. A promising vision: eFishery attracted investors by presenting itself as a solution for fragmented markets through vertical integration and improved efficiencies.
2. Start small, grow big: Initial minor revenue inflation escalated rapidly under pressures from ambitious fundraising goals.
3. Behind closed doors: The founders executed fraud through round-tripping transactions using shell companies to create artificial revenue.
4. Hard to detect: Auditors struggled to identify fraud due to heavy dependence on founder-provided information.
5. Overlooked red flags: Large bonuses to the finance team and sudden departures of key financial staff were early, but ignored, warning signals.
6. Strengthening investor checks: Investors need to leverage local expertise, perform forensic audits, and set up clear whistleblowing channels.
7. Recognizing red flags: Common fraud tactics include confusing GMV with revenue, overstating recurring revenue, aggressive credit offerings, and misclassifying discounts as marketing costs.
(00:58) Jeremy Au: Hey Sadaf, really excited to have you back on the show.
(01:01) Sadaf Sultan: Excited to be back, Jeremy.
(01:02) Jeremy Au: Yeah. I mean, I think you know, we obviously had a great time talking about on a prior episode about your journey into being a fractional CFO and running the agency for so many startups across the region. And I think the reason why we called back was because there has been an unfortunate financial scandal in the SaaS space with eFishery.
And what we both realized was that there wasn't a spot where two experts sit down and actually discuss it because I think there's a lot of good folks who are talking about it, about the implications of the startup ecosystem. Other folks are saying like, Hey, this happens all the time, but it's never been like, how exactly does it work from an accounting perspective? And I just thought it'd be fun to make it like a blue team, red team.
(01:39) Sadaf Sultan: Oh, fantastic. Yeah.
(01:40) Jeremy Au: Yeah. So blue team is how to win about a fraud and the red team is if you were a board if you were an external investor, how would you pierce that fraud? How do you fight or confine that?
(01:53) Sadaf Sultan: Yeah.
(01:53) Jeremy Au: And then after that, I think we can have a fun game of saying what are the other types of fraud or misstatements that we've seen in the ecosystem, just for the sake of, you know, everybody in the world.
(02:05) Sadaf Sultan: Informational as well as fun.
(02:07) Jeremy Au: Informational. So at least we're not like, okay. Yeah. Yeah. Hey, you know, I listen to that podcast with Sadaf and Jeremy and this was how they, you know, these types of things can happen. And so, you know, some VC doesn't lose his shit or kind of like lose their reputation. So I think that's kind of the recap for eFishery. So eFishery is an interesting company. They were accused of doing revenue inflation 90+ percent. And since then, I think the board has acted to fire 98% of the employees. There continues to be an internal investigation ongoing where they engage a forensic auditor, FTI consultant will come in, and then eventually run the company. And it looks like their current move is they're going to decide to liquidate the company. And maybe get about eight to 10 cents on the dollar. So it's a big fall from grace from, I think I remember those days where it was like, nobody knew who they were, to got this really fast growing startup you know, eFishery to this unicorn. And then every startup was like, we have an eFishery for rice, eFishery I mean, there's a lot of people just using that way to talk about the playbook and that being like a one stop shop, multiple blades of business, kind of going from, you know, inputs, the financing, the productivity, the trading, which seemed to make sense theoretically, I think, which is that, it was so inefficient at each stage, you know,
(03:17) Sadaf Sultan: Why wouldn't you be so vertically integrated, right? And capture more of the market share?
(03:21) Jeremy Au: Yeah. So I think maybe just for a quick moment, we'll just talk about what was the promise or why it was so amazing. And after we'll talk about how it actually happened, but from your perspective, obviously so many startups were also very impressed by eFishery. From your perspective, what was amazing about their innovation from people's perspective.
(03:36) Sadaf Sultan: Firstly, thank you, Jeremy, for inviting me back in the podcast and I'm super excited about just talking through some of these issues with you. With regards to eFishery, I think the excitement was really around the addressable market share that they're capturing. In typically some of these value chains like agriculture or education, in emerging markets, those value chains are so broken or so fragmented that if a new player with the promise of technology can aggregate and create efficiency in those ecosystems, then they can capture some of that unlocked
value. So that broadly is the theme or the narrative. Now for you to execute on that narrative, you know, you want to be close to the units of production in a value chain. So you want to close to farmers. And
you want to also essentially ensure that you are enabling those units of value chain be more productive. So you want to give them technology. You want to give them better inputs. You want to give them advice. You want to give them financing, but once you have actually helped those units of production be more productive, you also want to help them monetize that much better, and that is really a function of the distribution chain, which often has a lot of layers, and in that, what you want to do is you want to break some of those layers, and you want to help this units of production go straight to the end consumer. And as such, not just unlock value for the farmers, but also unlock value for, for yourself by capturing some of that sort of increased economics.
So for something like eFishery, it ticked all of those boxes. We're working with farmers. You were giving them feeders, making them more productive, you were giving them farm inputs. You are also giving them financing, but you're also operating as a marketplace whereby you are helping them market their finished products to the end consumer and helping not just the consumers at that end, like, who are consuming those products, but also the farmers, capture value. So it ticked all of those boxes, and therefore it ticked a lot of those addressable markets and, unlocking efficiency across the board those markets.
(05:29) Jeremy Au: Yeah. And I think intuitively it just made sense, right? Because I think historically a lot of folks were grabbed when you're doing one service and then you went to multiple geographies.
And that wouldn't really work for some sectors like agriculture. And so it felt like this was itself in a horizontal expansion, kind of like doing a vertical, integration expansion, go deep into one vertical, felt like it promised all the efficiencies of not having to change a customer or go to new geographies. They felt like it would be, you know, obviously increasing the profitability.
And it felt like good timing because at the time the market was moving towards more profitability. And this promised more capital efficient to grow revenues and more profitably, which eFishery, I remember was, you know, people was just raving about, wow, you know, they reached a billion dollar valuation because they had break even and they grew, doubled every year.
So, kind of like hit the triple jump. It's just like, increased profitability break even on cash flow basis and doubling revenue over a year, right? And it turns out, unfortunately, that the revenue growth was fraudulent and that margin growth was also fraudulent, right? And it was just a big shock for the entire ecosystem. So I think this is where we know it's interesting to zoom in into what exactly happened and I think we've seen a lot of reports out there from DealStreetAsia. A lot of them have also put out slides to show like some of the work by FTI Consulting that had prepared for the board. So I think we're working on that publicly available information that's out there. So how exactly did this happen from your perspective?
(06:53) Sadaf Sultan: The eFishery scandals, let's say, it's manifested, and come to the light now, but from the reports that have been published so far, it seems like there has been some degree of revenue inflation that has been ongoing for quite a few years. And generally, the revenue inflation typically happens because you want to get the next fundraising round. From practical experience, I have also seen sort of companies which were operating in a practical problem. Like they, the problem is real. What they're doing is valuable, but the rate of growth that is required for them to get to the unicorn territory in, let's say, four or five years just isn't there.
Maybe it will happen in a longer sort of time horizon, or even on a longer time horizon, they can get half of that valuation, but that unicorn valuation five years, it just isn't there.
And they were probably planning to grow with that sort of growth outlook in mind. But then everything changes once you want to go out to raise round and one potential GP comes and says who's new in this whole ecosystem comes and says, Hey I can fill the entire round, but my minimum ticket size is actually twice what you're raising. And when you hear that message, like really everything changes, not just with your fundraising strategy, but with also your growth strategy as well.
If you decide to basically take that capital, because if you decide to take that capital, then you have to essentially almost manufacture your valuation,
considering where you're at. And the growth trajectory just becomes totally different from that point onwards. And from that point on, you're just trying to catch up to that valuation. And so these things kind of happen when you see a lot of capital sloshing around in the market. And we, when you see also kind of some GPs just spraying cash, without really paying attention to the fundamentals. So I would say eFishery is really a function of the euphoria of 2021, post-COVID when there was just so much capital in the market and there were just such huge fundraisings at inflated valuations that thereafter I think startups really struggled to keep pace with that level of valuation.
EFishery, to a certain degree, kind of manufactured a story in order to capture that wave. And once the wave turned against them, they really could not get out of it. So that's how I would characterize it at all.
(09:00) Jeremy Au: Yeah. And I think just like how, you know, we look at fire, right? You know, heat, you need fuel, you need oxygen, right? Same level of fraud. I think there's some dynamic where, you know, there's an opportunity, there's a pressure or incentive to do so. And there's some sort of, you know, rationale, right? People feel like it's okay, right?
So those are the three parts of that fraud triangle. And I think what's interesting is that they felt pressured to get to the Series A. And I've seen the series A and the Series A deck was not fantastic, I'll tell you that.
And it did look like a fish feeder business. But, what was interesting was that, that deck that I saw years ago, already had that Original Sin, which is that inflation by 20%, which is interesting. So, you know, I don't think the cash had come in yet into the company, but that, that was the original sin in that sense. And then after that, they raised some really large series A, series B rounds, that growth curve that they expected versus what they had. And they just hit the gas as it, I mean, 20% revenue inflation with such a small amount of revenue back then was probably recoverable. And they could probably, my guess is, I don't think at the time they were like, let's do this fraud for, blow it up larger and for a longer period of time. Maybe this talk is like, okay, it's a one time thing. Yes. You get cash in. Yes. And it just happens to like
(10:09) Sadaf Sultan: Exactly. I think when founders do it, I mean, no founder wants to be in a position where they're going to be in the spotlight for all the wrong reasons. That's not where they want to end up at the, at the sort of eve of all of this, right? So probably, you know, when they inflated the revenue, they just wanted to get that next round of capital to, to be able to survive, frankly, but typically what happens is, you do that once you are probably compelled to to do it again.
And it all comes to a fore when the broader market turns against you because now you're not being able to raise capital, but at the same time you have to, you know, show growth.
And if there, and if, if in that sort of downward cycle, your revenue is going down rather than sort of going up. Then, you know, there is such a huge difference between where you ought to be in terms of your momentum and where you are that, you know You cannot sell that fabrication anymore. It just becomes clear day to everybody that there's something wrong.
(11:01) Jeremy Au: So let's double click into this, right? So how exactly did they do this fraud? Because a lot of people are like, okay, fraud is fraud. But I think what's interesting is that they were relatively sophisticated, it just wasn't caught, right? Because, you know, these VCs come into due diligence every two years.
And then, you know, the higher consultants do that. So, the way they approached it was not as caught by, you know anybody. But it was not detectable, even in the earliest and the later stages as well. So, how exactly did they do that?
(11:31) Sadaf Sultan: So there are two things that happened, right? I think one is, they were keeping two sets of books. So one which was internal and then one which was external investor. facing. So when investors were diligencing them, they were probably interacting with this external facing books, which were not a of the business. In terms of how they inflated the revenue on those external set of books, it was essentially an elaborate form of round tripping.
So what round tripping essentially means is you engineer some cash flow movements entity who is effectively in your control or over which you have influence and you use this cashflow movements to create the illusion of revenue. So let me give you a quick example here, right?
So let's say my friend, Jeremy you know, I want to, he is a partner, a typical business partner. I give you a business from time time. And so, as a favor, ask you, Jeremy, I'm going to send you a hundred dollars, or sorry, Jeremy, I'm going to issue an invoice for a hundred dollars because I'm buying something from you. This invoice is going to be fake and you, in return, will remit a hundred to my bank account. And so, I'm going to show $100 of revenue, but then, you know, soon thereafter, I'm going to basically send back, the $100 to you, but on my books, I'm going to show it as $100 paid to someone else. So effectively, what happened, from cashflow standpoint is that, I'm a net zero because I've received cash and send cash back, but in my books, I'm showing a hundred dollars up revenue and a hundred dollars up cost as well, but there's not as much focus on cost during the diligence phase because you're expecting a Series A company to really grow their top line. So that would be an example of a round tripping. Now, think about eFishery kind doing that at a more institutional and bigger scale.
scale Yeah. And I think that's because the ended up bringing out five different shell companies that were owned by the founder to kind of do this round tripping business.
(13:13) Jeremy Au: And so I think it's interesting because, what was happening, like you said, was the revenue was going up, they were sending cash and invoices to these shell companies. They invest shell companies, giving them cash and push the cash back. And it keeps rotating to that thing. There's a widening revenue that's positive, but also, I think, from the perspective of cost, they're showing it as CapEx or capital expenditures or other costs.
(13:35) Sadaf Sultan: Others term it OpEx. Operational expenditure.
(13:38) Jeremy Au: So I think what's interesting is that, you know, it creates, I think, the illusion of a company that is moderate burn. Low growth becomes a higher revenue growth and I guess the bird is also still moderate, because the net change doesn't happen, so, I think that's the net illusion is that, but I think it's kind of an interesting dynamic because a lot of friends ask me, you know, no way these investors are that dumb, right? They're like, why investors are doing due diligence. So a lot of people are either saying like, either they are really foolish, or they're in on it, right? And I don't think it's it's in on it, not in if you lose 92 cents of a dollar, that's a horrible way to be in on in on it. A horrible horrible outcome.
Yeah, and you want to probably raise funds in the future.
Yeah, exactly. So which person is like, wow, I want to help you conduct fraud and lose 92 cents of my dollar. That is crazy. But I think people are just kind of like really surprised that it feels like, how can they not catch it, right? So let's do the blue team red team dynamic, right?
So blue team, like you said, is your HR company is generating all these invoices. And then obviously you send these accounts to the due diligence folks. And I've conducted due diligence on people as well. And of course, I think the other thing they do is, everybody is like sworn to secrecy and promise not to talk to the VC. But I'm just kind of curious, like, why didn't they catch it? Why is it difficult for an auditor or for a due diligence process to pierce that?
(14:57) Sadaf Sultan: Yeah, sure. It's difficult in a round tripping scenario where you're fabricating these cash flows. It's difficult because you are ultimately relying on the founder's disclosures to be able to even audit. So, what would an ask in that scenario? That auditor would ask for the customer contact.
And before I give the customer contact, now playing the red team here, I will call up my friend and say, Hey, expect a call from PwC or EY and basically tell them that this invoice is real. Yeah. That's all I to say.
And then after I kind of make sure that my friend is okay and then I give the customer contact, EY calls and they're verified, right? So EY verifies a big four player verifies and so therefore the investor is also okay and comfortable, right? But that was so easy from the founders perspective because you know that they're going to ultimately rely on your disclosures and to the extent that you control the stakeholders. You can basically sell any story.
(15:49) Jeremy Au: Yeah. And I think that it kind of goes to, you know, my experience as a VC due diligence is that there's a clock, which is that, you sign a term sheet, which is based on the management financials that are presented to you. So you're not, you never go do that forensic live. And then after that, you're due diligence period, which was say on average three months. That's the same. And obviously you're doing an audit of the customers, the technology and also the financials. And like you said, I think from a VC due diligence, you basically have a call, right? So you are calling customers. You are calling the financial accountant. And also I think if they've gotten previously audited financial reports, you also call their prior auditors, their regular auditors to see that. But like you said, I think what is underrepresented is the ability for the founder to control that call, which is what we saw in Wirecard. Wirecard, I think they, they created a fake office. So the auditors turned up and did a call. And then it looked like there was an office of the person that's supposed to call. And so that's, I think the big, I mean, it's a big job to do it, which is making a call, but I think that's, but that's the control mechanism.
(17:00) Sadaf Sultan: Correct. and, you know, from the farmer's perspective, again, playing the red team, right? You have so much at stake that you're going to go to crazy lengths to sell that story. And if you are not as interested to grow a business, but selling that illusion. So I was watching a documentary by Bernie Madoff, and he had been fabricating trade transactions for 15 years, and he had a whole office just dedicated for that. So if your entire focus and operation is on just like fabricating transactions, you are putting in a lot more effort than the blue team ever can. Therefore you are, you know, you are going to be more bulletproof in terms of his story than the blue team's ability to poke holes through it. There's always a little bit of a mismatch here if the red team has bad intent, or intent to deceive.
(17:44) Jeremy Au: I'm laughing because you know like red team is enemy
and blue
team the good guys or is blue team the defense of the fraud guys and red team is the bot, kind of like trying to aggressively attack. And I think the crux of it is that, there is like two teams that are really at work. And I think the board and external investor team is actually quite consistent in approach, because they do a due diligence every half a year or every time you run a transaction.
So there's a standardized process and then you have that checklist where you kind of check off all these pieces. I think what's interesting to me as I went into some of the reports was really like the clusters of people that were implicated within eFishery. I think obviously there were the founders that were driving this fraudulent behavior over some time, but there were people that were explicitly carrying out forgeries right on action for the founders, the second cluster that were aware that there are two sets of books, but did not report this to the board. And then there is a third cluster of people who are just not aware, like, they're out in India or some other far away country. So they have no idea what's going on. So those are kind of like the clusters of people. I'm just kind of curious what you think about, I guess cluster one, because these are your controllers, these are your internal audit guys and stuff like that.
(19:01) Sadaf Sultan: Yeah. So if you have those different clusters, I think there are different levels of fallibility, right? Some people are directly implicated and others are a little bit distant. So they have the knowledge, but not exactly
sort of
directly involved. So I would imagine that the people who
are in the
closest cluster needs to be taking care of, so to speak. Like again, playing the red teams Yeah. sort of, role and taking care of, because they're at high risk, highest risk. So they not only have to see potential monetary benefits of this, but real monetary benefits.
So I think one of the things that was published is that there were generous bonuses that were paid out to finance functions and to to other functions. And that should have been a red flag. And
those types of bonuses can happen because of course, fundraising is a taxing kind of project. But what should have been, I think, assessed is whether or not the magnitude of bonuses that were paid was actually, you know, were they standard for a company of that stage and for a company in Indonesia, right? And if you applied those two sort of lenses on the magnitude of bonuses, I would say it was unusual, right? It was above a million dollar range, right? So that's an unusual level of bonus. I mean, you would would know better.
(20:02) Jeremy Au: I'm just saying like, wow, this is the best controller I've ever had. This is the best internal audit I've ever had. And even though they don't do fundraising as part of their daily workflow, clearly you'd be rewarded and not my sales guys. Bringing in the actual money. All my operational guys are actually doing cost controls and getting profitability. And then you give it to my internal financial controls.
(20:21) Sadaf Sultan: so you have to kind of take care of this cluster one, who's the closest, right? And then in the cluster two. Those who are aware of the audit, but are not directly involved I mean, typically I think they can be kept on board with the promise of the increase in value of their options.
And with each fundraising round, they see the value go up, right? It's all paper value, but you know, but it could be monetized, in a secondary and could translate into real money or, you know, in liquidation scenario, which was very possible around the 2021 SPAC era, a lot of companies were listing with aggressive metrics. It was very possible outcome for a lot of companies and therefore the employees. So these cluster two, I think you can, you kind of hold them with the promise of equity and equity options, but then, there will be a subset of this cluster who basically would not be comfortable, who are not directly involved, but just is not comfortable with where this is going and they would leave, and so in that, I think it's really important for there to be some exit interviews, specifically if some key personnel, like who are really essential for the continued growth of the business. And who have a lot of exposure to equity, just leave because it's unusual. Like why would they leave from a rocket ship? So that requires, I think, closer like investigation and independent investigation, probably like a independent conversation by a board member, an exit interview conducted with a board member I think that would shed some light on
(21:31) Jeremy Au: Yeah. And I think that's something that's really important is that I think if you have a CFO exit especially after like, you know, one year off, ten year, which is relatively short, especially when the company is going well. I mean if the company is doing badly, after one year, everyone's like, yeah, life because the company went to shit. Duh! But if the company is doing really well, and you just stay for one year and you're a CFO or a senior finance person, then it doesn't really make sense.
And I think that was something that was there. I think what's interesting is that, you know, the universe of people was just a lot larger than I thought in both in cluster one and cluster two, which was, you know, surprising. And I think one of the revealing anecdotes that they had was that the founder was like overwhelmed with the amount of forgery he had to do.
And so he tossed it to some junior people on the finance team and then the junior people on the finance team were like, whoa, that is, I don't want to do that. And then said no, and then the founder got his other founder to lean on them and then the junior finance team ended up actually executing it, basically got pressured into forging it. And, you know, it just blows my mind a little bit because, yes, I know some people resign, but why didn't someone you know, like obviously eventually someone did whistleblow but I'm just kind of curious, like, why wouldn't you just be like?
I,
(22:38) Sadaf Sultan: I think, let's kind of, look at it from the perspective of maybe someone who's junior in Indonesia, in what is a rocketship. And from their perspective, they see the founder basically operating at a global scale, being lotted by global media. It would take a tremendous amount of courage for you to whistle blow in that context, but do you also know how to whistle blow and who to whistle blow to? You have no access to the board.
It would be crazy for you to go out and contact the board directly. So there's no whistleblower policy. There's no whistleblower training. So you have no no idea of how to do this. And then I think finally, you're also afraid of what happens if you whistleblow. What if you're not right? What if you, what if the investors are also like, not to agree with your friend, but what if the investors are also in on it?
This is so crazy. How could that not be right? You know, maybe you think that, if the investors are also in on it, then, the board just crushes me, just like, basically goes crazy with legal action and ruins my life. So, coming out as a whistleblower, I think , is an incredibly courageous thing to do, especially if you are a junior person in that kind of a context. And unless there is a very sort of clearly defined process and a person who's designated on the board to reach out to, I don't think there's any avenue or reason as to why one should, especially if they're junior.
(23:43) Jeremy Au: So I think we're starting to talk about the different approaches that, you know, the board or external investor could potentially have done, right?
One is obviously conduct much more thorough calls or announce visits, unannounced visits. And that's one. Two is do exit interviews of departing folks, especially for senior finance leaders, I think is a common sector. And then third of course is maybe kind of enabling a whistleblower policy within a company. Obviously I think certain countries also have whistleblower protections as well, like America, which doesn't require internal companies to have that, but how else do you think from the perspective, because you know, there's so many growth station investors that I've talked to in the US and from your perspective, it's like, hey, if a very large reputable growth stage investor in Southeast Asia can't catch this fraud, how can I, as a non local fund that wants to do growth stage investment, how can we trust the numbers and how can we be expected to do due diligence that's better? Now, obviously, I'm kind of curious how would be the approaches for an external investor to pierce that?
(24:45) Sadaf Sultan: Yeah. An external investor coming in, I think obviously has to leverage local expertise. One would argue, did regional investors even, you know, leverage the right kind of local expertise, right? So, in that context of efishery, the type of people that you want to talk to are those who have operated within traditional aquaculture. And who understand the traditional business model that you're trying to displace very, very well and can do an independent analysis of whether this technological advances really have a time and place and can really deliver those outcomes for the farmers and for the broader value chain. So you need someone who has that domain expertise, but you also need someone with the language skills who can go and talk to the founders, the farmers, the clients, and almost kind of do that smell test of whether this story makes sense or whether things are being fabricated or exaggerated. So you just need that bloodhound so to speak, right? It's a combination of domain experience and cultural familiarity. So I think not just for regional investors, but also for global investors, I think, this sort of network of local experts is critical. Identifying people with this very sort of specific domain knowledge and some of that exists already.
You have GLG. You have Guidepoint. They serve a lot of private equity firms and global consulting firms when they want to understand a particular domain very well, can go talk to an expert for like a few hours and you get more knowledge than you could do from market study right on the desk. So those kind of talent I think will be critical going forward.
The second thing, I would probably suggest is, and this is, this may look a bit hostile, but I think it is necessary, which is, beyond just a financial audit, you also need to do a bit of a forensic audit particularly around revenue. And forensic audit basically means like you are actually calling up customers. You're trying to understand are those customers in any shape or form related to the founding team and really getting to that level of depth where you can have a chance of detecting some of these round tripping, or anything which is out of ordinary.
Now that makes the cost of diligence that much more expecting expensive, because forensic audits are not cheap, but from a portfolio construction perspective, if you are taking on such a big bet on a high value player, I think it is worth it.
It's almost like an insurance policy that you're taking on by spending that much more into diligence, right? So that would, those would be my two things. You know, leverage local networks, expert networks, and do a bit of a forensic audit on revenue recognition.
(27:07) Jeremy Au: I think those are really good points. The first one is interesting because I actually agree with you that one of the reasons why I think international investors really have a mess up in Indonesia and Vietnam and even to some extent the Philippines,
obviously, I don't think there's emerging markets which have different or even argue not global standard of accounting practices, right? So it's a very young financial ecosystem and so forth. But I think the tricky part of course is that the language barrier makes it hard to pierce. And so one thing I've seen is that investors are like, I need to talk to some clients and then then the founder basically says like, well only two out of 100 customers know how to speak English, and then the VC is going to default to like, I'll talk to the ones that can speak English. So be it because in the interest of speed and so forth.
But then obviously it's hard to get somebody who can speak local languages, so I think that's a, I think a big handicap that I've seen happen. Of course, I think the rebuttal to that for the first point is that in terms of domain expertise, it's like, you know, startups are meant to be disruptive. And of course the incumbent expert who knows everything about coffee in Indonesia is going to be a for sure downvote for Kopi Kenangan or some other coffee chain business because they don't understand the future and the vision.
(28:22) Sadaf Sultan: I think you almost, as an investor, you want to hear the counter narrative, no? I mean, you want to hear the pessimistic take, and then you can make up your own mind as to whether you really believe, right, this this disruptive story. But if you don't understand, or if you don't even acknowledge the counter narrative and by the optimism for what it is, it is a little bit going blind, or taking a leap of faith. So, just because you have a local expert providing diligence report doesn't necessarily mean you have to heed that report or you can discount certain aspects of that report but you need to have that, I feel. That should be table stakes.
(28:53) Jeremy Au: Definitely and I like the second point as well which is putting the money into some of the forensic audit which is the probe these revenue comes in for rejected party transactions because I think technically I guess what one by the way, they could have caught it is that if they looked at their vendors, those five shell companies who have looked up pretty high on that list of, vendors that were sucking up a lot of costs, so I guess technically you could have pierced it if you called those five shell companies. The problem with us is that when you call those shell companies, you know, the founder's friend is going to pick up, I guess. But at least I think if you probed it, you'd be like, why these five companies and do they have a website?
Why is that a key vendor?
(29:31) Sadaf Sultan: Or like, if you did a phone call and you're not convinced, then send someone, right? send someone on the ground and try to figure out like what work actually happened. Go a level deeper.
So you're absolutely right. I think, in a forensic audit, you would probably go in order of materiality. You would look at the entire financial picture and you would say, okay, here are the five vendors or customers that we have, that the business has the most concentration on 60% of the revenue or 40% of the costs are to just these customers and vendors. And so let's kind of zoom in on them. Let's have a chat with each of them. And then if we are seeing some sort of sort of something that is not clear here, then, let's send someone and let's kind of investigate even further.
So you're digging deeper and deeper and deeper. And at a certain point, I think you should be able to able to kind of send something, particularly if it is a fraud, which is fairly large in scale, then I think you will see some patterns in these conversations.
(30:22) Jeremy Au: And I think, you know, what's underrated as well is that the definition of founder friendly. And I think that was a big piece that we discussed a few years ago because I think some VCs that were, for example, doing those things, which was calling customers on a unexpected or random fashion from the founder's perspective, which is actually a forensic kind of like check. VCs who are taking longer, like say three to four months, it's like two months or one month to do due diligence. Another one would be that, like you said, is kind of like doing unannounced visits basically to various places. And lastly of course is setting up a lot of like, control provisions. You need to plug in your ERP system into mine. And so all of these have come across as kind of like founder unfriendly. I think the worst is like, there's a few cases where VCs have, backed out of investment round in the company after writing a term sheet. And obviously there are good reasons and are bad reasons, and a bad reason, of course is the VC is flaky, but a good reason is maybe to discover something in due diligence that's bad news. So I think that's kind of like that dynamic where VCs don't wanna come across as founder. A hundred percent unfriendly especially to the good faith actors.
(31:26) Sadaf Sultan: Yes. And at the same time, like, you know that it is a tight ecosystem and founders talk to each other. So if you have essentially, gone very, very deep and asked a lot of uncomfortable questions, I think even if it's a good faith actor, they would share that with other founders.
(31:39) Jeremy Au: It's like, wow, this VC is wow, so took so long. They asked so many questions. I thought it was going to take two months, but it's like five months and then, you know,
(31:49) Sadaf Sultan: That's not good for your reputation, right? That's not good for you to kind of win more, more deals in the future. And so it's there's always that pressure. You want to be fairly thorough. And of course, I think you've seen this also being in a VC as well, right?
Once you raise a fund from an LP, there is pressure to deploy. You have a certain investment period within which you have to deploy that capital. You don't have to deploy all of that in one year, but you have to pace yourself. So, in a given year, if you're not doing any deals, that's a red flag for the LP, and that also decreases the probability that you raise another fund in another four years. That would be the ambition. Raise subsequent funds.
So yeah, I mean, I think, GPs are also under pressure to deploy and in a capital rich environment where other folks are not being that thorough on diligence, obviously the founder is going to go for capital that is more forthcoming because, founders are also under pressure to not let their business go under and if someone is able to deploy in three months versus six, of course, you're going to lean a bit more towards the person who can be quicker.
(32:43) Jeremy Au: Yeah.
So I think talking about due diligence, let's kind of like do this activity where we bounce and say one thing that you've seen that's been caught in due diligence in our experience, right? So we'll take turns. We'll see who taps out, who has, who is able to, but I think we can encapsulate it. So I think one type of that I've seen is kind of beyond round tripping. The one that I've seen is I'll start with the easy one, the vanilla one, which is stating GMV is revenue, which is arguable in many aspects because GMV is for marketplaces.
Revenue is for direct transactions. But a number of investors who see revenue, but actually GMV. You know, and there's a big multiple difference, right? A GMV and multiple, maybe one x revenue might be two x three x multiple to valuation, but I think that's one type of, I wouldn't call it on the, and I'm not here to bet list, if it's really disclosed.
(33:37) Jeremy Au: It's more the slightly less, the northeast side. But I think, but I think that's one common call it accounting definition and one height of thing that trips up a lot of investors. So I think that's one. What's something else you have seen?
(33:48) Sadaf Sultan: So actually like, founders love to be able to argue their revenue as being recurring. So essentially the other one that I've seen is revenue that is really non recurring. It is a one time being lumped into, particularly if there is a component to your business, which is subscriptions based, right? So you start lumping in the implementation revenue also into that bucket and you inflate your ARR, because that has a direct line to increasing your valuation.
(34:12) Jeremy Au: That's a really good one. I've seen that because a lot of companies in Southeast Asia have multiple blades of business. It's not pure SaaS. So if you're a VC that's done a lot of SaaS businesses investing, which all the revenues are normally recurring, but now you're selling like, okay, I'm selling fertilizer, which is a one off basis, input sale versus the subscription fee versus you know, so I do.
That's a good one. Now I've seen is, you know, in the same vein of like multiple business lines. I've seen that a lot of companies do lending businesses, which are very different in terms of elevation. Because you really need to be looking at a net interest margin, which is that, okay, you know, at least I think you can make argument that like a subscription versus selling you a bag of fertilizer, at least it's still a transaction that happens. And so the magnitude of error is still detectable, I think, if you're a reasonable investor. A lot of investors got, because there's a lot of lending and yes, they come all of the repayments as revenue, but it's not, it's actually the fact that you lend them money.
So that has a certain amount of cost of capital. So you should be looking at the net interest. You You should be looking at the net interest margin, not on the repayments alone, which is, so they can't. So you can't take like, I took a hundred dollars of repayments and mark it up as a valuation multiple.
(35:25) Jeremy Au: Actually the repayment is 1%, so I should be recognizing $1 of that. And then also, there's a huge risk of non performing loans, which is highly correlated to the rest of your business. And so there's this very tremendous problem where you see these businesses that seem to be like, they've lent out millions of dollars, their own cash. And then when the business goes bad, because things can go bad, but you not only have suffered in terms of a revenue down and everything, but the cash that was on your books actually, it turns out to be sitting in somebody else's business and you can't put it back because it is not paid back.
(35:58) Sadaf Sultan: Absolutely. by the way interesting point on, for lending businesses right traditionally how investors value lending businesses would be on their book value on the equity base. And they do it on the equity base because essentially that is a very tangible kind of, I think, measure of the net asset value, but at the same time, the way that lending businesses make money is that they have a certain equity base and they're able to get leverage on top of that equity base.
So there's, they can get cheap funds either private debt and able to lend that out at a margin. So the more you can leverage on top of that book value you know, the more your return equity is going to be. And exactly to a point, like, when I was actually investing and I was investing in lending businesses, actually Southeast Asia, I did see some players come out of Indonesia, who are doing P2P lending and, other such types of sort of specialized lending.
They were basically saying they were getting valued on the basis of their revenue. They're getting a revenue multiple, which, being a traditional sort of lender investor, to me it was insane because that that is perverse incentives. The whole idea of lending is risk management. That's how you make money. You manage risk. And if you are incentivizing someone on the basis of their top line, you are basically asking them to throw risk management out of the window.
And so it was just, to your point, it was just a lack of understanding of what really is a cogent in a lending business and not valuing them properly. So I think similar to lending, I would say inflating revenue with very aggressive credit terms for your customers. So think about a business that provides inventory to mom-and-pop shops and the mom-and-pop shops go through this inventory on a weekly basis.
But when you are supplying these inventory, you are giving them six month credit terms, which makes no sense, right? No one else in the market, even big distributors are not giving those mom-and-pop shops those kind of credit terms.
And so, the very sort of simple way of competing would be on price, essentially you are giving them a discount that no other distributor is giving, but that's very detectable by an external investor or our diligence sort of or an auditor. So a more elaborate way would be to kind of fight with credit terms that doesn't show up as readily on the P&L, but it shows up on the balance sheet, right? It shows up in receivables piling up. And so, that's a very classic run in particularly in markets where you're trying to displace the traditional players, you can go in with very aggressive credit terms, but that basically means that you're in the business of giving financing to your clients more so than giving them value.
And you're not in the financing business. No. you are in the efficiency business. So that's a, you've morphed into a totally different business than what your investors have funded you for.
(38:27) Jeremy Au: That's a really good example. And you know, I think I've seen a lot of companies blew up because they, seeable quality went to very bad. And then every round of cash. A lot of investors have got the surprise when a company blows because they have so much revenue and there's so much like, from a accounting perspective, so much profit. But that, actually the cash balance is this horrible, horrendous because of every simple is effectively. I would say that another version of that is at the cash collection side is that a lot of businesses in Southeast Asia, because they're working with this brick and mortar mom-and-pop stores that primarily do cash.
So there's some level of reconciliation at the monthly or weekly level that's done. Basically, the half of the bubble transaction is effectively all cash, and then at some level it gets converted into a digital, monthly transaction into an account. And so the problem is that you can't pierce this part because it's not digitized.
Whereas, if I was doing a subscription service, the customer has a straight line between what they pay out, which is the credit card or equivalent to the stripe to the bank account, right? Versus this cash component. And so it's a very easy way for somebody to inflate their cash count. Because what you just say is like, okay, there were 10 people who gave me $10 each, which is $100 cash, but it's quite easy. And then $100 cash is deposited as $100 of revenue in the bank, but now what you can do is you say from these 10 people, they each did a hundred dollars of transactions so 10 has increased, but then because of the trade in and out, we sent back 900 bucks. And so I still deposit a hundred bucks in the bank, but I recognize it as a thousand dollars of revenue and $900 of trading costs. So I think there's a different version of, but is this done in a way that's at a cash part of the cycle.
(40:10) Sadaf Sultan: Right. So that's something I've seen there.
Absolutely. So, that would be wrong tripping again, right? So whenever you have cash involved, there is always a lot more governance risk, right? So it's related to that. I think another one I would like to mention is essentially the founders of senior management doing procurement on behalf of the company. So because the company deals in cash, there is like, let's say a petty cash register that is maintained, which is, quite big compared to like what a petty cash register for a regular company would be. So you're always taking cash out from that petty case with petty cash register and you're doing sort of transactions. So those will be booked as cash advances. You're advancing cash to an employee or you're advancing cash to a founder and they are doing procurement on behalf of the company, but they're not able to really generate any kind of receipts backing up those transactions.
So no one really knows where this cash went. Related party transactions and not tightening them particularly in a cash dependent kind of business opens you up to a lot of theft. right? I mean, I'm not saying necessarily even like founders would do it, but the procurement managers have a lot of scope for just, basically stiffening cash from the system because you're not reconciling properly at the end of the day.
(41:14) Jeremy Au: Another form of, kind of an accounting is I think I've seen like CM1, CM2, CM3, CM4 gross margin which is, I think, legacy from some of the earlier companies in Southeast Asia but basically I think that this practice where like, okay, GMV, revenue. So then gross margin, contribution margin one, contribution margin two, contribution margin three, contribution margin four.
And sometimes what it is doing is they're moving a lot of costs that should be higher up and is moving it lower. So technically it's fully disclosed. But then basically it's not the true gross margin. It's quite true contribution margin. And so I've seen a lot of fellow investors kind of get tripped up because they're like, Oh, this is the gross margin, but you're like, no, no, no, no, that's too positive.
It's actually, you should be looking at CM3 or CM4 as the right definition for looking at it.
(42:04) Sadaf Sultan: Right.
Yeah. That's quite common, right? So, for example, sales and marketing. What is really acquisition spend and what is essentially your branding, right? And so you can move a lot between those buckets, from CM2 down to kind of OpEx.
The other, you know, would be transportation or fulfillment. What is transportation that is related to, you know, fulfilling the order or receiving the inventory and, you know, what is transportation, which is like, more sort of OpEx oriented. So, there can be a lot of interpretation around how to book these things. Typically I think you want to be more conservative and also investors, I think, need to push back on each of those items that they see within CM1, CM2, and CM3, and try to also look at the OPEX and make sure that there's nothing there that should be up there, within the contribution margins. So that would be the start.
(42:48) Jeremy Au: Yeah. I think another one that I've seen is, I think cashback or discounts being moved from gross to net revenue as a cost of sales and being moved all the way into sales and marketing. And so what I saw, I was like, this company was like, we're going to grow this incredible top line. I was like, Oh, fantastic. And then it's like, because, and then you dig, dig, dig, and you're like, wait, the cashback program and the marketing is going out at the same rate. So most like, a vast majority of that growth is coming from a cashback program which should be recognized as a discount of your revenue rather than as a below the line.
(43:23) Sadaf Sultan: I think for that specifically for marketplace and e commerce businesses more useful than CM3 as a metric is to actually look at recurring revenue as a percentage of total revenue because that's the whole point of e commerce and marketplace business, repeat purchases.
You get a user once you delight them for a few transactions and then they become loyal to you and they transact, through you for repeat purchases and they become high LTV customers and you can spread out that LTV over the CAC that you've spent. So the metric that gets the heart of that is to what degree are those recurring transactions happening from customers that we have sold to before? And what is the churn rate of new customers that are coming on board every cohort? So, I think beyond the CM3 you need to go more into the operational metrics to really understand what's happening here. Besides that, I would say, in terms of kind of more flagrant essentially taking some of the CM2 costs and booking them as revenue which, how do you even do that? So essentially like, think about it this way, right? I'm selling you product but I'm also helping to fulfill that product. But I'm helping to fulfill that product with some sort of a writer network. But then let's say I start essentially booking out the capacity of certain writers I know there's going to be a predictable level of of fulfillment orders that will come through then you can kind of make the argument that hey, I'm also in the fulfillment business. I'm not just operating as a connector. I'm actually a principal in this transaction.
So there are good accounting grounds of doing that, but the question is to what extent are you showing that fulfillment revenue? Are you showing the piece that your writers are only delivering or are you showing everything? In certain cases, you know, you can kind of, I think, find a wedge to make that argument, but you can make a really crazy argument, right?
So the wedge is I'm fulfilling orders out of my own balance sheet. But then the exaggerated argument is that, you know, let me capture everything that is in CM2 as fulfillment costs, right? So I've seen that. Of course, that should be detected on diligence, but there is an argument there, a partial argument for doing that.
(45:12) Jeremy Au: Yeah. And I can imagine VC getting fooled by that pretty easily because there's so much buzz around like full stack, vertically indicated sensors. I think it is a fair argument for startups to say, if I'm paying so much for logistics, why don't I? I may do it myself. I'm not efficient. And I think in Southeast asia, a lot of the logistics are not efficient. So I think there's a fair business argument. But of course, I think the tricky part is like you're converting a cost into a revenue. And so it's debatable. I can see some scenarios where it's okay, but the question is like, what makes you? Cause I think basically it's a transfer pricing. Basically, that's what I call it. Like technically, even if you are making money on your logistics fee, you should charge a fair internal price to your internal prior business line up actually doing it.
(45:52) Sadaf Sultan: So I think the, question that I think investors can ask, you know, all across the board when this happens is, is there a good reason for this to be on your balance sheet? . Are you adding value by taking on this risk?
So, another example of this is essentially getting into the input financing. You're working with farmers you know, and you are operating a marketplace in which you are connecting them with farm inputs, right? But now you decide that, hey, I'm going to buy these farm inputs, and I'm going to warehouse them, I'm going to sell them directly to the farmers. And I'm also going to find some lenders who are going to finance this transaction. What, why did you need to kind of put this on your balance sheet? The lenders, the bank lenders were gonna lend to the farmers anyways, and those farmers could have then kept on buying from the merchants directly. Why did you need to get into this picture? Right? and take on this risk.
(46:38) Sadaf Sultan: One argument is because I want to make profits. Sure. But you know, is it worth the risk that you're taking on? And if that risk reward proposition doesn't make sense, you to take that risk onto your balance sheet, then you are really trying to kind of inflate a narrative. And that's really the purpose.
(46:53) Jeremy Au: Yeah. I think when you describe it that way, I think the crux of it is that the company starts out with a marketplace business model, which is that I'm looking at a gross GMV between all the transactions of it. But then if I take on input financing, I take a lot of control on one side. Effectively, it becomes a direct relationship in which case then you, you should no longer be value off GMV. You should be valued based on the consolidated revenue of that. But where the trickiness comes in is that if you did that, then you basically are being valued, doubled. Exactly. On one end, you have a marketplace business that you came separate, which you're being valued on a GMV multiple, and then you have your standard business where controlling the business.
But then, you take a multiple off the revenue and then you blend those two together. And then it looks fantastic. But I think, think this is a grey zone argument.
(47:39) Sadaf Sultan: Yeah. that is the ultimate stack. 100%. Right? I mean I think any marketplace at the late stages would wanna make a play like that. I mean, if you think about like supermarkets as an example, all supermarkets have private labels. And that's where they make a huge amount of margins. Every marketplace should have that ambition. But then the question is much like the private label, a corollary. The question is like, are you adding value? Private labels add value. They're typically cheaper than a lot of the other peer groups.
So, is your product cheaper and of a higher quality somehow? Or if they're worse quality, if they're more expensive, there's no reason for you to be a private label.
(48:11) Jeremy Au: Yeah, I think that's where some of the investor lack of clarity around. I'm just saying like, I have a fish feed. Is this high or low quality? I don't know, right? It's like, because you just took the existing fish feed and you just sell it, but supposedly the network is more efficient. Well, I think you just gave two examples. So I only can give one example. So that means they've officially won. It's okay. It's not a competition financial strategies, but the one that I've seen is a little bit more sophisticated is when the offload costs onto another entity, so this happens maybe, for example, like this person may have a family business, for example, and then they build a startup.
And so basically that's like a mothership entity. And basically this new startup in order to show profitability, a better margins. They actually have employees that are working for them in a mothership organization. Obviously, that requires you to be, you know, family connected, so that you actually have a profitable mothership to actually farm those employees out.
But that is one way that is a little bit harder to detect because basically what it looks like is like, wow, you are making this amount of money with 30 employees. Fantastic. Right. But actually, 10 or 20 of them are actually being paid for by mom or dad. That's what I'll tell you. And that's, I think how to detect because it doesn't show up as better revenue. So it's hard to detect. It doesn't show up as a fraudulent procurement supplier. Literally, it's, I think that's one of the hardest ones to catch.
(49:30) Sadaf Sultan: Yeah. I mean, that would be very hard. Right. And of course, it wouldn't be very scalable also, like you can't do it as Series C or D. That would just be very, very hard to detect.
I would think, I don't know how to kind of play the blue team on that, to
(49:42) Jeremy Au: be honest.
No, I mean, I think just you have to know, like, this person family connected? And then you have to look at the nature of the relationship. And just ask explicitly, is that a vendor vendee relationship? If they declare it, then you probe it. And if they don't declare it, then, you know. But, there's sometimes you need to make sure there's a consulting arrangement. There's unverifiable terms as well. It could be like
(50:00) Sadaf Sultan: Yeah. I mean, if there's an agreement between them, for sure, right? And then you can like get in the agreement if it's with a related party but you know, if this person is just like, sort of, remotely working, with no contract with the startup, then, it's just like, how would you even find that connection?
(50:11) Jeremy Au: I think it's fully disclosed. And the VC might just be like, okay, you know, it's a related party transaction, but it's a known benefit to the startup. So it's not a risk factor. It's just that we know that numbers look better than they are because of this subsidy. But at least it's disclosed. But I think the tricky part is like, if it's not disclosed, then the VC looks at it, wow, this business is so efficient compared to all the other competitors in this space. Yeah.
Well, that's the last one I got, but hopefully there's a nice one, a sophisticated one, right?
(50:38) Sadaf Sultan: Yeah, great, yeah. That'll be hard detect.
Yeah.
(50:40) Jeremy Au: So on that note, I'd love to wrap up. I think the three big takeaways of our conversation. First of all, thanks so much for going into the eFishery piece. And going into, like, how exactly it happened, and I think the different incentives and structures that happened into how it happened.
I think, secondly, thanks so much for sharing about how external investors or board can kind of penetrate this kind of like opacity to figure out who are the good faith actors and who are the bad faith actors in the space.
And lastly, thanks so much for brainstorming with me all the various shenanigans I've ever seen in the finance space.
So on that note, thank you so much.
(51:14) Sadaf Sultan: Thank you, Jeremy. And I'm hopeful that this was useful for the viewers as well. And, you know, always happy to come back. Thank you.
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