Founder Frauds, Startup Accounting Tricks (GMV, Revenue, Gross Margin, Contribution Margin) & Revenue Bundling & Valuation Multiples with Adriel Yong - E453

Adriel Yong, Head of Investments at Ascend Network, and Jeremy Au discussed three major topics:

1. Startup Accounting Tricks (GMV, Revenue, Gross Margin, Contribution Margin): Local VCs have often confused Gross Merchandise Value (GMV) with actual platform revenue, and gross margins with actual unit profitability. Startups have also split reporting contribution margin into CM1, CM2, CM3 and CM4. This has caused investor misunderstandings, accusations of misleading financial reporting and startup boards to focus on the wrong metrics. Prevalance is high due to inexperienced finance teams, emerging VCs and poor market norms/ incentives.

2. Revenue Bundling & Valuation Multiples: Jeremy and Adriel addressed how one-stop-shop/ superapp startups may bundle multiple revenue streams under a single total "revenue" term: one-off sales, onboarding fees, GMV-based revenue, direct material sales, SaaS subscription, and lending revenues. VCs may mistakenly apply the same "tech valuation multiple" to all of these different revenue streams, leading to inflated valuations and later misunderstandings of the actual growth rate. For example, many VCs failed to understand net interest margins for lending startups, thus failing to account for non-performing loans.

3. Founder Frauds: Jeremy and Adriel discussed real-life anonymized examples of theft, misrepresented financials, inflated invoices, related party transactions without proper disclosure and fake school credentials. They noted that these practices are common in markets with less rigorous due diligence processes or less professional founder / executive business norms. VCs face challenges in detecting fraud, such as spot-checking large-scale operations or non-existent offices, underscoring the need for thorough due diligence to verify data accuracy.

Jeremy and Adriel also talked about the impact of bribery and kickbacks on market operations, effective methods for verifying company operations, and the importance of appointing neutral CFOs to oversee transparent financial practices.

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(01:40) Adriel Yong:

Morning, Jeremy. Glad you just soloed your food.

(01:44) Jeremy Au:

I know, right? I didn't want to treat the audience to the whole sound of me kind of like gulping down my food and breakfast,

(01:50) Adriel Yong:

Yeah, but I guess at some point we should do like a mukbang episode of, us just eating and staring into the camera.

(01:56) Jeremy Au:

This is like what every VC's dream, right? It's I'm good for everything and people watch me do a mukbang. Hey, you know what? There's the differentiator, right? So you could be like, I'm Andressen Horowitz and I'm known for mukbangs.

(02:12) Adriel Yong:

It might not be a bad idea given that there are so many like F&B startups in Southeast Asia, anyways.

(02:18) Jeremy Au:

The other way of doing it would be like, if you're a famous eater, competitive eater, like Joey Chestnut or thatJapanese guy. And then you became a, like Kim Kardashian, right? You become like an investor. But instead of Kim Kardashian doing cosmetics and makeup, now you're doing, consumer food. I think it'd be great. You know what? A lot of people will take your money, right? Think about it.

You're like a competitive eater and you're like, Oh, I'm your investor. I think you put your face on the front those cutouts. I endorse this place, next thing, a Michelin star.

(02:45) Adriel Yong:.

And also my favorite ice cream and coffee brands out there until this age. Oh, yeah,

(02:51) Jeremy Au:

You know what, this is actually not a bad idea. Well, you know, today we wanted to talk about an episode because we saw some news and we're just reminded of all the stuff we've seen before. So today's our favorite list, which is like a list of all the fraud and accounting tricks and shenanigans that we've seen, and I think we share about it two ways, right? I think one of us is please don't do it. That's number one, rather than take it as a list of what to do.

And of course, I think there's a lot of VCs out there in the ecosystem who are not aware of them. And then they tend to run straight into a blender. They don't detect it. And then, the careers are destroyed because they accidentally invested in a fraud company. And I was like, you didn't do your due diligence. And you're like, yeah, because You only had two years of experience in VC and nobody talked about it. So I think this is what our community gift to the community based on all the stuff that we've seen together on the shenanigans. So I'll just kind of like start off first.

I think the easiest one and that we had to do a lot of math on was the definition of gross margin. So that's a very common trick. I think we saw that at Uber. We saw that at Grab in the early days. We saw that at like the Rocket Internet affiliated companies which is as a legal accounting definition, which is basically saying that we have a definition of gross margin. Then they have contribution margin which normally means gross margin minus some indirect costs. Of course, I think what's special is that now we have CM1, CM2, CM3, CM4. And I think that's the fun definition that we have.

In the interest of our professional code, we're also not going to mention any names because there are claims in the news about certain names. It's just that, I think it's just something for you to be aware of and so that we can do less work fighting off people.

So, I'll start off first. So the easiest one that we often see a lot of debate about is the difference between GMV, as well as revenue. So we see a lot of companies which are looking at GMV, which is gross merchandise value which is the, I think the volume of throughput and transactions on a platform versus revenue. And the reason why it's important is because let's say you're an e commerce platform, and you run a thousand dollars of transactions, but you only collect 1% as your platform revenue, you could either say it's a thousand dollars GMV, or you can say it's a thousand dollars revenue and there's a big difference.

And I think we've seen a lot of that where a lot of VCs or lead VCs seem to be very confused and they give these multiples which maybe are reasonable if you take GMV to the price of the company, maybe like 10X or 20X, but it doesn't really seem to make sense when it's looking at the platform revenue.

(05:14) Adriel Yong:

Yeah. And I think that's important because if I know the VCs out there are pricing my company on GMV or let's say 1X GMV and, I just gave black Friday, Blue Monday, go Wednesday, sort of like discounts. I run sales every day and that drives up my GMV massively, but the net revenue, I guess, is much, much lower because you think about what actual revenue you're making post discounts, subsidies all the stuff that you collect back. I'm sure Jeremy has seen a lot of Amazon packages around his house and, being shipped back as well.

(05:45) Jeremy Au:

Yeah. No comment. Not myself as a household purchase. But yeah, I think the tricky part is that I don't think it's fraud. It says accounting definition for that. And I think that a lot of new VCs kind of like take that revenue point of view and get confused. And what happens as a result is that the startups may end up getting like you said, focused on the wrong metric. And the, in terms of accounting, the difference between GMV and, like platform revenue of course is your, like you said any kind of like promotions, discounts driving up the volume of transactions rather than driving up the profitability. I would say barely profitability, but at least the revenue take of the transaction.

And I think we see a lot of that in Southeast Asia especially because I think in the U. S. there's a lot of SaaS, a lot of, like very companies that are very much more technology oriented. Cyber security is hard to, there's no such thing as GMV in cyber security. I think in Southeast Asia we see a lot of transactions. We see a lot of fintech companies that are taking some percentage of it. So I think there's something to be aware of so that you're not fighting over the wrong definition.

Quickly to the second one, I think, is if you're a fintech company net interest margin versus gross margin is something that we often see which is a bit more specialized. But basically what this means is that just because I lend you money, you pay me back 10 doesn't mean that's my margin, because I actually have to pay interest for the debt, the capital that I'm borrowing. And so a lot of fintech companies skip that step and just look at it as gross margin.

I think we've seen that a few times now, and it's always I think what happens is that people end up valuing the overall repayment flow, but they don't understand the cost of capital as one of the cost of goods sold for that repayment flow. And so they wrongly classify that revenue.

(07:24) Adriel Yong:

Yeah, no, I think this whole idea about net interest margin probably only made more sense because, when the interest rate environment changed, suddenly your margin profile for lending is very different, right? So looking at net interest margin becomes very important. I think also in the context of Southeast Asia, where non performing loans rate can be quite high in an emerging market where collections is tough, people run away with the money and there's, Indonesia has a hundred plus islands. How are you going to find that little bugger who ran away? Looking at the NPL rates as a cost of goods or factoring that in how you sort of calculate your net interest margin and just looking what, what is this lending companies, actual net interest margin, rather than how much top line revenue they're making from overall loan repayment. I think this much more holistic way of looking at the health of that lending.

(08:12) Jeremy Au:

So that reminds me of another error that often happens. Is that a company right now are trying to be all like the all in one for this, right? So they'll say like the super app for this.

And so the revenue may have multiple revenue streams, right? So this is a one off revenue. then there's like the, let's say GMV revenue versus the actual platform revenue versus the kind of they also lending to those same player pays as well. And so those are three different revenue streams and they bundled together, say revenue, but those are three very different types of quality of revenue, right? Because one is one off and not recurring. One is GMV, not actual platform revenue. And the other one is does include, interest rates and so forth. So then. People get very excited because they're like, wow, that's 5 million of revenue when actually in actuality, maybe it's only like 1 million of actually high quality recurring revenue.

So I think that's a, another one.

(09:06) Adriel Yong:

That's such a smart one. I will think of that if I ever start a company. I'm kidding.

(09:12) Jeremy Au:

You set up like a pork, right? Stall. And you're like, every time I sell one one dish of rice, it's a recurring revenue this one. And then I have a buy now, pay later you by your rice dish. And and then you sell some like shoes on the side and then you collect a wholesale price.

(09:29) Adriel Yong:

And then I'll make sure to start a website for this Char Siu shop and ask VCs for a tech multiple on it.

(09:34) Jeremy Au:

Oh yeah. Okay. Okay. That's another one. Okay. So another one that we often seen is not using the right multiples. And I think in general, we all understand technology multiples to be higher. And I think we obviously generally understand that services revenues tend to be multiple should be lower. And I think the big difference that we have here is, people get messed up.

So what I mean by that is for a startup, normally a multiple is high because you're growing very quickly and because you believe that the market size will get larger. So you're front loading some of that CapEx investment because you're gonna grow into the evaluation. But thirdly, of course, we should have an eye on what their end state is going to be.

And for early stage companies, obviously, that matters less because we're further away. So this is maybe more relevant for like when you hit the C, the Series A. The multiples, right? Because maybe if we, your startup may have no revenue in the first one, two, three years, but I think where we end up is, we end up a scenario where in Southeast Asia, there are many logistics companies that seem to have a technology multiple.

And then there's a big debate, which is that they shouldn't have it because the quality of revenue is different, in terms of the recurring nature that's one, but two also in terms of the profit ratio of that revenue as well. So I think we see that as well for every tech as well. What else have you seen?

(10:42) Adriel Yong:

Takes a big one. As consumers, always conflation of like multiple revenue streams, right? Because you might have a consumer SaaS, but, you also have something that, just like moving goods through your platform. And then, there might be a payment revenue stream embedded in there somewhere.

And each one of them have very different margin profiles and also very different quality of revenue.

(11:05) Jeremy Au:

So that's a totally fair debate to have. I mean, often you see founders debating one valuation multiple versus the founder, VC. And even within the VC committee, there could be people arguing, it's a high multiple, low multiple, but it's important because I think if you have too high multiple, especially it was inflated by zero interest rate policy era, public markets are crazy, then people end up making some bad decisions about that. And, you, Set your startup up for a future flat round or down round. If that doesn't combine with the other areas we talked about. So again, imagine you have a GMV multiple of 20 X, versus one round later, people are looking at it in terms of your revenue times a five X.

Then, there is like a huge difference, right? Imagine the scenario, which we see often Southeast Asia is that. We may see an e commerce company where the valuation is a function of their total GMV times, let's say a 20 X technology multiple.

However, next round the VC takes the revenue, which is 10%, let's just say of the GMV, so it's a 10 X smaller, and then they only put on, like I say, a five X multiple, right? And so there's if you look at the math, then, there's actually quite a dramatic slope difference because it becomes 10 times four is like a 40 X difference in basically the evaluation.

So I think you see a lot of pain. And then the founders, obviously it's not really their fault because they're like, great, I got a great valuation to start. And then they don't, no one's going to complain at that round. And then the next round they're like, wait, why am I talking to founders and CBCs who are very cynical about my evaluation?

And then there's a big fight and debate of the board.

(12:42) Adriel Yong:

I mean, that's interesting because it reminds me of one of our portfolio companies. I shall not name who, but you know, obviously they didn't go to talk as go to go and talk to as many VCs as possible.

And in the end it was like three funds that were offering them term sheets, right? And basically there was some level of like collusion between different funds to sort of like offer term sheets at similar valuations. which is, actually, I guess a good thing for the VC is issuing the term sheets because they sort of control the price and valuations a fair bit but from a founder perspective it was probably like suboptimal in terms of, sort of the dilution that they now have to manage and on top of the capital requirements that they want to have to grow the business.

(13:26) Jeremy Au:

Yeah the key thing here and my quick advice to founders is don't share who else is the potentially VC or competitor with your other potentially VC candidates. Or even your follow VC candidates, cause it's like round trips. So I think that's my advice to you. Otherwise you, you remove the competition era of your auction and then it moves into quite valid is if the two VCs really know each other, they'd rather come in together because they're like, Hey, we're buddies. We can be co lead VCs, on this round as well.

So there's other types of accounting definitions. I don't want is gross margin versus CM1, So for those who are not coming trained is basically means gross margin versus a contribution margin one, contribution margin two, contribution three.

And what it's supposed to be is that gross margin is supposed to be your direct revenue minus the direct cost of goods sold. And then contribution margin is supposed to be minus off some of the variable indirect costs that you believe reflect. And then after deducting this, this is the amount of.

Value that accrues to your company's fixed costs as a whole. But I think what that means in practice, of course, is that for example, and go back to the e commerce is that you have GMV where you're making a thousand dollars of volume transactions. You collect 1 percent as your revenue. So you're making 10 as your I'm sorry, let me say that again.

So let's use a scenario where it comes all together, right? So let's say you have an e commerce company and you have 1, 000 of transactions on it and you take about 1 percent as your take rate. Now there's a big fight debate now, which is, we know that GMV is 1000, but of course, whether we save revenue, I would argue that this would be 10.

Your revenue is 10. And obviously the gross margin could be your direct and this is where the debate comes in, but you can say logistics or credit card fees or other stuff that is fundamental to the cost of business of running this transaction on a one to one basis. And I think people start fighting very aggressively because they want to move like credit card fees or logistics or shipping fees to cM2, CM3, CM4, because what do you want to say is Hey, as a founder, they want to make arguments like, Oh, GMV is 1000. Our revenue is 1000. Our gross margin is 900. Our CM1 is 800. My CM2 is 700 and my CM3, CM4 is. Finally, like 5, right? So they're trying to do the same math, but move as much of that costs down into CM for and the argument again, is that trying to get the VC to give them a good CM one to valuation multiple.

(16:04) Adriel Yong:

I mean, I think there are many reasons why I guess founders would use all these varying levels of cm. I mean, one could just be really being, try trying to be like granular about understanding what the state of their contribution margin is. And I guess that's good, right? 'cause then you know at which part you know of the contribution margin you actually need to fix.

I think there are probably also some folks out there who are just. maybe a bit avoidant of the reality of the business where, in some businesses, it would be very, very tough for them to even hit CM4 break even. And so they just try to split everything up and say, okay, we are CM1 and 2 positive.

After this round, we can maybe hit CM3 and 4 positive. But, after this round that obviously does not happen. And all sorts of companies especially the marketplaces have blown up with this sort of. Avoidance of the reality of the contribution margin of the type of businesses that they run.

(16:57) Jeremy Au:

And I think that's the sad part, which is that obviously companies don't want to blow up, but because, I always tell it's you're driving a car and then you're trying to convince someone that you're, driving faster than you actually are and that your gas tank has more gas than it actually does. There's a lot of persons like, Oh, okay. It looks good to you because it's done, but then you end up believing those numbers and then you end up, kind of like, driving a car off a cliff.

(17:21) Jeremy Au:

So I think it's very important for founders to not drink your own Kool Aid, number one, if you're like making this definitional debate. But two is, I think if you're a smart VC, then you should be having a very fair conversation about the right margins and right metrics to track and to work at a board level with. And then by nature, if you are a good VC, then you should be working with good founders and good founders should want to work with good VCs.

So in general, I think having a good faith attempt of looking at the right metrics means that. You're more likely to hang out with the right board member because, there's adverse selection, right? Which is that if you're giving the wrong numbers, only the bad VCs are the foolish ones or the ones who are intentionally running with those metrics tend to want to continue to invest in you. So I think it's a big problem.

Think a corollary as well to that problem is I think a lot of V startups that maybe have a heavier requirements, so they require for example, account personnel to be on the ground. That cost, they may make it part of their fixed cost rather than being part of their contribution margin, right?

So I think we've seen stories like they had to have one person on the ground at every account, and, and I think there's a difference because if you're having a salesperson that just buys the transaction and then at each place and then Maybe that's a few refresher calls to remind them to pay.

That feels like relatively light. But when you have somebody who is basically acting as their arms and legs, effectively just running a service on their behalf. It should be part of the margin or cost structure for it being done. So I think that's the craziest I've ever seen. It's one person at every shop.

Helping them run transactions and obviously they were way less profitable than they showed it to be because they put those people as like a line item called HQ salaries. And you're like, why is this and it's actually not that large as well because even in Indonesia, the salaries are not that high, but it actually is quite meaningful.

(19:12) Adriel Yong:

You know, at the end of the day, we all just need to be clear about what is the actual cost of running this business and generating this sale and factor that into the contribution margin, right? But I think, adjacent to this topic about margins is maybe your margins aren't that bad, and maybe the margins are bad because someone's taking a kickback. We’ve heard versions of that. Yeah, yeah. I've heard I've heard stories of, new company CEOs coming in and then they're like, why is the company so negative in EBITDA over the last four years when this is an industry where the margins are supposed to be relatively healthy?

And then he goes, line by line. visits the operations of the company and then he just realizes there are just so many kickbacks happening at all sorts of transactions, right? Can be as simple as equipment buying, could be as simple as rental of certain locations. What, what sort of B2B kickbacks do you think both investors and founders should think about?

(20:14) Jeremy Au:

Yeah, I think the sad reality is bribery exists in Southeast Asia and other emerging markets. And so I think, people really have to be aware that it happens. I think there are different types and it just shows up at different levels, right? I think I would look at it in terms of the supply side, the demand side, and maybe even the founder side. I think the easy one that we often think about is the demand side. So people are often trying to fight for contracts. And try to win business. And then the guy says, Hey, I want some cash dynamic. And I think the legal version of that, I think we've seen is like promotions as well as cashback.

It can make sense in scenarios, for example, where the guy is like doing a hundred thousand dollars of transactions for year, year one, you want to give him a 20, 000, cashback just to make sure that he's really stuck in embedding a platform and it wasn't a transaction. So I think as long as you like legally define it and make it clear and in a perfect world, it'd be like gross revenue minus kind of like this cashback program equals net revenue. That's where it should be recognized. I think where it gets very tricky is when two reasons, one, when it is not recognized, in other words, effectively it's bribery, but then to hide it somewhere else under like marketing or sales expense or some random place. So they, so that's not okay. I think the other version is when they do it because they inflate the invoice. So the amount of transaction is correct to, in terms of the net profitability to the company, but they inflate the invoice. That's another version. I think the third one, which is like very gray area and I would not recommend it, but I think we often see like many startups put that cashback program and they move it under marketing and expense or sales expense.

And so I think more naive VC will be like, wow, your revenue is growing really like nicely, but then, and then they see a marketing and sales expenses going up quickly as well. And they're like, okay, that's fine. But they kind of like, get excited about the top line numbers. So I think that's a one version of it.

(22:06) Adriel Yong:

Get excited about the top line numbers. So I think that's one version of it. And then the person who made the FDD report was like, actually these are not the numbers that I signed off on. And then, it became a can of worms, right? And they started to do spot checks in different locations. And then they realized that certain locations did not exist. And I guess that's particularly challenging for VCs, diligence ing companies which have very large physical operations, numerous on the ground, say, stores. warehouses locations, outlets, et cetera. And just figuring out how to do that scalably because it's going to be very hard to check off, if let's say a company has a hundred plus locations, it's going to be very hard to check off one by one, all hundred exists and have real sales and revenue.

Or even I've, another investor friend was telling me, right at, she was in Vietnam and. Like she went to the company's office for due diligence, chat, felt normal. Okay. But then, on the last day of her trip she decided to just make a surprise visit back to the company's office. And then she realized that company did not exist.

(23:24) Adriel Yong:

And the office was fake. It was like, all this like shenanigans that you just have to do the unexpected things when you're doing like your due diligence to figure out.

(23:36) Jeremy Au:

You're doing your due diligence to figure out if that thing is not catching. And obviously, in the hot era, I think everybody was like, wow, these VCs are really slow. And I think it's true because it's slower in terms of whatever it is. But I think what I'm trying to say here is that if you have a VC where your reputation is that you do very fast DD, very fast to wire money, that's actually probably adverse selection. You'd probably have more fraudulent startups start to approach those they know that does less DD, and that's really important because you end up becoming like a prime target as a VC. Like you a, you become a money pinata for . It's like where the founders were like, yeah, it's okay. These guys do less dd. So it's more or less, more likely for me to do well. So I'm gonna spend more time pitching them and closing on them, rather than the VC that does more dd.

So I think it's important to have that reputation that you do your due diligence and it shouldn't be seen as a negative thing. Obviously it don't take too long. Don't take four months, five months, six months. But I think it's okay for you to be like. Hey, if we detect fraud we are going to pull out of the final stages of this post term sheet pre wire process.

And we're not gonna make a big deal about it, but the moment you do this kind of stuff, then people know okay, you actually, are willing to stand up for yourself.

(25:00) Jeremy Au:

I think another one that's interesting is there are startups in industries where kickbacks and bribery is common. And so the startup struggles to recognize how to do that. So they're quite upfront with that with the VC investors. And then you're just kind of like, that's hard to do accounting on. And that shows up in different places, but it's interesting, right? Because it's they're quite direct with the board about it when they talk around it. And then I mean, my general point of view is as a VC is just don't do the deal because it's so complicated.

And, eventually if you do a series B, series C, like growth investor, like all those numbers have to come up to the books, even go public as well. So actually I think it's quite hard to do that kind of deal. But I think we've definitely seen that where it's like, the behavioral norm but then the founder is direct about it with internal stakeholders, which is quite interesting twist on it.

(25:49) Adriel Yong:

I guess it's the function of how the investors feel about underwriting such expenses, which, I guess really varies based on, I guess, maybe ESG practices, who your LPs are as well, right? Those definitely play into the self decision making on such deals. I think the other interesting one actually, from a sort of I guess, P& L margin perspective would be things like salaries. We briefly talked about how some salaries should be recognized under you know your sales and marketing expands contribution margin accounting But you know, I you know, someone was telling me this recently, right? There was a certain company that hasn't played hasn't paid employees in eight months but you know, they have been paying their founders super high salaries So it almost feels like all the investment race is just to pay founders and not anyone else in the company. So I think maybe that's also something to to look out for and think about like high founder salaries and You whether they're actually paying like the people that they need to pay to run the business.

I've also heard of like companies giving very high severance pays like one or two years worth of severance salaries. And these are two people that the founder is related to, right? I think, controls for such large amounts of salaries should also be put in place by the board. But I guess at the end of the day, if you're a VC with a large portfolio, it becomes very hard to maintain relationships with the employees of your portfolio companies beyond the founders and maybe some people within the C suite. So I think this's also

something, an area that probably investors should actively think about as they go about making investments, portfolio managing.

(27:29) Jeremy Au: Yeah so I think that touches on something that we think about, which is, and I think a potential risk factor is if members of the executive team are related to each other so I think we've seen that so that could be in a form of siblings, or it could be in a sense of like brother in law, sister in law, or husband wife teams, I think the U.S. has not been seen pretty negatively because they want to see professional talent and everything. I think Southeast Asia is a bit more common to see this kind of a relationship because I think talent density is scarce in Southeast Asia. You probably birds of a feather flock together in terms of like family or blood or spouses.

So I think it's quite common for husband and wife scene. So I think that in itself is not a problem because as long as you work together, you're both professionals. Okay. I think the soft concern is that, Hey if the two people conflict, can they actually be a high performing team? Amen. Do other members on the executive team feel like they can voice, disagreement or strategy because maybe they conflict with the husband, the wife is a CEO, and then can a wife choose fairly between, the professional executive versus the husband, right?

So if they end up favoring their husband's opinion more, then that could be a net negative for the company's performance. But that's a soft concern. I think the hard concern is that I think we've seen scenarios where executive teams end up either conducting some version of fraud or shenanigans because they valued each other's relationship and trust each other more than the company.

So they don't feel like they'll get caught. And so we've seen different versions of that. Like for example, I think a good company should have dual key. And that means in a sense, in order for money to transfer, it requires two people to sign off. And if those two officers are both blood related or equivalent related, then you can end up in a scenario where money that's supposed to stay with the company can end up being transferred to other places, right?

So I think there's something to be aware of. I think there's also another case I've seen where I've seen was like a CFO was blood related, effectively. And then basically there was shenanigans at the overall reporting level which had to be caught through due diligence as well.

So I think there's something to be aware of is I mean, obviously I think if there's a blood relation by that person is very junior, like a product manager or a logistics manager, it doesn't really matter as much. But when that person is a CFO, especially or something, I think that can be a concern.

(29:42) Adriel Yong:

Yeah, I think it's very important for, the institutional investors to sort of control the hiring of key executive members like CFO is definitely something that I think, the lead investors should sort of drive and a point rather than it being some random person that the company decides to hire or has a very good relationship with, right? Because I think you want that sort of like independence, neutrality. And of course, people often usually see the CFO departure as a sign that, the company is not doing too well with how they're managing money both professionally, but also on a, sort of maybe personal level. So yeah, that's probably a thing to watch out for as well.

(30:23) Jeremy Au:

I think if you heard news that they depart before a one-year mark, that's probably a bad signal.

(30:30) Adriel Yong:

Or a one month mark.

(30:31) Jeremy Au: thing to watch out for as well.

Or a one month mark. Because it's a very, now it could be because they were not a good fit, but you know, you really just had to make sure that you understand why it actually happened. I think we've seen that happen multiple times now in the news, because normally they get announced very happily as Oh, we hired this great CFO of this caliber. And after it just disappears silently in LinkedIn. So I think there's something to watch out for. I think also other types of flat out fraud would be like a flat out transfer of money to the founder's accounts, right? I think we've seen that before. So I think we've seen scenarios of, Oh, executives transferring money to themselves and then they run off.

That's one. I think people have, founders have transferred money to the personal account and they're like, Oh, I was holding it on, on behalf of the company. But it was never approved by the board or other people. So there's another version of that. I think we've seen people do it on the, via the blockchain, which is the worst version of it.

(31:28) Adriel Yong:

Because decentralization.

(31:30) Jeremy Au:

But it's like, Hey, it's a public ledger, right?So everybody can tell and see it when it happens. So it's really hard to explain. So think we've seen that as well. How has a crazy shit, right? I think that the, okay, I would say that there is a legal version of this and that's happens in America, which is, as a founders, you're drawing a very low salary, primarily equity based, and you want to buy a house to live in, in San Francisco.

So what you can go is you can go to the board and get approval for either high salary or you get approval for a company guaranteed loan. And so basically. It's a housing loan, but to some extent the company's helping support it, either through a loan directly for the down payment or company guarantee and that's a way to unlock some cash in San Francisco.

But I think what I'm trying to say here is that in Southeast Asia, it does require to be approved by the board. And if it's not approved by the board, Or if you hear the founder buys a very, very nice house, all of a sudden then I think, question mark should pop up just be like, why is it happening?

(32:26) Adriel Yong:

No, I mean, we, I'm sure we have all heard, cases of certain companies where even customer payments are flowing through the personal bank accounts of the founders or executives. I mean, I guess that one on is more like if you're a company or a customer, then. I think there's some level of due diligence you should also do when you're making payments to like personal bank accounts instead of a company bank account.

(32:51) Jeremy Au:

Another version of that is cash payments being flowed into and consolidated at "hubs", bank accounts or so what I mean by that is there's a lot of cash transactions that floating at layer one, layer two, which is like supposedly like with the, let's just say, X player, then you have a hub, which is, and then all that is being reconciled. At some level, and then it gets transferred into your electronic bank accounts, one level down, right? Maybe at a, daily or weekly, a monthly level. And the reason why there's a big problem is that, that from here on the words the electronic level onwards is clean, or at least in terms of cleaner, or at least clean enough to at least understand the individual transactions, but I think we've seen concerns where if it's all cash, especially in Southeast Asia, as the emerging market, then there's a high potential for fake invoices to be generated.

So for example Hey, then at the end of this week, a hundred dollars was transferred to the bank account. Okay. That's fair. And then maybe the actual number of invoices that you did was actually like 1000 of sales, and then you had 900 of transactional costs. So you only transfer 100, but there's a concern that invoices, what you could do, you could have made it into 100, 000 of invoices, fake invoices. And then you have $999,900 of cogs right at that level. And then the amount they transfer to your bank account is still the same, which is a hundred dollars, but one is like you have a much higher top line. The other one is like users of your normal top line growth. So I think there's been another piece is that as a vc, if you're seeing that cash is reconsult only at a certain stage or certain tempo, you have to be aware that there's a potential for invoices to be faked or fraudulence at a stage.

(34:34) Adriel Yong:

I mean, I think it's a, it's especially a big challenge for emerging markets where payments hasn't been fully digitized yet. I think in the U. S. or the developed markets, people just assume that financial statements or revenue and margins are true just because, it's sort of traceable to electronic payments by what is a P2P customer or a P2C customer.

The other thing I was thinking about the other day is oh, if you actually raised a couple hundred grand, you could just use that couple hundred grand to artificially drive your sales and then go to the VCs and be like, look at my hyper growth. Do you want to give me my next round? And then you just pay yourself back right after that, after that new round is raised. So I think just having a more granular sense of the data and like actually talking to, customers to understand like why they're actually using or buying a product or service. Yeah, super important for, for due

(35:28) Jeremy Au:

I think in Southeast Asia, I think there's a lot of second generation, third generation children of wealthy families who are using those as a source of strength and leverage. And it is what it is. So I think that if that's what you need to do in order to close a transaction or to launch a fintech company or, tech startup, let it be. But I think it's important for any related party transactions to be flagged and disclosed to investors. I think where it gets tricky is that, maybe it's like a one off transaction or so and so forth. So I think that different versions of that, but you know, if somebody's company is buying stuff from you and you don't disclose it, that's not good.

I think the other version that we've seen more in China so far, it is a little bit more sophisticated and also a little bit more complicated because it requires you to be second or third generation, is where you offload costs into a shell company, or into your parents company.

So for example, you have, a million dollars of top line, and then all your other competitors have 200, 000 of SG& A, right? Headcount. Then you only need, 50, 000 of headcount I think that a VC should poke and make sure you understand why they're so much more efficient compared to their peers.

I think, don't take it at face value. It's wow, these guys are so efficient. I think you should just make sure that you check. It's just did they move 150, 000 of headcount expense into a shell company, a separate entity that's not visible to you or is it at a company that they control? It may be in a previous company they ran or a family, relatives, company.

(36:51) Adriel Yong:

No, I think that's interesting, right? Because you could, you could almost make a margin on your hiring expense. Yeah. It's like your, your pseudo HR recruiting recruiting firm or EOR.

(37:03) Jeremy Au:

Yeah, exactly. And I think one of the ways that the Chinese people have caught it is they give a public disclosure like, Hey, with this number of employees, because people like disclose very large numbers, right? Like 1000, 5000. But if you don't get your financial count and then you're like, okay, actually the actual number is closer to 500, then you just have that question mark. It was like, what was the difference? Is it contractors? Is it whatever? So you just had to be, I think that's one way to do the digits as well.

I think another example we've seen of emerging market founders is that as a company, they've chosen to outsource something, right?

The IT or some vendor, which makes sense. But then of course it turns out that entity is actually controlled by them or relative or something very close to that. And so what happens of course is you could make it the arguable case that if that was the best vendor out of, three quotes or 10 quotes, you could make the argument that that's the best way to do it but I think what the concern is, and I think what has ended up being the case is that because you're related to that vendor, then you end up in a situation where the invoice is inflated and it's delivering substandard work, right? And so basically you're collecting a percentage for the vendor, the managing and executive.

So this is like a standard, pretty standard procurement fraud. I would say that happens. If it's disclosed, I think it's a little bit easier to kind of like as a VC to be like, is this the best possible vendor, which potentially be, but I think when it's not disclosed, it's normally a pretty red flag.

(38:23) Adriel Yong:

Okay, so maybe just to wrap up, I think we have covered a lot of ground today, right? We started off talking through accounting definitions, confusions around GMB, net revenue, gross margins, EM1, 10. Lesson there, I guess, is really just be clear about what the actual cost of the, the revenue transaction is both from cost of goods, but also, the sales and marketing costs involved to generate that revenue you know in the b2b space, I guess there's a lot more Opportunity for for fraud to happen, especially when you have like large scale operations And it's just hard to manually check off one by one sales and marketing expenses, Bribery gifts question mark probably good to talk through with companies that you are sort of evaluating. You mentioned, I think, high founder or abnormal founder salaries, executive salaries as well and then I guess related party transactions is it from, certain, relatives people like how sort of sustainable, reliable are those related party transactions over the longer term, especially as an ambassador, trying to underwrite longer term growth.

I think, obviously financial controls, right? So I think having a CFO appointed by, the institutional ambassador is important to ensure that, you don't have outright money wiring from company account to personal bank account or vice versa. Cash transactions being reconciled before putting it into the bank account, probably hard to confirm the source of funds and all that as well. And then of course, I think finally we talked about how people are able to sort of pay themselves in indirect ways by vendor, true vendor contracts that they're hiring, say software engineers or even brand. And then, it ends up going back into the founders personal accounts. Super interesting long list of potential ways a company in emerging market could commit fraud. But I guess, the lesson here for me, I think it's, it's all about just being more watchful and having a closer eye rather than assuming everyone has like bad intentions or, is out there to commit fraud.

I think we just need to have more like open conversations about this. I think also it's if everyone in a society knows that these are ways that fraud can be committed, I think people are just less inclined and, and keen to do it because the risk of getting caught is probably a lot higher when people are talking. More openly about about it.

(40:47) Jeremy Au:

Adriel and I will catch you. We see too much. It's now, I think you listen to this podcast. You're like, ah, shit, I can't raise money from them. They already know what's happening. That's

(40:56) Adriel Yong:

That's great. That's great. We should put out more posts about potential fraud so that people like go through those yep, you don't pitch to them.

(41:02) Jeremy Au:

You put like a poster of you cut outsize life size that is like Adriel, a laptop. It's we can do Excel No, I think, sorry, you just reminded me the last type is the founder is not who they are, which is the most direct is I mean, the minor version is they don't go to, they didn't go to the university Ivy league, or I think we've seen Founders have been publicly named because they're like you didn't actually graduate from the university.

That's one. But of course we actually seen cases where the guy is like literally like a fraud. So make sure you do those background checks by the way. But I mean the key point, I mean, other than showing that bonus pieces, I agree with you. Please take this as a list of things to not do. And of course, it's a big range, right? Because some of it's fraudulent and some of it is. area and some of it is basically like accounting debates. But I think at the end of the day, over the course of 10 years, you want to build real company value. And I think the biggest concern I normally find is that I think I often see that founders who do this because they make it like a small lie at front because they feel like that's what's needed or because my peers are doing it, but I think it really often snowballs out of control because the problem is that once you start doing it. You can't unwind one of these accounting definitional problems, right? It's just hard to like suddenly reset your board meeting and just be like, okay, let's go back to the proper way of accounting.

Like it doesn't happen. And the snow, the problem is snowballs and then it gets worse. And then you destroy your reputation when it gets exposed eventually because eventually VCs that more sophisticated will eventually join around. And I think. It's important for people to be thoughtful about that. On that note let's peace out and save it for the next time.

All right, see you, buddy.

(42:36) Adriel Yong: Jeremy. Yeah.