Listen: My Noa Series for February

This month’s Noa Series touches on a subject I feel is absolutely essential – ‘Due Diligence’. When it comes to investing or buying a company, proper and effective due diligence is essential. It
strips back the window dressing and asks; what is actually for sale here? Have listen here FREE and UNGATED: The Importance of Due Diligence.

What is due diligence and why is it important? 

It would appear that this is a question that is often asked way too late. 

Due diligence is an investigation, audit or review performed to confirm facts or details of a matter under consideration.

You can’t pick up a newspaper at the moment without reading about the collapse of a high-profile company whose investors failed to perform effective diligence. Here are two of the most egregious cases:

Frank and honest

Founded in 2016 as a financial platform that helped college students manage their financial aid and student debt, Frank founder Charlie Javice had a lofty goal to build the startup into “an Amazon for higher education”. Javice is once recorded as having said that her biggest challenge at Frank was scale. So, it appears, she made it up. 

She first asked a top engineer at Frank to create the fake customer list. When he refused, Javice approached a data science professor to help. Using data from some individuals who’d already started using Frank, he created 4 million fake customer accounts-for which Javice paid him $18,000. Impressed by the stats, JPMorgan Chase rushed to acquire Frank, paying $175M for a lie. The bank first noticed irregularities with the list when a JPM employee observed that the database contained exactly 1,048,576 rows, the maximum allowed by Microsoft Excel. Their worries continued when they spammed all four million fake customers with cross-marketing opportunities (to the dismay of GDPR departments everywhere), only for all the emails to bounce back. 

JPMorgan Chase is now in the process of shutting the site down and suing the 30-year-old founder of Frank. If only their due diligence had been as, well, diligent as their marketing department, they might have saved themselves $175M. JP Morgan Chase can afford a 9-figure blunder, but that’s hardly the point.

The clowns were running the circus

I’ve learned a lot from the FTX scandal. I now know what a polycule is, for example. I’ve also learned that QuickBooks is an inappropriate accounting system for a multi-billion-dollar crypto exchange which processes a vast array of complex and intertwined transactions. Although to be honest, I already knew that.  

The US Securities and Exchange Commission is examining whether investors carried out appropriate due diligence before investing in FTX. And with good cause. John Ray, the misfortunate soul drafted in to sift through the wreckage has said, “never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” A damning indictment when you consider that Ray made his name as chairman of Enron Creditors Recovery Corp. after the fraud that brought down Arthur Anderson was uncovered.

Ray also named the key factor in the collapse of FTX as the “unlimited ability” of  the former CEO Sam Bankman-Fried and his fellow executives to control customer funds for their own use, describing the company as an “absolute concentration of inexperienced, unsophisticated individuals.” He later said that FTX was “in a unique position to fail”.

According to lawyers for FTX, Bankman-Fried ordered his co-founder Gary Wang to open a $65 billion “secret backdoor line of credit” for Alameda Research, a crypto hedge fund under his control. In essence, FTX top brass was using customer deposits to fund speculative Alameda trades in what many commentators are calling a crypto Ponzi Scheme. This comparison is unfair. Charles Ponzi’s original scheme was actually quite clever.

With a bag of tricks that would make Derek Trotter wince, you might well assume that no serious investors were taken in by FTX. Well, you’d be wrong. Blackrock, Sequoia Capital and Softbank to name but three. In the crypto gold rush that marked the Covid and post-Covid years, giddy investors either forgot about due diligence entirely or used one another’s investments as proxy evidence of fiscal rectitude. If the clowns were running the circus the monkeys were managing the investment decisions.

Ensure your diligence is diligent

Due diligence is a process that enables buyers of, or investors in, a target company to fully understand it from a financial, commercial, taxation and legal perspective before making an investment decision.

Here are three things we learned from the Frank and FTX cases:

1. All material value drivers (and drainers) should be thoroughly assessed:

While the quality of the tech and the IP that protected it will have been a key focus of commercial and legal due diligence in the case of Frank, the reality is that much of the deal’s intrinsic value was tied up in the customer database. While spamming Frank subscribers might have been one diligence step too many, there were several red flags. The customer database clearly wasn’t scrutinised before JPM made their investment.

2. The quality of the executive team is crucial:

The quality of the team that will execute the corporate strategy and ultimately deliver post-investment returns is of paramount importance. John Ray’s testimonial reads like a catalogue of everything that could possibly go wrong when a multi-billion-dollar company is being run by a cabal of inexperienced ego-maniacs. Everything did go wrong, and then some. The lack of controls and oversight at FTX is literally overwhelming, the litany of failures too comprehensive to begin listing here. Suffice to say that a leadership team who cannot produce an accurate list of current employees is probably not up to the job.

3. The simple stuff matters:

Such as reliable financial statements, a group structure that doesn’t require an advanced degree in applied algebra to untangle and an accounting system that is appropriate for the scale and complexity of the operation. A cursory review of FTX’s QuickBooks records (or for that matter the very disclosure that QuickBooks was being used in the first place) should have been enough to set alarm bells ringing. 

Appropriate, robust due diligence is a crucial element of any transaction. There are no shortcuts. The path of least resistance should be avoided. Diligence can, at times, be an onerous process, but for good reason. Caveat Emptor is insufficient protection when millions, or indeed billions, of euros are at stake.

Simply:

• 1. Download the Noa App here.
• 2. Sign up using your email. No payment details are required. This one’s on us, enjoy the listen!

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