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Founders Must Have Qualities: Ethics (Part IV)

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Ionut Patrahau

· 4 min read
Founders Must Have Qualities: Ethics (Part IV)
One of the advantages of alternative investments is that each investor can decide what to do at his own judgment.

Over the years, we have come across numerous cases where the actions of founders or managers have been judged by the outside world to be ethical or not so ethical. The adage "knitting is closer to skin than the jacket" has always played an important role, whether it is operational, financial or strategic. And here, as everywhere, we have two perspectives: an internal one of founders driven by the desire to ensure the survival of their startups, and an external one where those who judge take investment survival for granted and analyse each action individually to make judgments and assign labels.

The founders themselves may have different ethical standards. The farther in the future they pursue a goal - say five years - the more questionable paths they can afford to take in the short term. The closer the goal, the greater the risk that their actions will be deemed reprehensible.

Let us take a few examples: A founder develops a product that is not yet adopted by the market and miraculously signs a contract with a big corporate player. Everyone who evaluates the startup immediately asks the question: how could an unknown company with an unvalidated product win over such a large corporation? Opinions differ, of course: as long as everything is completely legal, we cannot discredit the figures provided.

On the other hand, we put this question to the startup, from which we do not receive a clarifying answer. After researching on the Internet, we find out that the founder's mother is on the board of the company in question. Again, opinions surface: We should have been told this detail. We cannot work long-term with someone who withholds such important information from us. On the other hand, if there is enough trust between two people to sign a contract, how can we assume that this trust is not there? In the end, we disqualify the founder in question and reaffirm the principle of conflict of interest, which should be made transparent when it occurs.

But is corporate governance a set of principles that guide us in the case of startups? We say yes, but not everyone thinks so. If the founder had declared the conflict of interest from the beginning - my mother was certainly required to do so - what would the verdict have been? Ethical or unethical?

Let's take an even simpler example: a founder succeeds in selling 30% more each month than in the previous month. General applause! Unfortunately, however, he pays VAT only a few months later and uses the money due to the state budget to finance the cost of the increase in sales. The founder is completely transparent about this and assumes the payment of penalties and the occurrence of possible liens. How should this behavior of taking the financial flexibility of working capital to the extreme be classified? I am absolutely sure that opinions are divided. Whatever our opinion, most insiders blame the state for the founder. Outsiders would rather have the same spectacular growth, with VAT paid on time if possible. What is the real truth? I think we all know what the tax inspector would think.

Third case study: the founder starts a company that he knows will only be able to differentiate itself in the market in the medium term. There are large companies that he will not be able to compete with at some point. He is aware of this and tells the backers not to worry about what will happen three years later when the startup has achieved more than decent sales. Just two years later, we find ourselves in the stupor described above and the founder decides to sell the company to one of the big companies using an earn-out program at a price that is undervalued to the previous backers and overvalued to the founders. Aside from the fact that the backers are justifiably outraged, the deal is absolutely legitimate. The dogs are barking, the bear is running. What can we say in this case? What is ethical and what is not? Did the founder know from the beginning how this story would end, or did he make it up on the spot? Does the time of conception matter, or are only the legal documents important?

Most people would vote against, but I am sure there are some who are in favour, especially the Founders.

Finally, a question worth pondering: is Sam Bankman-Fried, the owner of FTX, a crook since the company was a startup? Anything is possible. But it's just as possible that early backers valued the founding team as ethical. Perhaps the decision to invest customers' money in losing bets was made later.

However, the most important aspect is the lack of regulation. The same phenomenon can occur on regulated exchanges, where huge sums are wagered. But these are guarded by strict rules that divide responsibility between executives, risk managers and compliance officers. So beyond a certain amount, no one can rely on a small group of people to manage the money, and besides: it's not their money. Human nature has limits that have to be crossed by strict regulations. Otherwise, we have to expect an FTX or a Theranos every few years.

Returning to how we evaluate the quality of startup founders: While the first three components - character, discipline and transparency - are relatively easy to assign, fairness and ethics are extremely relative and impossible to assess correctly in their entirety.

An excess by the assessor should absolutely disqualify any inadvertence between actions and generally accepted rules of society. Unfortunately, however, society does not have standards for every type of economic action. Therefore, it is incumbent upon us to subject to risk analysis facts that can be proven and those that, even if unproven, are obvious upon closer examination of the transaction. This is precisely where risk management comes into play.

It is said that a good risk manager is not the one who says no to every dead end, but the one who manages to analyse everything as thoroughly as possible to find ways to mitigate risk. I have seen many due diligence reports where issues such as the order of payments in case of a bottleneck or the timely payment of tax liabilities were not captured as long as the business was running smoothly and seamlessly.

I have walked away from companies where the owners made decisions that I could not reverse so they could save their business. Some succeeded, most did not. I chose to leave without judgement . In their eyes, employees' jobs were at stake when the crises that hit them had nothing to do with the decision-makers' lack of competence.

If we are to judge the great entrepreneurs of all time, is there a single one that has not been talked about at some point in connection with dubious dealings and conflicts of interest? Is there one who, at least in the beginning, did everything by the book? My experience says no. Maybe that's the way great empires are built, and the reason I have not managed to build one yet.

But experience tells us that we are obligated to be diligent to the extent that we learn of certain short-circuits and to flag whenever a founder chooses unorthodox paths. It is our job to disqualify those who conceal dubious facts, to raise the flag in interpretable cases, and it is the job of the person who chooses to invest to consider those flags acceptable or unacceptable by his own standards.

This is one of the advantages of this type of alternative investment. Each investor can use their own discretion to decide what they want to do, safe in the knowledge that the proposed pipeline is cleared of anything we deem to be wrong, and marked with diversionary routes where appropriate.

So while I know the ethical standards of myself and my colleagues, I can not attest to those of everyone else, and certainly not the founders. We risk missing opportunities on the one hand, while protecting our investments as best we can and hoping for a better world on the other.

I think there is so much to be said about the quality of founders as a cumulative value. As always, it's much easier to be a teacher than a practitioner. But I hope that our opinions help founders find their hidden moral resources, and that investors know the standard by which we evaluate startups as a general practice. I truly hope they are helpful.

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