When it comes to venture capital and private equity investment, a founder’s vision, management style and industry knowledge are just some of the things investors must consider in their due diligence when probing for that elusive, entrepreneurial 'X factor'.
But one risk element is often latent and sometimes overlooked: personal integrity.
Roadstar.ai, a Chinese autonomous driving system developer, issued a statement this week in which it announced the dismissal of its co-founder and chief scientist Zhou Guang. It was an extremely rare case of a boss being fired.
According to the statement, Zhou was dismissed for embezzlement during the firm’s $128 million series A fundraising last May. Zhou, a former driverless software developer at Baidu and one of Roadstar.ai’s three co-founders, was also accused of producing fake project reports.
Zhou’s sacking, understandably, created a buzz among private equity investors because Roadstar.ai is widely seen as one of the most promising startups within China’s autonomous driving industry.
Roadstar.ai’s series A funding was one of the biggest fundraising deals seen in China for an autonomous driving technology firm. Among the investors that eagerly took part were government-backed Shenzhen Capital Group and CMB International, a subsidiary of China Merchants Securities – the country’s third-largest securities house.
The incident highlights just how much damage any misconduct by a member of the senior management can have on the company’s reputation and operations.
Keeping an eye on unethical behaviour is arguably more important for startups and small private companies, where decisions are likely to be made solely by the founder, or an individual of the senior management.
For larger, public-listed companies, the chances of such an incident happening are smaller because decisions are made collectively by a board of directors. Also, many large companies have internal committees that oversee compliance issues related to, say, audits and remuneration issues.
To be sure, it is probably impossible to check every aspect of an individual’s integrity. In the case of Roadstar.ai, it was difficult too for investors because Zhou is accused of having been bribed by an old classmate, who just happened to be working at one of the investors.
But that doesn't mean private equity investors cannot demand more transparency from the target company throughout the fundraising process. For example, they can request reports on where funds are used on a regular basis.
At the same time, the incident serves as a reminder for private equity investors to keep close tabs on their portfolio companies through the investment cycle for potential compliance breaches.
DJI, the world’s largest manufacturer of drones, said last week in an internal letter that it had suffered a Rmb1 billion ($147 million) loss due to corruption within the company. The amount was roughly one-fourth of the Shenzhen-based company’s 2017 net profit.
The company revealed some of its employees had taken bribes from external suppliers in exchange for contracts that were generally more expensive. As a result, DJI’s production cost was 20% higher than what it would have been if the contracts were awarded through a competitive tender process.
One private equity investor told FinanceAsia that it is a common scenario in China’s startup world.
“Bribery is quite common in fundraising deals for Chinese startups,” the investor told FinanceAsia. "Investors need to find the right team and build regulations to prevent such things from happening.”
In that respect, private equity investors and startups could potentially draw some lessons from bigger firms on how to combat corruption and bribery.
Take JD.com, the technology giant behind China’s second-largest online marketplace – it has a special website that rewards employees who report corruption and fraud.
And last month Alibaba took the bold step of bringing Yang Weidong, president of its video-streaming platform Youku, under police investigation for corruption. If the accusations are confirmed, Yang would be the highest-ranked senior management figure to be arrested in the group’s history.
Food delivery giant Meituan-Dianping also confirmed last month it has reported internal corruption cases involving 89 people to the police.