By Humberto Vivas, The Red Flag Group®
In 2019 several flagship entrepreneurships listed their shares on the New York Stock Exchange, and many of these listings highlighted how integrity and compliance was ‘done’ as a checklist for the initial public offering (IPO). Yet compliance and integrity was not engrained in these start-up companies; it was not part of their corporate culture and had not been given enough time to grow before the start-ups launched into the public markets. The result was numerous large-scale and significant fraud scandals involving publicly-traded start-ups.
Some of these scandals were partially triggered by the well-known ‘move fast and break things’ mindset that is pretty much endemic to start-ups’ nature. Certain innovating sectors, such as the high-tech industry, impose great levels of pressure on businesses’ technical and managerial staff, and that pressure encourages them to apply a different set of priorities and ignore chain-of-supply filters.
Other start-ups keep their founders in leadership positions – even if they are not qualified enough to meet the company’s new challenges after its breakthrough – raising concerns of overinvolvement and jeopardising corporate and financial transparency.
These elements have forced compliance officers and regulators to rethink their understanding of start-ups – as well as readdressing their compliance approach, calibrating their risk matrices and tailoring their controls.
Understanding these vulnerabilities is key when designing a compliance programme that really fits with the organisation’s third parties and with the organisation’s nature itself. Observing such characteristics is also essential for countering the collateral damage following a scandal, especially given recent events that have taken investors and companies by surprise.
Boards should challenge the entrepreneurial founder CEO
Many of today’s broadly-known entrepreneurships owe a big part of their success to their founders’ charisma and vision, and how in the early stages the founders used their personalities to gain the trust of customers and investors.
Sometimes when the numbers look attractive, boards fail to scrutinise a company’s corporate governance structure and, in the meantime, a key executive might be holding too much control or mismanaging the long-term success of the company.
The three steps to addressing this problem are:
- appointing an independent board of directors that represents the company’s interests and oversees its management and ethical standards through regular performance assessments
- conducting extensive background checks on potential candidates for executive positions in order to verify that they meet the qualification standards
- implementing a clear corporate governance framework where the fiduciary duties of the executives are well defined, along with the consequences of breaching those duties.
Just because laws and controls are old does not mean you can ignore them or flout them
Shaking up traditional markets by offering cutting-edge products or innovative services to people’s lives is naturally the start-ups’ ethos, which often drives them to sail into unchartered waters in terms of regulations.
A clear example of this is with online marketplaces offering short-term homestays. While these platforms transformed the renting business, some regions still restrict the terms by imposing minimum-stay limitations of two months to a year, depending on the area. Even so, this has not stopped the industry from adapting in those markets where the limitations persist, meaning that their practices remain in a legal grey area.
Another classic example is the ridesharing companies that are trying to operate in countries where governments are receiving elevated pressure from taxicab associations that see their business threatened. Another recurrent situation affecting this sector has been whether the drivers should be considered employees or just independent contractors.
It is recommended to seek legal guidance on the local regulatory environments before releasing a disruptive product or service in a particular market.
Some steps to addressing this problem are:
- analysing how the local authorities have responded to the release of similar products or services in the past, and studying how regulations have impacted their feasibility
- studying the relevant country’s culture and tolerance towards creativity and innovation, observing international indicators such as regulatory efficiency, business and state freedom etc.
- striving to frame the product or service to the closest existing legal and regulatory parameters
- designing an action plan, outlining strategies to approach different foreseeable scenarios
- entering into talks with guilds, unions and lawmakers before launching the product to give a clearer outlook of how it will be received from different sides.
Choose your partners wisely
Regardless of their financial strength, start-ups are driven to find new customers as they try to convince their audience to acquire or invest in products whose attractiveness and rentability is still uncertain. Simultaneously, they must fight commercial barriers, regulations and better-established companies.
Compared to some of their mature competitors, start-ups also have a considerably smaller range of options when it comes to business partners. It is likely that many start-ups’ resellers and distributors are far from being hand-picked.
It can be the case that some top-tier suppliers, resellers, customers, agents or distributors are already committed to other, long-established companies. When these potential third parties are unwilling or unable to do business with a start-up, that start-up needs to look at the next tier of service providers. This next tier of third parties could be less desirable for not only business reasons, but compliance reasons as well.
In these cases, not applying proper controls would make an organisation vulnerable to the extensive effects of its third parties’ wrongdoings, fraudulent operations and control failures.
There are several actions that might be considered in order to mitigate risks and improve the compliance outlook:
- since many of the start-up’s prospects will be newly-established low-profile companies with no industry reputation, conducting in-depth due diligence searches and business and reputational intelligence will identify red flags that might otherwise remain undetected
- building a visible solid compliance structure and obtaining anti-bribery and anti-corruption certifications would elevate the company’s corporate profile and public perception, allowing it to have access to better-established suppliers
- hiring senior staff to occupy key executive positions would also strengthen the company’s image, providing a hint of maturity.
Too much money drives poor controls
Mismanagement, misappropriation and inadequate behaviour by organisations’ upper executives are essential risks to consider, especially at start-ups, whose skyrocketed cashflows during their funding rounds can hinder their already-fragile controls. Fostering and generating a compliance culture within an organisation takes time and planning, so the fast and out-of-control dynamic of some start-ups does exactly the opposite.
This is especially true when a start-up is engaging in the preliminary stages of an IPO, where the urge for earnings and rush for going public clouds the judgement of the investors and stakeholders. In many of these cases, key executives downplay compliance agendas, regarding them as simple pre-IPO administrative items.
The result: ethics and compliance programmes unsuitable to the company’s reality, with policies that never reach full implementation – and even if they do, that implementation often comes late, leaving significant gaps in the earlier stages when the company is particularly vulnerable to engaging in shady dealings and questionable partnerships.
The three steps to addressing this problem are:
- creating board committees formed entirely by independent executives, aimed to perform auditing and oversight functions within the organisation, to enhance transparency of the processes, add neutrality to the decision making, and improve the company’s preventive and reactive abilities towards integrity issues
- conducting widespread ongoing screening of current and potential third parties and business partners against daily-updated databases
- outsourcing part of the third party selection process, entrusting it to a team of compliance experts to add comprehensiveness without slowing down the organisation’s prospecting strategy.
Compliance comes with a cost in terms of both time and resources, and this cost can seem substantial given start-ups’ small budgets. But if compliance is ignored, the cost can be much more.
The Red Flag Group® is helping companies select the best customers, suppliers and business partners by providing data, intelligence and rating solutions across all industries and countries. With our curated data, intelligence and rating solutions, our clients make Better Decisions when selecting companies and people they engage with, allowing them to not only meet their own statutory compliance obligations, but to also drive up standards and improve our society. Visit us at www.redflaggroup.com or email us at email@example.com.