The biggest startup bankruptcy since Circular 331

A tragedy called Bookwitty

It may have all started six years ago, with the zone of low air pressure that moved westward over the Atlantic, encountering large amounts of relatively warm water in the middle of nowhere. The resulting tropical cyclone became known as Hurricane Sandy and caused havoc in eight countries in the Americas, taking more than 230 lives and destroying properties along its northward trail through the Caribbean and along the Eastern seaboard of the United States. Damages were an estimated $65 billion in the US—with $42 billion in New York State alone. 

One reading of the series of misfortunes behind the mid-2018 shuttering of Bookwitty, a star in the firmament of Lebanese entrepreneurship, was that it all began during Sandy, when the company’s warehouse in New York was flooded. Inventory and equipment were destroyed, and sales revenue lost to the tune of more than $1 million (technicalities and legalities meant this loss could not be recovered by insurance or local emergency relief funds). 

Technicalities and stormy moods apparently staged a recurrence in Beirut’s entrepreneurship ecosystem, in context of investments into Bookwitty and related enterprise Keeward. And when Bookwitty’s chief executive Cyril Hadji-Thomas saw no way forward and announced the halt of operations in June 2018, the decision marked the meltdown of a company that had previously been referred to as one of Lebanon’s top-valued entities in its budding entrepreneurial ecosystem. Indeed, at the time of the 2016 BDL Accelerate event, there was talk of a future conjoined company comprising Bookwitty, Keeward, and Levant. At that time, it was also announced that investment bank MedSecurities had been given a $20 million fundraising mandate for the venture.

Rather than seeing the fulfillment of such ambitions, the subsequent 18 months witnessed what was the inexperienced ecosystem’s financial worst-case scenario to date: the implosion of a venture that had been financed through very large investments (by the ecosystem’s standard)—about $24 million from two local venture capital groups, Middle East Venture Partners (MEVP) with $5 million and Leap Ventures with $18.8 million in equity and debt.

A most serious case

Adding to the seriousness of the case was that most of the invested funds (all but $1 million) were coming from the two venture capital funds as bank-backed money under the provisions of Banque du Liban’s Circular 331, the innovative financing decree by Lebanon’s central bank that initially empowered Lebanon’s commercial banks to dedicate up to 3 percent—and later 4 percent, according to an amendment in 2016—of their capital to funding the knowledge economy. According to central bank sources, the amount of funding available has so far reached about $700 million.

The central bank also guarantees 75 percent of a bank’s participation in funding under Circular 331. The case that has entangled Bookwitty/Keeward, MEVP, and Leap thus also has repercussions for several large commercial banks, along with the central bank as ultimate guarantor. 

A Bermuda triangle of misunderstandings

For more than a full quarter since the fateful June day of Bookwitty’s cessation of operations, Leap and Bookwitty, key actors in this tragedy, kept their silence. In response to Executive’s requests for interviews, only Walid Hanna, founder and chief executive of MEVP, went on record with his perspective, in a short interview in July.

Using the terms “amateurs” and “unethical,” he left no doubt at the time that MEVP had been opposed to the way in which these two parties handled their relationship in the context of the aforementioned merger of Bookwitty, Keeward, and Levant under involvement of share swaps and the conversion of Bookwitty into a subsidiary.

“[With] Levant being the supplier of Bookwitty, and Levant owning approximately half of Bookwitty, there was no reason to merge them,” Hanna told Executive in July. “However, we were okay with the merger, but not at the terms [under which] they forced [it upon] us.” He added that for his part, he felt that the merger had been pursued in this form by Leap and Bookwitty “to corner us into a subsidiary, [and] dilute the subsidiary by forcing a merger with Levant.” Hanna argued further that investing in Keeward made no sense to him, because all intellectual property and Keeward staff had already (at the time of the last MEVP investment) been transferred to Bookwitty, which left Keeward what MEVP considered to be “an empty shell that is worthless.”

Hanna’s July answers notwithstanding, many questions about the triangular scenario at the core of the case were left open—not to mention questions relating to details of Bookwitty’s bankruptcy, and its impact on other stakeholders, which include several entities in the Lebanese banking sector, the Levant Group, the Naufal family (which had been involved with companies Keeward and Bookwitty from their inceptions), the employees, and numerous small affiliate ventures.   

In the last week of October, both Leap chair Hala Fadel and Bookwitty CEO Hadji-Thomas surprisingly agreed to answer Executive’s questions, and also offered explanations as to why they had chosen not to communicate earlier. Hadji-Thomas suggested in his interview that the reason for his silence over the summer had been personal shock. Fadel, meanwhile, said that Leap did not want to talk earlier because the VC had many unanswered questions surrounding the Bookwitty bankruptcy, but that the picture had recently become clearer, thanks to an accounting investigation and review at Bookwitty.

“Today, after part of the investigation is done, it is clear that the numbers on the gross margins [of Bookwitty] were wrong, even as I still don’t know why they were wrong, and if these misrepresentations were just by mistake or intentional,” Fadel tells Executive. She goes on to note: “However, I know that [the entrepreneurs in charge of Bookwitty] did not profit from this; all the revenues went into the Bookwitty bank account. In terms of cost, there also was misrepresentation, but whether this was fraudulent misrepresentation,  intentional misrepresentation, or just negligence, we still have to see.”

According to Fadel, the accounting team of Bookwitty had been kept on after the company ceased its sales activities and was engaged with reviewing the company books. Audit firm EY France had also been conducting a revenue reconciliation and integration, under commission by Leap. “We are paying for the investigation by the accounting team, plus a mission by EY France to understand exactly what has happened. The team includes senior people, including a very competent CFO, who was hired by Cyril Hadji-Thomas in March 2018,” she says.

Fadel explained that problems at Bookwitty had been developing since the end of November 2017 and escalated in April 2018 into “big difficulties.” As she tells it, the company from then on went bankrupt “very quickly”—employees departed, and only the accounting team was retained for the ongoing investigation, with Leap having assumed—as Hadji-Thomas clarifies—partial responsibility for paying the accounting team’s salaries and the EY mission.    

All about books

The investigation into Bookwitty’s books, according to Fadel, has determined a number of accounting irregularities. “In 2015, 2016, and 2017, the gross margins have been clearly overstated, by a huge amount. This was an amount that would completely change the investment thesis. The question, if [Bookwitty’s business model] was a viable model or not, was hugely altered because the margins were so slim at the gross margin level compared to what was reported to us, even in the audited accounts. These slim gross margins would not leave any room for overheads or fixed costs … Things that we took for granted, like that they were selling rare books on the internet, were also put into question.”

Seen from Hadji-Thomas’ side, the reality was not so, or, at least, not exactly so. For him, neither the gross margins, nor the accuracy of accounting had never been the root of any problems, but instead Bookwitty’s problems all related to shortfalls and delays in financing, ever since the company used up its reserves in the aftermath of Sandy. 

As to the specificity of Bookwitty’s revenue formula, he tells Executive that the business model of sophisticated, algorithm-supported book trading across diverse geographic markets—with, he says, an average of 56 percent of sales over the long-term in the United States, but significant business internationally—was based on providing a supply of “medium seller” books and elements of price arbitrage. “Bookwitty was specialized in trading such medium sellers at the exact moments when demand existed but supply was not universal. Moreover, we traded such medium sellers not only in their home markets, but also in all other markets,” he says.

According to Hadji-Thomas, by using this method, the trader could hedge risks between markets, and also benefit from having stock available that could be sold in the source market but also at a higher profit in the other markets. “It is a very sophisticated undertaking, and that is why we invested heavily into algorithm to manage supply and acquisition of stock under this business model,” he explains.

That online book trade in the digital era is a hugely challenging business should not come as a surprise. A common myth—that books are an endangered or even an almost extinct species­—conflates the demise of the neighborhood bookshop with the fate of ultra-sophisticated online book traders, or the immense diversification of content delivery forms with a reduction in reading and literary consumption.

It is worth noting that book markets are in constant crises (an estimated 2.2 million books are published around the globe per year, but a book has a less than one percent chance to reach the shelves in a bookstore, or to sell more than a few hundred copies). The overall market potential for book selling in the knowledge era notwithstanding, it is unlikely that book trading in ever more competitive online and offline markets with increasing geographic and topical complexity and seasonal market cycles would ever translate into easily understandable economic dynamics. Ultimatley, the business is not low-cost. Hadji-Thomas says that Bookwitty’s approach to tackling the book market internationally required large expenditures on logistics and multi-locational inventories, as well as large investments into proprietary trading software and IT. “The problem in this book industry is that the more you grow, the more working capital you burn until you reach the breakeven point,” he says.

It seems that from 2013 until mid-2018, this extremely challenging business model overburdened the company’s fundraising efforts, despite its annual revenue growth and upbeat projections (full-year projection for 2017 was $50 million in revenue, the company’s breakeven). Monies came in, but according to Hadji-Thomas were either late or insufficient in the fundraising rounds with the MEVP Impact Fund, as well as with Leap Ventures.

Leap’s transactions apparently necessitated complex and time-consuming negotiations between the VC and its banking funders, as well as the central bank, since they were already in contravention of the investment allocation ceiling for a single company. What was invested thus arrived with several months of delay: In 2016, the term sheet was signed by Leap in April, but the funds came in the last quarter of the year.“Unfortunately, the valuation and merger deal came very late, at the end of 2016, and at the same time, MEVP started suing us, for reasons that, on paper, had nothing to do with the merger,” Hadji-Thomas says. “They were suing over transferring shares between shareholders.”

Because the financing rounds in 2016 and 2017 came up short against the company’s prejected needs of $30 to $50 million, Bookwitty approached MedSecurities for a $20 million fundraising mandate and engaged with other several investment groups for a planned Series C round of capital raising. This round, to be led by European investment bank Bryan, Garnier & Co, never materialized.

In 2017, the funding—supposed to be a bridge into the expected Series C investment round—furthermore was meant to reach the company at the end of the third quarter, but was delayed until the end of November. The year 2018 then started with a pileup of bad surprises on both ends of Bookwitty’s business: Suppliers severely cut their credit limits for the trader, and, on the distribution side, ratings plummeted, and key partner Amazon froze money owed to BookWitty, as well as a number of seller accounts.   

The 24 million dollar question

What happened between 2016 and 2018 seems to involve misperceptions and miscommunications that hardened into firmly-held positions. MEVP’s Hanna, for example, told Executive in July that his company had zero responsibility for the mess. He said that the VC only threatened to sue the other parties in the Bookwitty triangle, but did not do so. Meanwhile, Hadji-Thomas’s perspective in this regard seems to be driven less by the legal fine print than by the comments he received from potential investors, who told him to first clarify the issues behind his disagreements with MEVP (which were in arbitration, with “lawyers talking to lawyers,” he said) and then to come back to obtain the investments that he so urgently needed.

As Hadji-Thomas confirms when speaking to Executive, Bookwitty, for years, was in the unenviable situation of being not profitable but growing rapidly, so was in a constant search for investment. He recalls how Bookwitty had not reached the breakeven point yet at the end of 2015, but had incurred annual losses in 2013, 2014, and 2015. “We had to cover all that and were covering it with our own bank, so money was very thinly stretched. It was all difficult for us, but we were still growing, so we were confident that we could reach our goals.”

From Leap’s perspective, two factors were important in the fund’s second investment of $7 million into the venture. One factor was that the new Series C investment round was in the works with the potential to capitalize the Keeward/Bookwitty group to a degree that it would not only survive, but would safely be able to secure an annual turnover of above $50 million. According to Fadel, Leap was asked to participate in this round.

The second reason for Leap’s investment at a time when the Keeward Group’s financial cushions were frighteningly slim, and concerns over urgently needed funds were rising (shareholder Levant had even put up real estate as collateral for bank loans expected to bridge a temporary funding need) was that, according to Fadel, “They were delivering their business plan perfectly, in terms of revenues and margins … We are not stupid. We did due diligence and looked at their numbers, but the business plan was perfectly delivered month over month, quarter over quarter. Afterwards, this seems like a flag: Who delivers their business plan exactly?”

When asked if he sees any responsibility on the part of MEVP for what transpired, Hanna is unequivocal. “Definitely not. We were very transparent with all parties,” he says. From the MEVP perspective, the situation is not seen as ambiguous at all, but as one that could still build into a court case. “We believe the company is completely bankrupt, and there’s nothing to be salvaged. And, one, or both, of Leap and Cyril Hajj-Thomas are responsible, and we reserve the right to take any legal action against whoever is responsible,” Hanna said in the July interview. At the end of October, MEVP’s CEO remains adamant in his characterization of Leap’s actions as unprincipled: “I have to say today that it is unethical what they did back in 2015-16.”

The interviews given by the three parties in this conflict to Executive in October still each had gaps, and all were marred by inconsistencies. The financial question, if the loss of $24 million in VC money could have been avoided, has not, and may never, be solved to the satisfaction of all stakeholders. Around Beirut Digital District, one hears hints of coming consequences—of impending admonishments for Leap, but more importantly that this case will accelerate a shift from Circular 331 to a “Circular 331 2.0” in which venture capital players will play less important roles, and banks will be incentivized to take action themselves in the ecosystem.

One thing that all three parties to the Bookwitty case seem to be in agreement on is that all investigations, soul searching, and potential reactions on regulatory side must not be allowed to disrupt future relations among the financial players in the small Lebanese ecosystem. In Fadel’s words, peace in the system is a priority, even as not all questions may ever be answered to everyone’s satisfaction.

As the curtain descends on the first high-profile tragic play in the Lebanese entrepreneurship ecosystem, there are two things to hope for. The first is that the system’s stakeholders will soon have digested this first big failure. The second hope is that the system will always be more of a human system than an economic system, with human principles, such as compassion, tolerance, humility, and even forgiveness and self-forgiveness.

Thomas Schellen

Thomas Schellen is Executive's editor-at-large. He has been reporting on Middle Eastern business and economy for over 20 years.

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