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Luckin Coffee’s frothy finances

For a business named Luckin, its luck sure ran out quickly. Founded in October 2017, the upstart coffee chain grew at an apparently breakneck pace to overtake Starbucks as China’s biggest bean-brew slinger by the start of the year. But as its acknowledgment of rampant fraudulent accounting would later reveal, the company’s caffeine fever-dreamed ambition—to hook a tea-drinking nation on joe—featured far more froth than substance.

As one of China’s youngest, hottest so-called unicorn startups, Beijing-based Luckin pitched itself as a tech company rather than a glorified barista biz. Luckin lured people to order drinks for takeout and delivery through its mobile app. The company served up copious discounts and “free” beverage vouchers, cutting the price of its drinks to about a third of the competition’s. Like any good tech startup, executives prioritized growth over profits.

The strategy worked well, for a while. By the end of 2018, a little more than a year after its founding, Luckin opened more than 2,000 stores and acquired a $2 billion valuation from private investors. By May 2019, it raised $561 million at a $4.2 billion valuation going public on the Nasdaq stock exchange. In early 2020, after supposedly usurping the Chinese market’s coffee crown from Starbucks’s tiara-donning merlady—as measured by total number of stores (4,500 versus Starbucks’ 4,300)—its valuation soared to an all-time high of $12 billion.

Then came the accusations of fraud. Luckin initially denied a report, circulated on Jan. 31 by Muddy Waters, the prominent U.S. short-seller firm, alleging fabricated sales. A few weeks later, though, on April 2, Luckin came clean, fessing up to $310 million in made-up money inflows—a large portion of its reported revenue for 2019. The company acknowledged the inflated figures, saw its stock delisted, reorganized its leadership team, and in December reached a $180 million settlement with the U.S. Securities and Exchange Commission.

Jinyi Guo, Luckin’s recently instituted chairman and chief executive, said in a statement that the deal “reflects our cooperation and remediation efforts, and enables the company to continue with the execution of its business strategy.” He added that the company is “committed to a system of strong internal financial controls, and adhering to best practices for compliance and corporate governance.”

Carson Block, Muddy Waters’ founder, tells Fortune that he believes Luckin is just the tip of the iceberg when it comes to securities fraud by Chinese-based companies. “I’m of the view that almost every single one of them is committing fraud to some extent,” he said, noting that it is difficult for the SEC to enforce its rules on businesses based abroad. —Robert Hackett

QUESTIONS:

1) What conditions gave rise to unethical business strategies and behavior?

2) What do you estimate the costs to the company resulting from the company’s business ethics failure?

3) What advice would you offer the leaders of the company to do better in the future?