Yet news like Elizabeth Holmes’ infamous US$600 million wire fraud and B2B startup Capiter’s US$33 million fund mismanagement allegations have cast the spotlight on the need to dig deeper into a startup before financing it.
If you’re a new VC making your stake in the midst of this startup winter, it’s even more crucial for you to be wary of startup fraud and prevent it from happening to you.
In this article, we highlight some key things you should do to identify the red flags and prevent startup fraud. Here’s an overview of what this article covers:
- What is startup fraud?
- Do your due diligence
- Give yourself ample time to evaluate your findings
- Ask the hard questions
- Be stringent in your oversight and governance review
- Talk to the people on the ground
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What is startup fraud?
The less painful version of startup fraud is when you invest in entrepreneurs that over-promise and under-deliver. The more painful version? Getting stuck in scams, and having your startups mismanage your funds, evade tax, encounter lawsuits and even file for bankruptcy.
And it pays to research, evaluate, and question before diving into a startup investment. With that said, here are three things you can do for startup fraud prevention.
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1. Do your due diligence
Consider due diligence to be your risk calculator. When conducting startup due diligence, pay attention to legal, corporate, and industry due diligence.
Legal and corporate due diligence seeks confirmation on whether the startup can deliver its promise, even studying financials to see if the growth projection is reasonable.
Industry due diligence comprises understanding a startup’s product or service’s competitive advantage. Is it yet another alternate product in an already saturated environment, or is it the next big thing that could break boundaries?
There’s a rarely spoken aspect to due diligence that you should apply. Observe your founder and see if they have what it takes to be a great leader. Do they have the soft skills and aptitude to deliver their vision, even as hurdles crop up? Are they willing to adapt and learn, and not let challenges throw them entirely off balance?
A good leader is not reliant simply on their passion which could burn out, but puts their heart and soul into the enterprise.
With in-depth research in due diligence, you’ll decide to invest from a more informed standpoint and lower your chances of startup fraud.
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2. Give yourself ample time to evaluate your findings
Time is an essential factor that you can work to your benefit. An intensive review conducted on a startup is likely to deliver better rewards in the long term.
Give yourself time to comb through factors like financial performances, founder background checks, the presence (or lack) of specific internal regulations, and even toxic work environments.
Additionally, don’t lose sight of minor issues, as it could be a band-aid covering more significant stakes.
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3. Ask the hard questions
There’s never a wrong time to raise questions before you invest, but it pays to ask the hard questions when you notice irregularities in a startup.
Take the pitch deck, for instance. Does it look polished, yet either lack data points or have revenue projections that aren’t realistic? Also, if a founder puts up a facade but steers away from talking about his previous businesses, it’s time to probe him.
The ideal thing to do is to have a transparent discussion with the founders.
Drive questions from different topics and see how they respond. Ask them about their burn rate, for instance, and see if their answer matches the due diligence you’ve conducted. Or talk about the magnitude they expect their employee headcount to grow in a year – this shows that they’ve paid attention to their growth rate and future funding.
If their responses dismiss, evade, or raise even more red flags, it’s time to step away. You’re avoiding a scam bullet.
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4. Be stringent in your oversight and governance review
To further mitigate your risk from startup fraud, you should set strict standards when conducting your reviews of the startups you invest in.
As Burkland Associates recommends, your annual board-level review should include checks on financial controls and anti-fraud measures. During these reviews, you should scrutinise all financial reports to ensure that the checks and balances are well in order.
You should also check that the startup in question has an adequately staffed finance and accounting department. This department should properly segregate duties and approval processes.
With the practical boxes checked, you should then move on to look at the people. Is the “tone at the top”, or the honesty and ethics of the leadership, appropriate? Act swiftly should you detect even the slightest hint of a “fake it ‘til you make it” culture – this is a definite no-go for any startup you funnel precious investment dollars towards.
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5. Talk to the people on the ground
All the strict and rigorous reviews aside, detecting fraud in a startup can be as simple as talking to its employees. More often than not, it is the employees themselves who are privy to insights that could serve as potential red flags that warn you against the startup in question.
According to The Dropout, a documentary covering Elizabeth Holmes and Theranos, Elizabeth enforced a toxic culture where employees were neither allowed to speak to each other nor existing and potential investors. Investors had only one source of information: Elizabeth and her leadership team. Her team would never disclose everything to their investors to protect the company.
As this example shows, startup fraud can be mitigated when investors speak to employees. These employees can raise red flags that will help VCs make a more informed decision on whether to continue backing the startup.
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Learn more about success by studying the mistakes of others
To reach the pinnacle of VC investments – profitability from startups that become unicorns – a mindset geared towards finding success is vital.
While success is the end goal, it pays to learn from failure — the test bed to find success through growth and change. Spend more time, instead of money, on helping your founders make better decisions. You’ll quickly pick pointers on what works and what doesn’t.
In his Ask Me Anything session, Managing Partner for GGV Capital, Hans Tung, shared his insight on doing just that:
“Spend more time with the companies you invest in to help them to succeed. If it doesn’t work out, the loss to the firm or to the partnership won’t be too great, but you’ll learn a lot in the process. Learning how to survive on the battlefield is truly half the battle won.”
Indeed, doing the necessary groundwork goes a long way to ensuring that you pick the right startups to invest in and minimise the risk of fraud every time.
Check out our managing partner Jenny Lee’s advice on what you should do to survive startup winter.
