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Evaluating startups for fraud



The waitress in the diner had just taken their order when Sam, a venture capitalist, received a call from a blocked phone number. The caller told him to step outside if he wasn’t alone. Sam covered the phone and told Tom, the newly appointed CEO of the shoe company Sam had just invested in, that he needed to take the call. For the next 30 minutes, Sam paced IHOP’s parking lot while the caller explained why appointing Tom as CEO was a huge mistake.

The caller had learned of the purchase and Tom’s role with the shoe company earlier that morning and felt compelled to tell his story. The caller told Sam that Tom had used the company as his personal piggy bank and then disappeared. Sam could barely control his rage. The caller advised Sam to back out of the deal. But Sam and Tom have already signed on the dotted line.

Regardless of the caller’s troubling information, Tom was already making tremendous progress in landing new business for the shoe company. After breakfast, Tom had set up four meetings with potential customers. The future looked rosy. So, for the time being, Sam chose to ignore the anonymous caller’s warnings.

Tom excelled at making new contacts because of his charisma, unbridled optimism and an ability to read people well. However, Tom seldom delivered on his promises. He consistently overpromised and underdelivered. Tom hadn’t told Sam that he’d driven several companies into bankruptcy.

In the coming months, the shoe business floundered. Tom had made several decisions that infuriated customers and attracted terrible press within the industry. Only a handful of the potential customers Tom had contacted signed contracts and for far less than he initially promised. After six months, Sam fired Tom, and his firm eventually sold the shoe company for a significant loss.

If Sam had had a CFE on staff, they could’ve conducted a background check on Tom and his startup, and saved Sam’s firm money and prevented heartburn.

Looking for a good career move? Seek out stable venture capital (VC) and private equity (PE) firms that need experienced anti-fraud professionals to protect them when they vie for hot startups.

We want to believe in entrepreneurs

Sam’s shoe-business debacle highlights a critical weakness in how the VC and PE communities often evaluate deals. Sam failed to gain a complete picture of the entrepreneur he selected to run his business. Then, he chose to ignore the anonymous caller’s warnings. He wanted to believe that Tom was going to succeed. A CFE on staff would’ve slowed Sam down enough to find the cracks in Tom’s past.

VC and PE firms are always on the hunt for the next “unicorn” — that rare billion-dollar business. They face considerable pressure to find and invest in promising businesses before their competitors do the same. Some startups receive vast sums of capital from multiple firms, but others wither because of lack of investments. So, what makes the difference between the haves and have-nots in the startup community?

Investors back the promising business idea — particularly one with the potential to disrupt an established industry. They also like to support larger-than-life founders or those who appear to possess more intellectual and personality horsepower than their peers, such as Elon Musk, Steve Jobs, Bill Gates and Oprah Winfrey.

Nonetheless, we need only look to Theranos and its founder, Elizabeth Holmes, for an example of what can happen when an investment community falls in love with a founder and fails to peel back the layers of their business to see if the hype matches reality.

The rise and fall of Theranos shows what can happen when groupthink develops in the investment community. None of Theranos’ investors, board members and customers raised red flags about the company’s lofty promises and failings. A whistleblower’s tip finally brought the company back to earth. The “fake it until you make it” approach finally led to Theranos’ downfall.

The Theranos case is just one of many examples of entrepreneurs failing to deliver on their lofty promises, which left investors with staggering losses. In another, Yogome, an educational startup based in Mexico, shut its doors recently amid allegations of fraud and mismanagement by its CEO. What could the investment community do to avoid investing in entrepreneurs that feel compelled to stretch the truth or commit fraud to establish their reputations?

CFEs to the rescue

The startup world contains ample pressure, opportunity and willingness of entrepreneurs to rationalize decisions to secure market share and deliver on the promises they made to investors.

As a CFE, you can help evaluate startups by reviewing companies’ financials, conducting background checks on founders and participating in meetings with executive teams.

Rarely do the teams that conduct due diligence for VCs and PE firms include someone with experience in detecting and investigating fraud. These firms might believe that adding anti-fraud professionals could send the wrong messages to entrepreneurs and their teams. But it’s unrealistic for them to assume that every startup founder and their team is beyond reproach.

As a CFE, you can help evaluate startups by reviewing companies’ financials, conducting background checks on founders and participating in meetings with executive teams. If VC or PE firms publicize the addition of CFEs to their teams, perception of detection increases, which could dissuade entrepreneurs from committing fraud. The additional work time probably will worry antsy VC or PE firms who are jostling for stakes in hot startups. But the extra anti-fraud due diligence ultimately can save time and money.

If you join a VC or PE firm, develop lists of standard procedures and time estimates for all steps. Ask the firm for administrative support staff and junior analysts to conduct basic tasks.

Allow time to digest findings

If you uncover troubling facts about a startup founder, their executive team or the financial performance of their business, ask the leadership of the VC or PE firm to set aside time to review your findings. The firm should engage legal counsel to commission the review and protect your work under attorney-client privilege.

Some of the issues might appear relatively minor, but they could mask bigger problems. For example, if you determine that the startup lacks specific internal controls, it could struggle to prevent bribery and corruption in its foreign operations.

Alternatively, if you uncover lawsuits from former employees of a startup who alleged employment law violations, you might have found a failing human resources department and a toxic office culture. It’s not unusual for startups to foster aggressive cultures, but long-term ramifications can be severe and create headaches for companies and their backers.

Uber is the poster child for a toxic company culture. After a series of allegations of unethical behavior and a willingness to turn a blind eye to reports of sexual harassment, the board forced CEO Travis Kalanick to resign. The fallout continues with additional allegations of sexual harassment involving other members of the executive team.

Counsel investors to ask hard questions

If you uncover fraud risk problems or questionable past behavior in a startup, counsel the VC or PE to sit down with the startup founder to review and resolve the issues (preferably with you in the room).

If the founder’s responses create more concern, your VC or PE client can decline to move forward with the startup because they now have the intel you’ve uncovered. And they can thank you for possibly avoiding fraud. Regardless, your client now has the information to make a fully informed decision.

As for Sam, who we met at the beginning, he continues to work as a venture capitalist. However, he never invests in a startup until he conducts robust due diligence, which includes a fraud examiner’s analysis.

Paul McCormack, CFE, is a freelance writer specializing in fraud, security and compliance. He previously worked for SunTrust, EY, PricewaterhouseCoopers and Delta Air Lines. Contact him at paul@mccormackwrites.com.




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