Fraud in Startups
This blog post was written by DougL. Edits provided by friends. AI was not used to write or edit it. Browser-based technology with generative AI and ChatGPT was used to fact check.
Elizabeth Holmes, the disgraced Theranos founder, reports to prison today where she will serve an 11-year sentence for fraud. Holmes and her partner (in crime) Ramesh Balwani were sentenced on criminal charges related to wire fraud and conspiracy to commit wire fraud. By now we all know about the charges, the scam and the blatant defrauding of investors. She and Balwani were also ordered to pay $452 million in restitution to victims of the firm's fraudulent blood-testing devices. Balwani reported to prison last month and will serve nearly 13 years in prison.
In other fraud news, SEC charged Sam Bankman-Fried with defrauding investors in while CEO of FTX – crypto asset trading platform. Bankman-Fried concealed his diversion of FTX customers’ funds to Alameda Research – a hedge fund under his control – while raising more than $1.8 billion from investors. While his fate is still being determined, it is safe to assume he will be wearing orange at a corrections facility in the near future as well.
These are just two examples. There are more (unfortunately).
It is important to note that the majority of startups operate with the highest levels of integrity and adhere to legal and ethical standards as they build their businesses, but the increasing number of fraudulent cases in the startup community is certainly a concerning trend.
Here are a few factors that may contribute to the increased incidence of fraud in startups:
Culture & Mindset: Individuals may be more inclined to bend rules or engage in unethical behavior in emerging businesses that celebrates risk-taking, disruption and personal achievements in an ‘ends justify the means’ manner. While these qualities can be beneficial for business growth, they can also create an environment where fraud can flourish.
Lack of Oversight & Controls: Early-stage and even later stage startups often lack the internal controls and rigor that larger, more established companies have in place such assigning authority, accurate and current book keeping, fund deposit scrutiny, vetting out personnel, active Board of Directors oversight and more are requisite steps that companies put in place as part of a broader governance effort. These efforts have a very clear and present purpose of removing vulnerabilities to prevent individuals – potentially executives in the company – from committing fraud.
High-Pressure Environment: It is said that “pressure bursts pipes” and in the faced-paced startup world, the intense pressure to hit milestones and to achieve exponential growth sometimes lead individuals to engage in fraudulent activities to meet those expectations or secure funding.
Limited Resources: Startups often operate with limited financial and human resources, which prevents proper governance and can lead to stretched capacities and shortcuts. In some cases, this can create opportunities for fraudulent behavior to go undetected.
Flush with Resources: Some startups raised significant amounts of funding and yet shortcuts are taken by the Board and/or its operating officers. The cause often times is related to a combination of factors such as pressure, arrogance or inexperience, all of which open the door for fraudulent acts by companies with flush bank accounts.
Addressing the issue of fraud in startups requires a multi-faceted approach, including:
Promoting a culture of integrity and ethics
Implementing strong governance and internal control systems
Conducting thorough background checks on employees
Providing ethics training
Whistleblower mechanisms, and
Fostering a transparent and accountable environment
In the end, investors have to up-front conduct rigorous due diligence and not depend of others to do the job and subsequently maintain systematic oversight of the company to help identify and prevent possible fraudulent activities. This approach is actually quite normal, but has slipped in attentiveness and thoroughness in recent years.