Fraud is an inevitable outcome of the venture funding system
Last week the NY Times declared an end to Faking It In Silicon Valley.
The impetus for declaring the end of an ignominious era was:
- Elizabeth Holmes, the founder and convicted chief fraudster of Theranos finally ordered to prison
- Charlie Javice, founder of the fintech startup Frank arrested for defrauding JPMorgan Chase
- Rishi Shah, co-founder of Outcome Health, convicted of fraud
- Sam Bankman-Fried, founder of crypto exchange FTX, facing fraud charges
- Carlos Watson, founder of Ozy Media, arrested for fraud
- Christopher Kirchner, founder of Slync, arrested for fraud
While the headlines are exciting, as an early-stage investor, I can say for certain the arrest of these few entrepreneurs are simply the tippy top of the iceberg — the few that have made it far enough, raised enough money, allegedly hidden their frauds long enough to be worth prosecuting. The other 99% percent simply fade away when their startups fail.
Worse, though, the NY Times is wrong. This is not the end of an era. This is not the end of fake-it-til-you-make-it. Because when the difference between getting investment to build your startup and watching your dreams die is a bit of exaggeration of the startup’s condition, some percentage of founders will be tempted to cross that line. But how many?
Over the past 13 years, I’ve invested in almost exactly 100 startups, mostly pre-seed and seed stage.
None of these 100 startups turned out to be outright ponzi schemes as FTX seems to be. But 2 of the 100 outright lied to investors.
One claimed to be generating revenue from sales of their product. We found out later the product wasn’t finished yet. The company was generating revenue, but selling consulting services rather than the product.
This sounds like a small lie, but it’s huge. Had we known the product wasn’t built yet, we wouldn’t have invested, certainly nowhere close to the valuation of an in-revenue company.
Had they completed development and gotten into revenue with our round of funding, we probably would never have noticed the lies. Unfortunately, the company ran out of money before generating sales and died.
Could we call the FBI? The SEC? Hah! Prosecutors don’t care when a handful of rich people lose $1 million because the founder said his revenues came from product sales instead of consulting. With the company dead and the founder broke, there was nothing to gain from suing for fraud ourselves.
The founder of a second startup claimed the MVP of his product would include really impressive features in the next version that was “almost ready”. It sounded great, though I wondered how those features could be implemented. It turns out the founder had no idea either.
Not as clear cut a fraud as hiding real blood testing machines in the back room, or creating a database of fake customers, but not that far away either.
Out of 100 early-stage investments, 2% were what I consider fraud.
Obviously, I only invest in startups I’m confident are legit. And I’m a skeptical guy. But what about the ones I didn’t invest in? There things get more interesting.
Especially in the early stages, it’s hard to tell whether many are outright frauds or just founders with stupid ideas. But I’ve been pitched on quite a few that seemed super sketchy.
One founder I was assigned to mentor at an accelerator claimed to have invented a new way to recycle plastic. He had no chemistry or materials background on his resume. When I asked for details on the technology, he maintained they were confidential and couldn’t be disclosed.
How did his process deal with plastics coloration? What percentage of recycled material could be mixed with virgin plastic? Basic questions needed for the pitch deck I was tasked with helping. All confidential.
He didn’t want my help on the pitch deck, just wanted me to introduce him to rich guys so he could convince them to give him money. This startup smelled worse than a plastics factory.
I’ve been pitched on the fuel additive scam reborn as a cleantech solution — a special chemical mixed in fuel tanks will save millions of tons of CO2.
And windmills installed on the back of electric vehicles to generate electricity to charge the batteries.
These are just scams, plain and simple, targeting people with more money than brains. If you invest in these startups, I’ve got a bridge to sell you. I’d guess 1% of the pitches I hear are outright attempts to steal money.
That leaves the bigger category of lies and misrepresentations, or as it’s called in Silicon Valley, “optimistic assumptions”.
In the earliest stages before the business coagulates around a specific product targeted to specific customers, the projections can be anything. $100 million in sales in 5 years? No problem! Customer acquisition costs? $0 — it’ll go viral!
Since revenue projections of $100M are a prerequisite for funding, nearly every pitch deck shows $100M in revenues. Many strain credulity. A nail salon / coffee shop that will generate $100M? Hmmm.
Alternatively, I see products that would be worth billions if they were possible to make. Machines to run 130 tests instantly with a single drop of blood. Batteries with 10x the storage capacity of Li-ion. Fusion power. A cure for cancer. A social media platform that will unite humanity instead of tearing us apart. Who’s to say they’re impossible? The company has already applied for patents!
Then there’s the clueless scientist who naively projects $10 million in sales and $9 million in expenses. She’s laughed out of room as uninvestible. Because we only invest in people who are either good liars or self-deluded.
We as investors create the atmosphere for fiction, then act surprised when we find out the story was embellished, the assumptions overly optimistic, the truth spun to tell us what we demand to hear.
Unlike public companies that have to list every possible risk factor in their public filings to avoid being sued when the stock drops, startup founders only tell us why they will succeed. It’s up to investors to uncover the risks ourselves. Caveat emptor. DYD3 — due your damn due diligence!
What happens when those outrageously optimistic projections fail to materialize? When sales are growing at a respectable 20% per year instead of the promised 100% per month? When it becomes obvious the market size is an order of magnitude smaller than projected? Or that there are technical challenges that might be impossible to surmount?
Is it time to give up? Call it a day? Of course not. Investors only back founders who are resilient. Who don’t take no for an answer. Who know how to sell the hell out of their products. It’s time to spin the situation and put on the best face to investors.
The first thing to do is show the revenue pipeline. Any possible customer who said hello to at a trade show get listed in the sales funnel. Customers who said they’d be interested in learning more are listed as in negotiation. People who’ve downloaded the software are listed as huge deals ready to close any day.
There’s a hazy line between being optimistic and being misleading. And when it’s the difference between getting funded or not, there’s a huge temptation to cross over that line. To show everything is going well. To sweep the problems under the rug. To make up explanations that sound plausible, even if they’re bullshit.
Investors have no way of knowing the real situation. We try to suss out the true situation during diligence, but without knowing what questions to ask, it’s easy to miss key information.
The vast majority of founders are reasonably honest, and if not showing us the problems, don’t lie when asked directly. But a non-trivial minority actively hide the bad news, claim sales they don’t have or product features that haven’t been built.
They figure it doesn’t matter. They need the money to build the product. The ends justify the means. Who cares about a few exaggerations? If they succeed, as they’re sure they will, those early investors will reap a huge return.
It’s a wild guess, but I figure at least 10% and perhaps as much as 20% of seed-stage founders go over that line into actively hiding the true state of the business from investors.
But whether the true number is 20% or 1%, the NY Times is wrong. The arrest of 6 people for fraud is not the end of faking it in Silicon Valley.
As long as founders are human (still waiting for that first pitch directly from ChatGPT to hit my inbox) and need venture capital to build their startups, a small percentage will find it impossible to resist the temptation to do whatever it takes to get funding.
Some will use the money to build a successful startup and we’ll never find out they were lying. Most will fail in the next round and become nothing but yet one more failed startup investment. And a tiny fraction will fake it again in the next round and the next, snowballing into the billion dollar frauds that the world hears about in the pages of the NY Times.