COVER STORY: The anatomy of venture capital fraud

What do Elizabeth Holmes, Sam Bankman-Fried and Charlie Javice have in common? Not only have they all been featured in Forbes Magazine, but they have been caught defrauding investors.

These three people are just some of the hundreds who sold a dream that ended up being exactly that, made up and completely false.  

When Holmes was caught lying to investors, Bankman-Fried was arrested in the Bahamas and Javice’s subscriber numbers were bloated. The same question popped up: Where was the due diligence done by investors?

Marc Andreessen, co-founder of Andreessen Horowitz, a VC fund that has backed some of the biggest names like Facebook, Pinterest and Twitter once said, “venture capital business is a 100 percent game of outliers - it’s extreme exceptions.”

When there are millions of dollars moving around quickly and the potential to snag the next big tech giant, sometimes due diligence isn’t done as thoroughly as it should be.

Amanda Price, head of high growth ventures at KPMG said, “When there's so much money, things are moving very quickly, there's a lot of investment dollars around and there's a lot of competition from the VCs to secure the right deals. Potentially, there is not the level of diligence that is required at times, so, things slip through.”

Neil McMurchy, research VP at Gartner said the proportion of investors heavily outweighs the number of good ideas in the start-up space.

He said, “I'm not saying that due diligence has become lazy, but as one VC I'm potentially competing with another VC to invest in an organisation in an environment where my investors do not want me to have a whole pile of cash sitting there in the bank, they want to see it actively invested.

“I'm not suggesting due diligence has failed here, but in that environment where people are chasing deals, VCs are chasing opportunities to invest.”

How is due diligence conducted?

Venture capital due diligence is done in three stages: screening, business and legal. Screening evaluates the hundreds of pitches sent to a firm to see which has the most potential.

The business stage appraises the chosen start-ups to assess the viability of the business and make sure it fits the VC funding model.

Finally, the legal round is done by the VC's team of lawyers to ensure there are no legal issues with the business.

Leo Wang, senior analyst at boutique investor PAC Capital said early stage VC due diligence is done on the background of the founder and the core team and includes heavy reference checks.

He said, “It is looking for a degree of alignment between what the founder has done in the past, his network of contacts and the stated goal of the business or project. There has to be a relatively substantial degree of alignment there. Otherwise, it will raise red flags.”

A very fine line

The difference between who a scammer is and who is a genuine disrupter is a fine line, Wang explained.

He said ultimately, the biggest difference comes down to the economics of the funding rounds.

“Scammers tend to be much more conscious of cashing out in the early rounds through secondary sales, where instead of raising new funding during a venture capital round, the founders would cash out and sell some of their shares to the next party.

“Watching out for those types of behaviours is going to be the biggest way to differentiate between who is genuinely fraudulent versus founders that are just genuinely too optimistic,” Wang added.

Price at KPMG also explained that some start-up founders are just plain, old liars.

“We know some people are very good at being duplicitous, that also has a role to play as well,” she said.

“It is quite amazing when those things happen because you start to think about how many people must have been involved in it. A lot of that too is driven by the market.”

But making those risks can have a huge payoff. If an investor backs the next Facebook, Apple or Microsoft, they will wear that investment like a badge of honour.

Price said more people want to say they’re in a VC fund and have that opportunity to brag but they don’t understand the risks involved with investing.

“We want the start-ups to get that investment. When you saw the Theranos people on the board, there was pride. It says 'I'm smarter than everyone else because I got in early, I got in right at the bottom, I knew this was going to be big’,” she explained.

“They probably don't ever talk about the ones they got in early and didn't do that well.”

Risk it for the biscuit

McMurchy at Gartner said the whole point of VCs is to take ginormous risks and hopefully reap the reward.

He said VCs are only as good as their last deal.

“They have a brand and bear in mind that they largely not investing their own money. They are investing investors’ money to who they have the mandate to grow at a certain rate. They're investors who don't want to stick their money in a bank term deposit at two and a half percent a year.

“They are investors who are prepared to take a level of risk,” he said.

However, he said not all VCs are all about risk.

“There was an Australian VC just a week ago that said ‘we haven't invested in a new company in the last 12 months’. They've invested more in existing portfolios, so their mandate is relatively conservative in VC terms,” he explained.

“Then they're not prepared to invest in new companies with valuations that they believe are unsustainable and unsupported. There are other VCs who have a mandate from their investors to be more aggressive, and therefore take greater risks.”

When does this happen?

Wang at PAC Capital explained that investors will see the most amount of fraud during a bull market cycle.

“Once that bull market cycle becomes modulated to a normalised state, then the quality of due diligence, like the preference to complete due diligence on the part of venture capitalists is going to be much higher than before. As they’re incentivised to complete this due diligence,” he said.

“Whereas previously, if you ask for any degree of due diligence, you would have been not able to complete that round, because another fund that has less pressure on its due diligence would be able to come in and provide funding before you're able to complete your required due diligence.”

As the market continues to cycle and the bull market calms down, that’s when Wang said VCs will see an uptick in thorough due diligence.

“[It] would substantially lower the proportion of fraudulent companies or companies that only release vapourware products that we've seen today. This dynamic is going to be clearing itself out over the next two, three years," he added. 

Fake it, 'til you make it

When it comes to the start-up space, Wang said there is a strong mentality of “fake it, 'til you make it” especially when start-ups release vapourware.

Vapourware is hardware or software that has been announced but has never been manufactured.

Wang said this vapourware is used to generate buzz and get funding or a prototype developed before figuring out how to mass manufacture the product.

There is a small distinction between fraud and a viable product with vapourware, Wang explained.

“Where you'd label vapourware as fraud comes down to the execution of whether you can turn what used to be vapourware into something that is genuinely a viable product,” he said.

Theranos is a rare type of fraud and what VC investors would see more of is inflating numbers. Wang said it comes down to what is claimed versus what is feasible.

“Sometimes it's hard to differentiate between something that is truly disruptive and something that's plainly crazy.

“It’s up to the venture capitalists to make that distinction between what is the technological readiness of some of these ideas and prototypes and whether the consumer is ready to adopt certain products,” he explained.

A slowing down process

VC firms are now beginning to take their time with understanding their potential investments so they don't bet on the wrong horse.

Price said she is seeing a slowing down and VCs taking time with the numbers.

“The metrics are very much just under scrutiny now, in terms of making sure that you're measuring the right things. There are a lot of terms that have become bigger in the last few years that people measure the business by that have nothing to do with profit and loss, nothing to do with cash flow, nothing to do with the profitability of the business at all,” she noted.

“But there's a whole heap of other metrics, and there's a big school of thoughts around whether that's right or wrong.”

In the end, Price said VC funds will go back to the basics, asking the basic questions of “when will you become profitable?” and “when will you break even?”

“It's going to be around, how are you going to reach those levels of profitability or breakeven at least in the early stages, whilst you're continuing to grow,” she ended.