SAN FRANCISCO – Pretend it’s over. That’s the feeling in Silicon Valley, along with some gloating and a pinch of paranoia.
Not only has funding for money-burning startups dried up over the past year, fraud is now in the air, as investors scrutinize startup claims and a technical downturn reveals who “fake” it till you make it ethos too far.
Take what’s happened in the past two weeks: Charlie Javice, the founder of the financial aid start-up Frank, was arrested on charges of falsifying customer information. A jury found Rishi Shah, a co-founder of advertising software start-up Outcome Health, guilty of defrauding customers and investors. And a judge ordered Elizabeth Holmes, the founder who defrauded investors at her blood-testing startup Theranos, to begin an 11-year prison sentence on April 27.
Those developments follow the February arrests of Carlos Watson, the founder of Ozy Media, and Christopher Kirchner, the founder of software company Slync, both accused of defrauding investors. The fraud trial of Manish Lachwani, a co-founder of the software start-up HeadSpin, which will launch in May, and that of Sam Bankman-Fried, the founder of the cryptocurrency exchange FTX, who faces 13 charges of fraud, yet to come. later this year.
All things considered, the chorus of accusations, convictions, and verdicts has created a sense that the fast-and-loose bogus practices of the startup world actually have consequences. Despite this generation’s many high-profile scandals (Uber, WeWork) and downfalls (Juicero), few start-up founders, aside from Ms. disrupt the future.
The financial crisis may be to blame. Unethical behavior can be largely overlooked in good times, such as in the 2010s for tech start-ups. Between 2012 and 2021, funding for tech startups in the United States has increased eightfold to $344 billion, according to PitchBook, which tracks startups. More than 1,200 of them are considered “unicorns” worth $1 billion or more on paper.
But when the easy money dries up, everyone repeats Warren Buffett’s proverb about finding out who swims naked when the tide goes out. After FTX filed for bankruptcy in November, Airbnb CEO Brian Chesky decided to updated the adage for millennial tech founders: “It feels like we were in a nightclub and the lights just came on,” he tweeted.
In the past, venture capital investors backing start-ups have been reluctant to take legal action if duped. The companies were small, with few assets to recover, and going after a founder would damage the reputation of the investors. That has changed as the unicorns have soared, attracting billions in funding, and as larger, more traditional investors, including hedge funds, corporate investors, and mutual funds, have entered the investment game.
“There’s more money at stake, so it just changes the calculation,” said Alexander Dyck, a professor of finance at the University of Toronto who specializes in corporate governance.
The Justice Department has also urged prosecutors to be “decisive” in its push to increase corporate fraud, including at private start-ups. So costs for founders of Frank, Ozy Media, Slync and HeadSpin and expectations for more.
IRL, a messaging app valued at $1 billion by investors, is under investigation by the Securities and Exchange Commission for allegedly misleading investors about its number of users, according to reporting from The Information. Rumby, a laundry delivery start-up in Ohio, allegedly concocted a financial success story to secure funding, with which its founder bought a $1.7 million house, according to a lawsuit from one of its investors.
News outlets have also reported unethical behavior at startups, including Olive, a $4 billion healthcare software startup, and Nate, an e-commerce startup that claims to use artificial intelligence. An Olive spokeswoman said the company has “contested and denied” the reported allegations.
All this makes for an awkward moment for venture capital investors. When startup valuations skyrocketed, they were seen as visionary kingmakers. It was easy enough to convince the world, and the investors in their funds – pension funds, college funds and wealthy individuals – that they were responsible stewards of capital with the unique skills needed to predict the future and create the next Steve Jobs. find to build it.
But as more startup frauds are revealed, these titans of the industry play a different role in lawsuits, bankruptcy filings, and court testimony: the victim who was duped.
Alfred Lin, an investor at Sequoia Capital, a leading Silicon Valley firm that put $150 million into FTX, reflected on the cryptocurrency disaster at a startup event in January. “It’s not that we made the investment, it’s the year and a half working relationship after that that I still didn’t see it,” he said. “That’s difficult.”
Venture capital investors say their asset class is one of the riskiest places to park money, but it holds the potential for outrageous rewards. The startup world celebrates failure, and if you don’t fail, you’re seen as not taking enough risks. But it’s unclear whether that defense will hold up as the scandals become increasingly humiliating for everyone involved.
Investors are increasingly turning to consultants like RHR International to help identify the telltale signs of “Machiavellian narcissists” more likely to commit fraud, said Eden Abrahams, a partner at the firm. “They want to tighten up the protocols around how they assess founders,” Ms. Abrahams said. “We had a series of events that should lead to reflections.”
Startups have many of the conditions most associated with fraud, Mr Dyck said. They tend to adopt new business models, their founders often have significant control, and their backers are not always closely supervised. It’s a situation ripe for bending the rules when a recession hits. “It is not surprising that we are seeing a lot of fraud committed in the last 18 months now coming to light,” he said.
When Ms. Javice tried to sell her financial planning start-up, Frank, to JPMorgan Chase, she told an associate not to disclose exactly how many people used Frank’s service, according to a complaint from the SEC. She later asked the employee to make up thousands of accounts, assuring her staff that such a move was legal and no one would end up in “orange jumpsuits,” the complaint said.
After JPMorgan bought the startup for $175 million in 2021, so did Frank’s investors fast to have a round of congratulations on Twitter. “So many more students and families will now have more access to financial aid and more opportunities,” an investor at Reach Capital said wrote. “It’s so exciting to know that you now have an even bigger platform to make a positive impact on so many people’s lives!” was the praise from an executive at Chegg, who invested.
Ms. Javice faces four counts of fraud. Last week, JPMorgan accused her of transferring money to a shell company after the bank discovered her alleged fraud.
Outcome Health, which sold drug ads on doctor’s office screens, raised $488 million from investors including Goldman Sachs, Google-affiliated fund CapitalG and the family of Illinois Governor JB Pritzker, while making public claims of breakneck growth and profitability. In reality, the company had fallen short of its revenue targets, was struggling to manage debt and overbilling its customers.
Still, investors poured money into it anyway, and even Outcome Health co-founders Mr. Shah and Sradha Agarwal paid out $225 million in shares. One of the company’s smaller investors, Todd Cozzens of Leerink Partners, said he wasn’t deterred by red flags like missing revenue targets and other “sloppiness” because “they could have cleaned that up.” The company encountered fraud when it changed a sales report, which would have been difficult for outsiders to detect, he said.
“This was a great business model and the product worked, but these founders got really greedy,” he said. “They wanted more.” Mr. Cozzens’ company lost 90 percent of its $15 million investment.
Mr Shah was convicted of 19 counts of fraud and Ms Agarwal of 15. A spokesperson for Mr Shah said the verdict left him “deeply saddened” and he plans to appeal. Ms Agarwal’s counsel said they were reviewing the verdict and considering her options.
Slync founder Mr. Kirchner lied to investors about Slync’s business performance and used the money raised to buy a $16 million private jet, among other embezzlements, according to an SEC complaint. When an investor dug into Slync’s finances, Mr. Kirchner told the individual that Slync was in the process of transitioning to a new financial services company, the complaint said. The investor transferred $35 million.
A Slync spokesperson said the company has appointed a new CEO, is cooperating with government investigations, and “looks forward to a just resolution of this matter.”
FTX raised nearly $2 billion from top investors including Sequoia Capital, Lightspeed Venture Partners and Thoma Bravo, giving it a $32 billion valuation. The company was so poorly managed that it didn’t even have a full list of people who worked there, according to a report from the company’s new management this month. Mr. Bankman-Fried told colleagues at one point that FTX’s hedge fund, Alameda Research, was “unverifiable” and that the team sometimes found $50 million in assets they had lost track of. “That’s life,” he wrote.
Sequoia, which commissioned a glowing profile of Mr. Bankman-Fried to be published on its website, apologized to investors after the company collapsed. It also deleted the profile.
Mr. Lin explained at the start-up event that the venture capital industry is ultimately a business based on trust. “Because if you don’t trust the founders you work with,” he said, “why would you ever invest in them?”
