Recent charges, convictions, and sentences all indicate that the start-up world’s habit of playing fast and loose with the truth actually has consequences.
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By Mehran Mazari
SAN FRANCISCO (AP) — It's time to stop pretending. That's the mood around Silicon Valley, mixed with a dash of schadenfreude and paranoia.
Not only has funding for cash-burning start-ups dried up in the last year, but fraud is also in the air, as investors scrutinize start-up claims more closely, and a tech downturn shows who has gone too far with the industry's "fake it till you make it" mindset.
Consider what has occurred in the last two weeks: Charlie Javice, the founder of financial aid startup Frank, was arrested and charged with misrepresenting client data. Rishi Shah, a co-founder of the advertising software start-up Outcome Health, was found guilty of cheating consumers and investors by a jury. A judge also sentenced Elizabeth Holmes, the founder of the blood testing startup Theranos, to begin an 11-year jail sentence on April 27.
These developments come on the heels of the arrests in February of Carlos Watson, the founder of Ozy Media, and Christopher Kirchner, the founder of software company Slync, both of whom are suspected of scamming investors. Manish Lachwani, a co-founder of the software start-up HeadSpin, faces a fraud trial in May, as does Sam Bankman-Fried, the founder of the cryptocurrency exchange FTX, who faces 13 fraud counts later this year.
Taken together, the chorus of indictments, convictions, and sentences has given the impression that the fast and loose fakery of the startup world has consequences. Despite the high-profile scandals (Uber, WeWork) and failures (Juicero) of this generation, few start-up founders, aside from Ms. Holmes, have ever faced criminal charges for stretching the bounds of corporate puffery as they disrupted us into the future.
The funding crisis could be to blame. When times are good, as they were for tech start-ups in the 2010s, unethical behavior might be disregarded. According to PitchBook, which analyses start-ups, funding for tech start-ups in the United States increased eightfold between 2012 and 2021, reaching $344 billion. On paper, more than 1,200 of them are called "unicorns" valued at $1 billion or more.
When the easy money runs out, everyone repeats Warren Buffett's adage about figuring out who is swimming nude when the tide goes out. After FTX declared bankruptcy in November, Airbnb CEO Brian Chesky updated the adage for millennial tech founders: "It feels like we were in a nightclub and the lights just turned on," he tweeted.
Previously, venture capital investors who sponsored start-ups were hesitant to take legal action if they were deceived. The companies were small, with few assets to recover, and pursuing a founder would damage the investors' reputations. That has changed as unicorns have skyrocketed, attracting billions of dollars in capital, and as larger, more traditional investors such as hedge funds, corporate investors, and mutual funds have entered the investing fray.
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"There is more money at stake, so it just changes the calculus," said Alexander Dyck, a University of Toronto finance professor who specializes in corporate governance.
The Justice Department has also urged prosecutors to "be bold" in their pursuit of other commercial scams, especially those involving private start-ups. Thus, charges for the creators of Frank, Ozy Media, Slync, and HeadSpin, with more to follow.
According to The Information, the Securities and Exchange Commission is investigating IRL, a messaging app valued at $1 billion by investors, for allegedly misleading investors about the number of users it has. Rumby, an Ohio-based laundry delivery startup, allegedly created a story of financial success in order to acquire investment, which its founder used to purchase a $1.7 million property for himself, according to a complaint filed by one of its investors.
In addition, news outlets have revealed unethical behavior at start-ups such as Olive, a $4 billion healthcare software start-up, and Nate, an e-commerce start-up that claims to use artificial intelligence. According to an Olive spokesperson, the firm has "disputed and denied" the stated charges.
All of this creates an unpleasant situation for venture capitalists. They were seen as visionary kingmakers while start-up prices were skyrocketing. It was simple enough to persuade the rest of the world, as well as the investors in their funds — pension funds, college endowments, and affluent individuals — that they were responsible stewards of capital with the unique skills needed to forecast the future and identify the next Steve Jobs to build it.
However, as more start-up frauds are exposed, these sector titans are taking on a new role in lawsuits, bankruptcy filings, and court testimony: the victim who was fooled.
At a start-up event in January, Alfred Lin, an investor at Sequoia Capital, a renowned Silicon Valley firm that committed $150 million into FTX, pondered on the bitcoin tragedy. "It's not that we made the investment; it's that after a year and a half of working together, I still didn't see it," he explained. "That is difficult."
According to venture capital investors, their asset class is one of the riskiest places to deposit money, but it also has the potential for massive rewards. Failure is celebrated in the startup scene, and not failing is seen as not taking enough risks. However, it is uncertain whether that defense will hold as the scandals become more humiliating for all parties involved.
Investors are increasingly turning to consultants such as RHR International to help them spot "Machiavellian narcissists" who are more inclined to perpetrate fraud, according to Eden Abrahams, a partner at the firm. "They want to tighten up the protocols around how they're assessing founders," Ms. Abrahams explained. "A series of events occurred that should have prompted reflection."
Mr. Dyck stated that many of the conditions most commonly associated with fraud exist in start-ups. They frequently use unique business structures, their founders frequently exercise extensive authority, and their funders do not necessarily impose stringent monitoring. When a slump comes, the scenario is ripe for breaking the rules. "It's not surprising that a lot of frauds committed in the last 18 months are now coming to light," he remarked.
According to an S.E.C. complaint, while Ms. Javice was trying to sell her college financial planning start-up, Frank, to JPMorgan Chase, she dir
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cited an employee not to divulge how many individuals used Frank's service. Later, she encouraged the employee to create thousands more fake accounts, telling her team that it was legal and that no one would end up in "orange jumpsuits," according to the complaint.
Frank's investors took a victory lap on Twitter after JPMorgan purchased the start-up for $175 million in 2021. "So many more students & families will now have greater access to financial aid & #highered opportunities," a Reach Capital investor wrote. "It's so exciting to know you will now have an even bigger platform to make a positive impact on the lives of so many people!" said a Chegg executive who invested.
Ms. Javice is charged with four counts of fraud. JPMorgan accused her of transferring money to a shell business last week after discovering her alleged deception.
While making public claims of fast development and profitability, Outcome Health attracted $488 million from investors including Goldman Sachs, the Google-affiliated firm CapitalG, and the family of Illinois Gov. J.B. Pritzker. In truth, the company had missed its revenue projections, was struggling with debt management, and was overbilling its consumers.
Nonetheless, investors poured money in, allowing Outcome Health's co-founders, Mr. Shah and Shradha Agarwal, to cash out $225 million in shares. Todd Cozzens of Leerink Partners, one of the company's smaller investors, said he was not put off by red signals such as missed revenue targets and other "sloppiness," because "they could have cleaned that up." He claimed that the corporation committed fraud when it altered a sales report, which would have been impossible for outsiders to discover.
"This was a great business model, and the product was working, but these founders got really greedy," he explained. "They wanted something more." Mr. Cozzens' company lost 90% of its $15 million investment.
Mr. Shah was found guilty on 19 charges of fraud, while Ms. Agarwal was found guilty on 15. Mr. Shah's spokesman stated that the conviction "deeply saddens" him and that he intends to appeal. Ms. Agarwal's attorney stated that they were reviewing the verdict and discussing her options.
According to an S.E.C. complaint, Slync's founder, Mr. Kirchner, misled investors about Slync's economic performance and used the money acquired to buy himself a $16 million private plane, among other misappropriations. According to the complaint, when one investor inquired about Slync's finances, Mr. Kirchner informed the individual that Slync was in the process of transferring to a new financial service provider. The investor transferred $35 million.
According to a Slync representative, the business has chosen a new CEO, is working with government inquiries, and "looks forward to a just resolution of this matter."
FTX received over $2 billion in funding from major investors like as Sequoia Capital, Lightspeed Venture Partners, and Thoma Bravo, valuing the company at $32 billion. According to a study produced this month by the business's new management, the corporation was so poorly administered that it didn't even have a complete roster of employees. Mr. Bankman-Fried once informed colleagues that FTX's sibling hedge fund, Alameda Research, was "unauditable" and that the team occasionally discovered $50 million in assets that they had lost track of. "Such is life," he concluded.
Sequoia, which published a favorable profile of Mr. Bankman-Fried on its website, apologized to investors when the company went bankrupt. The profile was also erased.
Mr. Lin stated at the start-up event that the venture capital industry is ultimately a trust-based enterprise. "Because if you don't trust the founders you work with, why would you ever invest in them?" he asked.
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