Not only has funding dried up for cash-burning startups over the past year, but now, fraud is also in the air, as investors scrutinise startup claims more closely and a tech downturn reveals who has been taking the industry’s “fake it till you make it” ethos too far.
Take what happened in the past two weeks: Charlie Javice, the founder of the financial aid startup Frank, was arrested, accused of falsifying customer data. A jury found Rishi Shah, a cofounder of the advertising software startup 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. Still to come is the fraud trial of Manish Lachwani, a cofounder of the software startup HeadSpin, set to begin in May, and that of Sam Bankman-Fried, the founder of the cryptocurrency exchange FTX, who faces 13 fraud charges later this year.
Taken together, the chorus of charges, convictions and sentences have created a feeling that the startup world’s fast and loose fakery actually has consequences. Despite this generation’s many high-profile scandals (Uber, WeWork) and downfalls (Juicero), few startup founders, aside from Holmes, ever faced criminal charges for pushing the boundaries of business puffery as they disrupted us into the future.
The funding downturn may be to blame. Unethical behavior can largely be overlooked when times are good, as they were for tech startups in the 2010s. Between 2012 and 2021, funding to tech startups in the United States jumped 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.
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But when the easy money dries up, everyone parrots the Warren Buffett proverb about finding out who is swimming naked when the tide goes out. After FTX filed for bankruptcy in November, Brian Chesky, CEO of Airbnb, updated the adage for millennial tech founders: “It feels like we were in a nightclub and the lights just turned on,” he tweeted. In the past, the venture capital investors who backed startups were reluctant to pursue legal action when they were duped. The companies were small, with few assets to recover, and going after a founder would hurt the investors’ reputations. 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 investing game.
“There is more money at stake, so it just changes the calculus,” said Alexander Dyck, a professor of finance at the University of Toronto who specialises in corporate governance.
The Justice Department has also been urging prosecutors to “be bold” in its pursuit of more business frauds, including at private startups. Thus, charges for founders of Frank, Ozy Media, Slync and HeadSpin and expectations of more to come.
IRL, a messaging app that investors valued at $1 billion, is being investigated by the Securities and Exchange Commission for allegedly misleading investors about how many users it had, according to reporting from The Information. Rumby, a laundry delivery startup in Ohio, allegedly fabricated a story of financial success to secure funding, which its founder used to buy himself a $1.7 million home, according to a lawsuit from one of its investors.
News outlets have also reported unethical behavior at startups including Olive, a $4 billion health care software startup, and Nate, an e-commerce startup claiming to use artificial intelligence. A spokesperson for Olive said the company has “disputed and denied” the reported allegations.
All of this creates an awkward moment for venture capital investors. When startup valuations were soaring, they were seen as visionary kingmakers. It was easy enough to convince the world, and the investors in their funds – pension funds, college endowments and wealthy individuals – that they were responsible stewards of capital with the unique skills required to predict the future and find the next Steve Jobs to build it.
But as more startup frauds are revealed, these titans of industry are playing a different role in lawsuits, bankruptcy filings and court testimonies: the victim that got duped.
Alfred Lin, an investor at Sequoia Capital, a top 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 afterwards that I still didn’t see it,” he said. “That is difficult.”
Venture capital investors say their asset class is among the riskiest places to park money but holds the potential for outsize rewards. The startup world celebrates failures, and if you’re not failing, you’re viewed as not taking enough risks. But it is unclear whether that defense will hold as the scandals become more humiliating for everyone involved.
Investors are increasingly asking consultants like RHR International to help identify the telltale signs of “Machiavellian narcissists” who are more likely to commit fraud, said Eden Abrahams, a partner at the firm. “They want to tighten up the protocols around how they’re assessing founders,” Abrahams said. “We had a series of events which should be prompting reflections.”
Startups have many of the conditions most associated with fraud, Dyck said. They tend to employ novel business models, their founders often have significant control and their backers do not always enforce strict oversight. It is a situation that’s ripe for bending the rules when a downturn hits. “It’s not surprising we’re seeing a lot of frauds being committed in the last 18 months are coming to light right now,” he said.
When Javice was trying to sell her college financial planning startup, Frank, to JPMorgan Chase, she told an employee not to share exactly how many people used Frank’s service, according to an SEC complaint. Later, she asked the employee to fabricate thousands of accounts, assuring her staff that such a move was legal and that no one would end up in “orange jumpsuits,” the complaint said.
After JPMorgan bought the startup for $175 million in 2021, Frank’s investors were quick to take a congratulatory victory lap on Twitter. “So many more students & families will now have greater access to financial aid & #highered opportunities,” an investor at Reach Capital 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!” was the praise from an executive at Chegg, which invested.
Javice faces four counts of fraud. This past week, JPMorgan accused her of transferring money to a shell company after the bank uncovered her alleged fraud.
Outcome Health, which sold drug ads on screens in doctors’ offices, raised $488 million from investors including Goldman Sachs, the Google-affiliated fund CapitalG and the family of Gov. J.B. Pritzker of Illinois while making public claims of breakneck growth and profitability. In reality, the company had missed its revenue targets, was struggling to manage its debt load and was overbilling its customers.
Yet investors plowed money in anyway and even allowed Outcome Health’s co-founders, Shah and Shradha Agarwal, to cash out $225 million worth of shares. One of the company’s smaller investors, Todd Cozzens of Leerink Partners, said he was not deterred by red flags like missing revenue targets and other “sloppiness,” because “they could have cleaned that up.” The company crossed into fraud when it altered a sales report, which would have been difficult for outsiders to detect, he said.
“This was a great business model and the product was working, but these founders got really greedy,” he said. “They wanted more.” Cozzens’ firm lost 90% of its $15 million investment.
Shah was convicted of 19 counts of fraud and Agarwal of 15. A spokesperson for Shah said that the verdict “deeply saddens” him and that he plans to appeal. Agarwal’s counsel said they were reviewing the verdict and considering her options.
Slync’s founder, Kirchner, lied to investors about Slync’s business performance and used the money raised to buy himself a $16 million private jet, among other misappropriations, according to an SEC complaint. When one investor dug into Slync’s finances, Kirchner told the person that Slync was in the process of switching to a new financial service provider, the complaint said. The investor wired $35 million.
A Slync spokesperson said the company has appointed a new CEO, is cooperating with the government’s 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 valuation of $32 billion. The company was so poorly run that it didn’t even have a complete list of people who worked there, according to a report issued by the company’s new management this month. Bankman-Fried told colleagues at one point that FTX’s sister hedge fund, Alameda Research, was “unauditable” and that the team sometimes found $50 million in assets lying around that they had lost track of. “Such is life,” he wrote.
Sequoia, which commissioned a glowing profile of Bankman-Fried to publish on its website, apologized to investors after the company collapsed. It also deleted the profile.
Lin explained at the startup event that venture capital industry was ultimately a business based on trust. “Because if you don’t trust the founders that you work with,” he said, “why would you ever invest in them?”