How to Detect a Fraud
Investors can learn to spot warning signs from Fyre Festival, Theranos, and similar situations
High profile documentaries on Netflix, Hulu, and HBO describing alleged fraud at the Fyre Festival and Theranos are raising awareness that “the next big thing” may not always be what it seems. Spotting fraud has applications beyond venture capital investing, as anyone can be victimized by a con, including employees, customers, and the general public. Investors, however, should be in a unique position to sniff out these situations.
Failure and fraud are not the same thing. Venture capitalists expect plenty of failure from honest entrepreneurs who try hard but don’t manage to succeed. Failure is part of the business. But fraud is another story, where an entrepreneur deliberately deceives employees, customers, investors, and other stakeholders. A few weeks ago, Dan Primack of Axios reported on how a Washington, D.C. startup Trustify may have purposefully defrauded investors.
Every startup presents some level of risk for investors, but prudence requires a sharp lookout for the following tell-tale signs that an investment opportunity may be too good to be true:
What are some red flags that an opportunity might be a fraud?
- Entrepreneurial fraudsters’ primary playbook is to sell a fantasy instead of a business opportunity. The fantasy could be sinful gratification, like money, sex, or fame; or it could be a positive ideal, like changing the world or backing a visionary, next generation business leader. Theranos appealed to virtuous desires with its goal of providing a painless and anxiety-free way to collect blood for medical tests. Fyre Festival, on the other hand, promoted a fantasy of cavorting with models on the beach. If hanging out with models isn’t already part of your regular routine, the story you are hearing might be a fantasy and not a legitimate investment.
- Fraudsters can use fear of missing out (“FOMO”) and try to force you to make an irresponsibly quick decision. To a certain extent, all entrepreneurs use a version of this technique when closing any deal. It’s important to set closing dates, or investors can simply wait. But if the entrepreneur uses artificial deadlines and the threat that “the deal will go away forever” to convince investors not to complete any due diligence, it’s a red flag that there may be problems.
- On a related note, frauds often won’t answer reasonable questions. If you are stonewalled when attempting to perform routine due diligence, there might be a reason to be suspicious. If entrepreneurs will not allow you to conduct personal and customer reference checks, review legal documents and contracts, understand financial statements, or assess research and development plans, it could be a sign they are hiding something.
- Fraudulent entrepreneurs may also try to distract you with big names. High profile advisors could provide validation that the entrepreneur can gain the attention of influential people who can help the company, but ask yourself whether the advisors are relevant. For example, Theranos attracted world class advisors like George Shultz and Henry Kissinger, but as reported by Jennifer Reingold, these luminaries lacked domain expertise in the startup’s core business.
- It should also set off alarms if entrepreneurs won’t let investors talk to anyone else on the team. The documentaries describing Theranos and Fyre Festival focused on how key employees who could have raised concerns with existing and potential investors were sequestered from communicating what they knew. When charismatic promoters are your only source of information, it’s another red flag.
So what should you do if you think an opportunity might be a fraud?
- Pay attention and be skeptical, especially when you’re excited. If you can’t be emotionally detached, appoint someone else on your team to be a devil’s advocate and maintain objectivity. Fantasies usually aren’t real, so don’t let your rational faculties be overtaken by outlandish promises. Make sure you have a reality check before closing.
- Take your time. Don’t give in to FOMO or be bullied, and be okay with missing a deal. Don’t worry about being popular. While the entrepreneur’s narrative may be that the deal is going away forever, that’s rarely true because startups tend to raise money as frequently as every year. In venture capital, odds are good there will be “another bite at the apple” if you are polite and focus on developing a relationship with the founder and the other investors in the syndicate.
- Insist on doing your homework and understanding the fundamentals. In other words, insist on performing routine due diligence even if it seems boring, because there are no shortcuts. A friend from a well-known fund with a solid track record looked at Fyre Festival as an investment opportunity and passed. I asked him about his general approach to validating opportunities:
When considering investment into companies with material revenue, we reconcile bank statements to claimed financial performance, and we test the integrity of systems and processes. This is in addition to reviewing audited financials. If a company can’t satisfy that validation process and testing, we won’t invest. This is standard practice for us. No magic really, just conservative financial diligence.
- Don’t be wowed by impressive names — focus on understanding why they are there and how their expertise is being leveraged for the success of the startup. Don’t allow advisors’ fame to distract you from paying attention to business fundamentals.
- Interview the entire senior team and listen for consistency. Conduct a site visit to get a feel for morale at all levels, and keep an eye out for potential issues. Be wary when you see charisma but little else. Charisma is necessary but insufficient — startups generally need substance and operational competence to bring products to market successfully, especially in regulated markets like healthcare.
A lot of this advice comes down to “do your homework,” which might seem obvious. But over the past decade’s bull market, the highest profile entrepreneurs have seized power in the dynamic with investors, so this isn’t always the easiest thing to do. If you want to ensure you are investing and not gambling, stick to your discipline when it comes to the due diligence process.
This article originally appeared in Forbes.
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