Professionalism/Startup Deception

In recent years, many startup companies have sprouted up and made impressions on the world. Startups such as Uber, Lyft, and Airbnb bring convenience to daily life, while disrupting long-entrenched industries. They are lauded for innovation, but many are unaware of the problematic side of startups.

Introduction

Startups are known for their culture of cutting edge technology and innovation. The latter half of the 2010s has been nicknamed “the age of unicorns,” where the term “unicorn” refers to a privately held company valued at $1 billion or more. It is common for startups to raise large amounts of money from venture investors, and in 2018 a new unicorn was named every four days on average. With this culture of aggressive growth comes the “fake it til you make it” mentality. Historically, startups have been ambitious with their visions and marketing in order to get funding from venture investors.

However, startups can fail hard when the promises they make to investors don’t come to fruition. As a startup grows, investors want tangible results and may withdraw their support (and ask for their money back) if they don’t see any. Startups are also subject to regulations and ethical concerns when their line of business affects people’s lives. Theranos, a biotech startup, was exposed when its employees contacted journalists over concerns about faulty blood tests. Theranos had made deals with Safeway and Walgreens to offer its tests in stores, and patients would have been making medical decisions based off of these tests.

Why Does It Happen?

The Need For Funding

Venture capital plays a large role in startups trying to commercialize their product. More than 80% of venture money given to a startup goes into the infrastructure needed for the startup to grow its business, such as manufacturing and marketing. This funding is temporary and intended to sustain the startup until it is stable and credible enough to be sold to a corporation or launch an initial public offering. Venture capital fund investors typically want a return of 25% to 35% over the lifetime of the investment. As a result, venture capitalists prefer investments that are low risk. They are known to heavily evaluate potential before making investments.

Funding is essential to a startup’s success. To maintain investor confidence, an entrepreneur has to keep an air of optimism and aggressively push the company vision. In order to keep up with the high expectations they set, startups may misrepresent their achievements. Founders can feel pressure to make sure their ventures succeed as well. Some entrepreneurs drop out of college or put their other careers on hold to focus on their business idea. If a competitor appears with a similar idea, that can also add pressure to succeed. After participating in a fraudulent act, founders may rationalize that other successful startup founders have done the same or that legal consequences won’t be severe.

Founders of startups may also feel personal guilt over losing investors money in cases of failure. Jeff Wald claims that many investors in his failed startup were friends and stated, “I reached into my own pocket and paid them back. I was so ashamed of it.”

Startups are also vulnerable to fraud. Deceptive sales pitches resulting from the presumption that startups are more likely to partake in shady activity mean negotiators are more likely to present faulty claims during negotiations. One study performed by Jörg R. Rottenburger and Lutz Kaufmann found that startups have a much higher chance of being deceived by experienced negotiators during sales.

The CEO Worship Problem

The startup community is also prone to CEO worship. Following the trend started by Steve Jobs, founder of Apple, corporate leaders are taking on the role of prophetic figures who profess to be disrupting industries and changing the world. Elon Musk is a prominent example: the founder of Tesla and SpaceX proposed pneumatic tube systems as a new public transportation method, and at least three multi-million dollar startups have been formed to implement the idea. Charismatic leaders can inspire employees to work harder, but issues arise when they value their personal brand over the company’s integrity.

In addition, many startup CEOs tend to have psychopathic traits. A psychopath is an individual who has Antisocial Personality Disorder, characterized by manipulative behavior, difficulties with empathy, and a tendency to lie often. They also tend to have dominant and bold personalities. Corporate environments are already known for attracting psychopaths, as 4-8% of high-level business executives are psychopathic compared to 1% in the general population. Entrepreneurship requires relationship sacrifices, convincing others to join or invest, and a high level of confidence, things that psychopaths excel at. Psychopaths tend to surround themselves with people who will follow them without question, meaning psychopathic startup founders will fill their companies with subordinates who will enable their behavior.

Industry Pressure

As more unicorn companies are beginning to emerge, more and more people feel that becoming a unicorn company isn’t enough to “make it” anymore. A common notion is that your company must have “ultra-success” to be viewed in a positive light. According to Jeff Wald, the former CEO of WorkMarket, upon selling his startup for an undisclosed amount, other members of the startup community expressed condolences that the company “didn’t work out.” Startups also feel immense pressure to be successful as quickly as possible. The sooner you begin to make a lot of money, the sooner investors want to invest prompting more of the “fake it till you make it” mentality. Through unchecked confidence, some CEOs can convince investors to invest in their company, with unkeepable promises.

Entrepreneurship Culture

Another reason for the prevalence of startup deception is that entrepreneurship inherently lends itself to questionable behavior. By definition, entrepreneurship means marketing products or services that don’t exist yet. Even altruistic startup founders have to persuade investors and customers to believe in a vision, and if the vision fails the investors have lost their money. As a result, misdirection among startups is extremely common. Jakub Kostecki is the founder of StartupFactCheck, a consultancy that helps investors evaluate startups for legitimacy. Kostecki has investigated 150 early-stage startups, three fourths of which were found to have given investors misleading or incomplete information, such as claiming that users who registered for a free trial were customers. Interestingly, Dave McClure, founding partner of the venture fund and accelerator 500 Startups, states that his firm will sometimes invest in a startup even if some misrepresentation is discovered. McClure even claims that there may be a correlation between “interesting behavior” and successful entrepreneurship.

The perception of startup deception is aided by the culture in Silicon Valley, a hotbed of high tech. It is home to tech giants such as Google and Facebook, and many startups are located in the Bay Area. Due to the Valley’s tech-heavy culture, engineers and inventors are praised above managers. Many startup founders are also young and inexperienced, while simultaneously exposed to venture capitalists who pressure them to break traditions and think innovatively. As a result, bad leadership is common.

Examples

Hampton Creek was a vegan food manufacturer founded in 2011. They bring vegan food options for egg based products such as mayonnaise to market. The company enjoyed strong early success as a competitor to traditional egg based products. In 2016, it was found that employees and contractors of the company pretended to be customers by purchasing their products, thus inflating their consumer demand. Josh Tetrick, the founder of Hampton Creek, justified this as product testing. A year later, Target pulled all of Hampton Creek’s products from its shelves, citing allegations that pathogens had been found at one of their manufacturing plants and that the products were mislabeled as non-GMO. Later investigations have questioned the validity of these claims. They recently renamed to JUST, still operating and successful.

Theranos was a health technology company aimed at manufacturing blood test kits that required very little blood. See Professionalism/Tyler Shultz, Elizabeth Holmes, and Theranos

Bouxtie was a startup aimed to sell online gift cards for various companies. The CEO, Renato Libric, reportedly made false claims to investors to gain investment money through forging signatures from several different entities such as bank statements and loan approvals from his board of directors. The company never gained traction and the CEO is facing up to 20 years in jail with a $250,000 fine.

Outcome Health was a healthcare information startup that installed flat screen televisions in doctors’ offices at no cost to the doctors, then offered pharmaceutical companies airtime for advertisements, with the implication that they would be viewed by patients. The U.S. Securities and Exchange Commission (SEC) and the U.S. Department of Justice (DOJ) filed claims that Outcome would sometimes charge pharmaceutical companies for more screens than they’d actually installed at the doctor’s office. Some employees of Outcome claimed that it would sometimes charge for doctor’s offices it hadn’t installed screens in yet, but hoped to. In addition, the SEC and DOJ claim that the founders manipulated the results of surveys that measured how doctors and their patients responded to the ads, making it appear that more patients participated. In 2017, the Wall Street Journal wrote a story about Shah and Agarwal which led them to resign. Shah and Agarwal face a combined 26 counts of fraud, with the most serious charges carrying up to 30 years in prison and a $1 million dollar fine if convicted.

Solutions

The Association of Certified Fraud Examiners (ACFE) helps to evaluate startups for fraud. Members of the ACFE are vetted with background checks and must have fraud-related work experience such as in accounting, auditing, criminology, sociology, fraud investigation, loss prevention, or law. Certified members of the ACFE are often hired as auditors, accountants, consultants, or analysts by venture capitalists and private equity firms to keep track of startups they’ve invested in. To preemptively combat fraud, a certified fraud examiner (CFE) could review companies’ financials, conduct background checks on founders, or participate in meetings with executive teams. In addition, if the investing group publicizes that they’re working with a CFE, it could dissuade startups from committing fraud in the future.

There are many startups focused on fraud prevention through fields like machine learning, auditing, and cybersecurity. AngelList, a platform for startups to raise money online, recruit employees, and apply for funding, lists 202 companies solely focused on helping other companies detect fraud.

In 2016, the SEC announced that they were closely watching the conduct of private companies as well as emerging platforms that trade in private company securities, and will bring enforcement cases as needed to protect investors. Named the “Silicon Valley Initiative”, SEC chair Mary Jo White emphasized that companies are not immune from the scrutiny of the SEC despite reaching certain sizes and maturities. In addition, Whiet noted that the SEC was also focused on the secondary market for trading pre-IPO, with the mission to protect investors.

Conclusions

Fraudulent startups present a great risk to investors. A highly successful tech industry entices many companies to try to get a foothold in the industry, resulting in many startups making promises they can’t keep. Absurd confidence and a highly charismatic CEO can secure a company funding, but the company’s success ultimately depends on the quality of its product. Companies will continue to falsify claims so long as they aren’t harshly punished or aren’t caught.