Founders and Fraud

I was reading the news when I came across the story of Christine Hunsicker, who was charged in a $300MM investment fraud scheme as part of her startup, CaaStle. I don't know anything about her or her company, but this is yet another example of investment fraud in the venture capital space.

There is a growing amount of fraud in startups (or at least a growing amount of which I am aware!). In addition to significant public cases, like CaaStle or Theranos, I have heard from various investors about many scams they have fallen prey to.

Professional investors have to be very upset to bring a criminal case, as they are embarrassed to admit how little diligence most investors do, especially at a company's earliest stages.

Thing about it for a moment: with as little as a presentation (or sometimes not one at all), a person can ask for and receive millions of dollars to build a startup. Most early-stage (e.g., pre-seed or seed) startups are not required to have third-party auditors or outside bookkeepers. Usually, no one except the founder and CEO can access the books.

I have made investments in founders with less-than-stellar moral qualities. I have seen one of these founders lie about his experiences and go on to raise funds from a top-tier venture fund. Why is this possible? Because no one does real research.

Part of the reason that the research and diligence are limited is that most deals have a time factor. If a deal doesn't move fast, it dies. If you don't move fast, you might lose the deal. A recent super-obnoxious LinkedIn post was all about closing in 24 hours. You can believe that the investor didn't do any diligence.

I love the quote in the press release from the Department of Justice:

The promise of pre-IPO technology companies can be fertile ground for fraudsters who play on investor euphoria.  Investors should be aware of these incentives and that pre-IPO companies are not subject to the rigors of SEC registration.  This Office is committed to protecting investors who place their trust and capital in emerging companies.  We will continue to work closely with our law enforcement partners to investigate, detect, and prosecute those individuals who abuse our markets and our investors.

An audit firm did uncover this fraud. Even after investors removed Hunsicker from her role at the company, she continued to fundraise fraudulently. It's totally wild.

Unfortunately, this story is more common. Venture capital investors continue to push startups to do more with less. However, the cost of an annual audit and the practice of external supervision (e.g., an independent board member, external financial reviews short of a full audit) would go a long way toward preventing this type of fraud.

Auditing, hiring a great bookkeeper, and hiring an external board member might cost $50,000 - $100,000 per year. If you've only raised $1MM, that might seem undoable. If you raised more, it should be no problem. However, the issue is that once you get on the train, every subsequent investor assumes someone earlier did the work. And yet, maybe they didn't.

This isn't new, and it won't be stopping anytime soon, but I encourage all investors to do reasonable diligence. Unfortunately, the difference between founders who lack basic management and those who are committed may appear similar from the outside. Looking under the good is the only way to figure this out.