Silicon Valley Startups Can No Longer Fake It: The End of an Era
- ByStartupStory | April 18, 2023
The tech industry is experiencing a shift away from the “fake it till you make it” mentality, as investors become more cautious due to a funding slowdown and increased scrutiny of start-up claims. Recent events have highlighted this trend, including the arrest of Charlie Javice, founder of financial aid start-up Frank, for allegedly falsifying customer data, the guilty verdict against Rishi Shah, co-founder of advertising software start-up Outcome Health, for defrauding customers and investors, and the upcoming 11-year prison sentence for Elizabeth Holmes, founder of blood testing start-up Theranos, who also defrauded investors.
Recent months have seen a number of high-profile arrests and convictions related to fraud in the tech industry, indicating a shift away from the “fast and loose fakery” that has characterized the start-up world. Carlos Watson, founder of Ozy Media, and Christopher Kirchner, founder of software company Slync, were both arrested in February for allegedly defrauding investors. Manish Lachwani, co-founder of software start-up HeadSpin, is set to go on trial for fraud in May, and Sam Bankman-Fried, founder of cryptocurrency exchange FTX, is facing 13 fraud charges later this year. These cases highlight the potential consequences of pushing the boundaries of business practices in the tech industry, a trend that has been seen in previous scandals involving companies like Uber, WeWork, and Juicero. Elizabeth Holmes, founder of Theranos, is one of the few start-up founders who has faced criminal charges for such behavior.
The recent funding slowdown in the tech industry may be exposing unethical behavior that was previously overlooked during the boom times of the 2010s. According to PitchBook, which tracks start-ups, funding for tech start-ups in the US increased eightfold between 2012 and 2021 to reach $344 billion, resulting in over 1,200 “unicorns” valued at $1 billion or more on paper. However, as the tide goes out and easy money becomes scarce, unethical practices are coming to light. Brian Chesky, CEO of Airbnb, likened the situation to being in a nightclub when the lights suddenly turn on after FTX filed for bankruptcy in November. This shift is causing a shift in mentality for millennial tech founders.
Previously, venture capital investors were hesitant to take legal action against start-up founders who deceived them. Small start-ups with few assets made it difficult to recover losses, and pursuing legal action could harm investors’ reputations. However, with the rise of unicorns worth billions and the entry of larger investors such as hedge funds, corporate investors, and mutual funds, the situation has changed. The increased amount of money at stake has shifted the calculus, according to Alexander Dyck, a finance professor at the University of Toronto who specializes in corporate governance. This trend is leading to a change in mentality among investors in the tech industry.
The US Justice Department has been pushing prosecutors to take more aggressive action against business fraud, even at private start-ups. As a result, more founders are facing charges for their fraudulent activities, including those at Frank, Ozy Media, Slync, and HeadSpin. Additionally, IRL, a messaging app that was valued at $1 billion, is reportedly under investigation by the Securities and Exchange Commission for misleading investors about its user base. In another case, an Ohio-based laundry delivery start-up called Rumby is facing a lawsuit from an investor who alleges that the company fabricated financial success to secure funding, which the founder then used to buy a $1.7 million home. These developments highlight a shift in the tech industry towards increased scrutiny and accountability for start-ups and their founders.
Media reports have recently exposed unethical practices at several high-profile start-ups, including Olive, a $4 billion healthcare software company, and Nate, an e-commerce start-up that claims to use artificial intelligence. A spokesperson for Olive has denied the allegations. These revelations have put venture capital investors in a difficult position, as they were once hailed as visionary investors who could predict the future and identify the next Steve Jobs. However, the recent wave of scandals and fraudulent activity in the tech industry has called their reputation into question, particularly among the pension funds, college endowments, and wealthy individuals who invest in their funds.
As more start-up frauds come to light, venture capital investors are playing a different role in lawsuits, bankruptcy filings, and court testimonies: that of the victim who got duped. They are increasingly seeking help from consultants to identify the signs of “Machiavellian narcissists” who are more likely to commit fraud. Start-ups have many of the conditions most associated with fraud, including novel business models, founders with significant control, and backers who do not always enforce strict oversight. The scandals in the start-up world prompt reflections on the potential for outsize rewards and the riskiest places to park money. The defense that the start-up world celebrates failures and risks will hold as the scandals become more humiliating for everyone involved is unclear.
According to Alexander Dyck, a finance professor at the University of Toronto, the high incidence of start-up frauds that have emerged in the past 18 months is not unexpected. One example is the case of JPMorgan Chase’s purchase of Frank, a college financial planning start-up, for $175 million. The founder, Ms. Javice, allegedly asked an employee to fabricate thousands of accounts, saying it was legal and that no one would go to jail. After the purchase, investors congratulated themselves on social media, but Ms. Javice now faces four counts of fraud. JPMorgan has also accused her of transferring money to a shell company after discovering the alleged fraud.
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