In the start-up world, the adage “fake it till you make it” has often been brandished as a success mantra by entrepreneurial hopefuls. But in recent years, there has been a dramatic uptick in high-profile cases where the “fake it” part spiraled into criminal fraud, irreparably damaging the trust between start-ups, their investors, other stakeholders, and the public.

One of the most notable cases is the rise and fall of Theranos’ founder, Elizabeth Holmes, who made materially false representations about the capabilities of its technology and the financial position of the company. On May 30, Holmes reported to a federal prison to start a nine-year prison sentence for four convictions of fraud. However, Holmes represents the tip of an iceberg of founders who, under a distorted understanding of “fake it till you make it,” have allegedly falsified records, inflated valuations, and defrauded investors.

Recent Examples of Start-Up Fraud

In the entrepreneurial sphere, there is a fine line between aspirational projections and criminal deceit. Three recent cases of start-up fraud are examples of the “line” being crossed, ending in criminal charges:

1. Charlie Javice, Frank:

Summary

As reported by the Department of Justice (DOJ), Charlie Javice, the founder of Frank (a start-up aimed at assisting students with financial aid), was accused of misleading investors by inflating the number of her company’s customers in order to induce J.P. Morgan Chase (JPMC) to acquire the company for $175 million. Javice would gain at least $40 million from the fraud.

• Length of fraud: ~ June 2021 – November 2022
• Arrest: April 3, 2023

The Fraud

According to the Complaint, when two major banks expressed interest in acquiring Frank, Javice repeatedly indicated that Frank had 4.25 million customers/users. In truth, Frank had less than 300,000 “users,” which the company explicitly defined as an individual who had both signed up for an account and for whom Frank had a minimum of four categories of data (such as first names, last names, phone numbers, and email addresses).

To satisfy a potential buyer’s (JPMC) diligence needs, Javice fabricated a data set with a co-conspirator. Javice first asked Frank’s director of engineering to create the data set – the employee declined – leading Javice to hire a third-party data scientist to create the data set, which was provided to the bank. JPMC agreed to purchase Frank for $175 million.

To cover up the fraud, Javice and a co-conspirator purchased real data for 4.25 million college students. Following the acquisition, Javice provided this data to JPMC for use in a marketing campaign.

The Consequences

As a result of the $175 million acquisition by JPMC, Javice received over $21 million for selling her equity stake. She was to be paid $20 million as a retention bonus. Javice has been charged with one count of conspiracy to commit bank and wire fraud, one count of wire fraud affecting a financial institution, and one count of bank fraud. Each carries a maximum sentence of 30 years in prison. She is also charged with one count of securities fraud, which carries a maximum sentence of 20 years. Javice was formally indicted on May 18, 2023, and pleaded not guilty on May 22, 2023. Details about the trial date have not been made public as of the writing of this article.

2. Rishi Shah, Shradha Agarwal, and Brad Purdy, Outcome Health:

Summary

According to the DOJ, three executives of Outcome Health were convicted of selling advertising inventory it did not have to clients while under-delivering on advertising campaigns but invoicing as if the company had fulfilled its campaign in full. This scheme lasted six years and resulted in at least $45 million of overbilled services. This led to a material overstatement of Outcome’s revenue in certain years, an overstatement used to raise over $972 million in financing.

• Length of fraud: 2011-2017
• Conviction: April 11, 2023

The Fraud

The three executives were Rishi Shah, the former CEO and co-founder of Outcome Health; Shradha Agarwal, the former president of Outcome Health; and Brad Purdy, the former chief operating officer and chief financial officer of the company.

Outcome Health’s business model involved installing screens and tablets in doctors’ offices across the United States and selling advertising space on these devices to primarily pharmaceutical companies. Evidence presented during the trial revealed that Shah, Agarwal, and Purdy sold advertising inventory that the company did not possess to Outcome’s clients and failed to fulfill their advertising campaigns as promised. Despite the under-delivery, the company still invoiced clients, and materially overstated revenue, as if the advertising had been delivered in full. To conceal these under-deliveries, Shah, Agarwal, and Purdy either lied or coerced others into lying, giving the impression that the company had provided the contracted advertising content to the specified number of screens.

The scheme, which targeted Outcome’s clients, began in 2011 and lasted until 2017, resulting in a minimum of $45 million in overbilled advertising services. The inflated revenue figures gave Outcome Health the ability to raise $485 million in debt financing, resulting in a $20.2 million dividend to Shah and a $7.5 million dividend to Agarwal, and $487.5 million in equity financing, resulting in a $225 million dividend to Shah and Agarwal.

The Consequences

Each defendant was convicted on multiple counts of bank fraud, each which carries a maximum penalty of 30 years in prison. They were also convicted on multiple counts of wire and mail fraud, each which carries a maximum penalty of 20 years, and sentencing is still set to take place.

3. Renato Libric, Bouxtie:

Summary

The DOJ reports that Libric deceived investors about the financial health of his digital gift card start-up, leading to wire fraud charges. This fraud included lying to potential investor representatives that a large public corporation was interested in purchasing Bouxtie, as well as forging a signature of a corporation executive to highlight this and falsifying a bank statement (claiming Bouxtie had over $2 million in an account that had less than $8,000). This fraud led investors to transfer $1.5 million into accounts for Bouxtie.

• Length of fraud: August 2017 – February 2018
• Indictment: May 10, 2018

The Fraud

Libric undertook several actions to persuade individuals from Las Vegas-based Moose Run to invest more than $1 million dollars in Bouxtie. As part of the scheme, Libric deceptively indicated to representatives of potential investors that a prominent publicly traded company, First Data Corporation, was keen on acquiring Bouxtie for $150 million. To reinforce this assertion, Libric illicitly affixed the signature of an executive from the alleged acquiring corporation onto a counterfeit term sheet, asserting the corporation’s interest in purchasing Bouxtie. Additionally, Libric orchestrated the transmission of the fabricated term sheet and a falsified bank statement to the prospective investors. The fraudulent bank statement indicated a balance of over $2 million in Bouxtie’s account, while only $7,642.82 was available. Furthermore, Libric forged the signatures of members of Bouxtie’s Board of Directors on a document purportedly authorizing Libric to enter into agreements where the investors would lend $1.5 million to Bouxtie, with the loan eventually being converted into Bouxtie shares.

Libric successfully persuaded investors to transfer $1.5 million into Bouxtie’s accounts through his scheme. Subsequently, once the $1.5 million had been deposited, Libric proceeded to withdraw over $130,000 from one of the investment accounts and redirected the funds into his personal checking account.

The Consequences

Libric was indicted by a grand jury for one count of wire fraud. Libric pleaded guilty and was sentenced to three years in prison.

Understanding the Fraud Triangle and Start-Ups

To understand what drives bad actors to commit fraud, we look to the fraud triangle, a model for explaining the factors that cause someone to commit occupational fraud. It highlights three components: opportunity, rationalization, and pressure.

Opportunity

Opportunities for fraud often arise due to the lack of internal controls, especially in start-ups:

• Lack of internal controls / segregation of duties: Start-ups often grapple with limited resources, both human and financial. The limited number of employees may result in a single individual handling multiple roles, which could result in a lack of segregation of duties. Furthermore, many start-ups lack formally documented policies and procedures or adequate employee training due to the pressures of rapid growth or resource constraints. These circumstances can make it easier for an unscrupulous individual to manipulate records or misappropriate funds without detection.
• Lack of transparency: Start-ups, especially privately held ones, are often subject to minimal to no financial reporting disclosure requirements. This lack of transparency can create an environment where financial manipulation becomes more feasible and less detectable.
• Non-disclosure agreements (NDA) and non-compete agreements: With proprietary products/data, it is common for start-ups to require employees to sign NDAs and non-compete agreements. These can inadvertently create a shroud of secrecy that can be exploited to hide fraudulent activities.

Rationalization

The rationalization component is a psychological mechanism whereby individuals justify their unethical actions. Motivations can include the following:

• Company or product success: Bad actors may convince themselves that the company or product will be successful given more time or more money. This mindset can lead them to justify unethical actions as temporary measures intended to “buy time” or secure additional funding.
• Job security: In an unstable start-up environment, employees may rationalize fraudulent activities as necessary measures to protect their jobs and the company’s future.
• Comparison with peers: The idea that “other start-ups are doing the same thing” can be a powerful rationalization, normalizing unethical actions in a competitive environment.

Pressure

Pressure can often come from both internal and external sources in a start-up, such as:

• Funding and IPO pressures: The need to obtain investor funding or reach IPO can place enormous pressure on start-ups, sometimes leading to compromised ethics. The constant expectations from investors to hit certain financial metrics can also incite fraudulent behavior.
• Investor withdrawal: The fear of investors pulling funding can create an environment of desperation where the lines between ethical and unethical practices blur.
• Competitive market: Start-ups often operate in highly competitive markets, where the pressure to stand out can lead to over-promising and under-delivering.
• Desire for big accounts: The desire to land big customer accounts can tempt start-ups to exaggerate their profitability or success, leading to fraud.

The Importance of Due Diligence

Investors must remain vigilant, using thorough due diligence processes to detect potential red flags:

1. Documents: Request and thoroughly inspect all pertinent documents such as financial statements, tax returns, and documents provided to other investors.
   
   Tip: Any hesitation from the start-up to provide documents should be met with skepticism. Test the documents provided for completion and accuracy, and verify them against source documents as much as possible.
2. Testing projections and/or valuations: Check if the start-up’s financial projections align with industry norms. If the numbers seem too good to be true, they often are.
   
   Tip: Consult with valuation professionals to understand any appropriate discounts to cash flow models that are unique to the age of the company and industry. Often, higher risk will lead to greater discount rates, leading to a lower enterprise value.
   1. Inspect the assumptions: All projections use many forms of assumptions to project growth, so be wary of “hockey-stick projections” in which growth resembles a hockey stick with flat actuals but rapid, unrealistic growth into the future.
      Tip: Ask questions about what assumptions were used to forecast the growth.
   2. Peer Comparison: If the projections are far outpacing industry peers, ensure that there is a quantifiable justification for that departure.
   3. Consider economic factors: Make sure that the company incorporated economic factors (supply constraints, inflation, etc.) in its model.
3. Founder evaluation: Consider the founder’s charisma, personality, and social capital. Although these traits can be advantageous, they can also be employed to mislead and manipulate.
   
   Tip: Go beyond the founder, such as interviewing/speaking with the founder’s right-hand, or others who are involved more deeply on the operational front, separate and apart from the founder. Evaluating the projections and/or financial documents created by the company provides an opportunity to speak with someone in operations. In doing so, you can perform a walk-through with the employee and see the source documents for any analysis/financial model.

With the increasing number of charges against start-up executives and an increasing focus on white-collar crime by the DOJ, as well as other government bodies, financial due diligence is critical.¹ The success of any start-up should be built on integrity and honesty. Investors, in turn, need to ensure that they use robust due diligence procedures to protect their investments and maintain trust in the start-up community.

1. “AG Garland defends crackdown on white-collar crime,” American Bar Association, March 7, 2022.