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HEIDI: Welcome to The Startup Solution and “The Case of the Fraudulent Founder.” I’m Heidi Roizen from Threshold Ventures.
. . .
In this final episode of Season Two, I want to talk about something that's been getting a lot of media attention lately. I want to talk about fraudulent founders.
Jessica Mathews of Fortune recently wrote about founder fraud in their terrific newsletter Term Sheet. I’ve linked to this particular article in the show notes. In it, she summarizes a number of cases that have already been tried, like Elizabeth Holmes and Sam Bankman-Fried, and also covers a number of cases that’ll be coming up in the near future. And as she herself said, it’s a lot.
She talks about the “fake it til you make it” culture and the dangers of using it as an excuse to mislead investors. To underscore her point, she quotes something US Attorney Damian Williams said during the sentencing of Nikola founder Trevor Milton. Williams said, “Today’s sentence should be a warning to startup founders and corporate executives everywhere. “Fake it til you make it” is not an excuse for fraud, and if you mislead your investors, you will pay a stiff price.”
. . .
I’ve heard plenty of people sniping at these disgraced founders, probably while thinking, ‘That would never be me.’ And for sure, some of these cases were long premeditated, deviously orchestrated, and, in some cases, massive.
But.
I also know one of the people on this list (and no, I’m not going to say who) – and I know that that person did not set out to be a felon. In fact, I’d argue that with a few rare exceptions, the vast majority of people facing criminal indictment over their actions as entrepreneurs didn’t originally set out to steal money or deceive anyone.
They set out to start and grow companies. Just like any of you founders listening today. The problem is that when they ran into difficulties, they started to color outside the lines to keep their dream alive.
As the expression goes, the road to hell is paved with good intentions – and it can become remarkably easy for some people to justify some minor embellishments to serve good intentions. Things like keeping your employees employed, keeping your investors’ hopes of a return alive, and, perhaps most of all, continuing to pursue the solution to the problem you set out to solve in the first place.
. . .
But for some, that creative fudging turns into something darker as the problems continue to mount – and eventually, those entrepreneurs end up in the headlines for all the wrong reasons.
Which is why I want to talk about it today. Not because I think this is justifiable – because I don’t.
My hope in talking about it is that I can walk you down the path of how it happens so that you can not only be aware of the circumstances yourself, but you can also take some actions to prevent them from developing in the first place.
Let’s start with some examples of creative fudging – and play a game called “spot the fraudulence.” I’ll give you examples of stuff I’ve seen, then you decide whether it’s just creative entrepreneurship, or something that crosses the line.
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For example, we’ve all gotten those emails asking us to vote for someone’s app as best in this or best in that – even if we’ve never used the app. Is that fraud, or just an excited entrepreneur playing the game that he knows everyone else is playing?
Or how about this – one entrepreneur I know, whose company had a retail storefront, messaged all her friends to drop by the store on a particular day. She knew that a prospective investor would be coming in that day, and she wanted to be sure that the store felt lively and busy. Is that fraud, or just good marketing?
Another entrepreneur I know left his messaging app open while he was going through his pitch deck with some prospective investors. About midway through his pitch, a message popped up that said ‘Great news, the term sheet we were expecting just came in.’ He acted all embarrassed and made a show of closing the messaging app. But he wasn’t actually surprised because he’d asked one of his cofounders to send him that exact message at that exact time. Sketchy, to be sure, but okay to do or not? What do you think?
In another situation, an entrepreneur was negotiating with Google for a company-making business development deal. The Google team was coming to his office that day to see if they could hammer out a deal. So, before Google arrived, the entrepreneur went into the conference room, and filled the white board with what looked like notes from a negotiating session with Microsoft. He wrote out columns, like what his company was to deliver, and what Microsoft was to deliver, plus a list of a few issues that remained to be solved, like legal review and launch date.
When the Google team arrived, he had his admin bring them into the conference room five minutes before he went in. And then when he did go in, he looked at the white board, acted flustered, and said ‘oh, this shouldn’t have been left here’. Then, he frantically erased the whiteboard. He didn’t need to capture what it said before he erased it, because he had fabricated the whole thing in the first place.
. . .
So, you tell me, is that just creative negotiating, or is it over-the-line fraudulent behavior?
My point is, some people see these acts as lying and deception. While other people see these as the very definition of “fake it til you make it”. In each of these cases, there wasn’t an actual lie specifically told to anyone. But, in all of these cases, the intent is to bend reality to create an impression that is in fact not real.
And if you’re comfortable with doing stuff like this, the next step, data omission or data manipulation, may just seem like another way to put your best foot forward. I mean, that isn’t technically lying, is it?
And then you take another little slide down that slippery slope.
. . .
What do I mean by data omission or data manipulation? Well, for example, I’ve seen more than a few pitch decks where non-standard accounting terms are used instead of the standard ones. This is usually done to make the numbers look better – because the standard ones would have made them look bad.
In a much-publicized case, WeWork reported “community-adjusted EBITDA” instead of regular old EBITDA. Why? Well, because by inventing a new stat that sounds just like a version of a standard stat, they could create a much better earnings number. But it was only impressive because, in addition to omitting the regular ITDA stuff – that is interest, taxes, depreciation and amortization – it also left out some of the other costs like marketing, admin, and development. Which, of course, made their EBITDA a prettier number than the real EBIDTA. And yes, you could find that out in the fine print. But most people don’t read the fine print.
I’ve also seen entrepreneurs omit income statements and balance sheets from their early pitch material and wait as long as possible to disclose them – since those financial details tend to tell a story not as shiny as the narrative in the deck. Some might label a round as a 10 million dollar raise, and it’s not until the third or fourth meeting that I find out that of the 10 million, four million is a bridge convert that’s already been spent, and another two million will immediately be paid to the bank for debt that has likewise already been drawn and spent. So yeah, it’s a 10 million dollar raise, but only four million of it is actually going into growing the company. And trust me, that’s not a positive in the eye of any new investor.
Some entrepreneurs kind of know when their numbers are suspect but pull a bit of an ostrich move – that is, if you don’t push on it, maybe you won’t have to realize that those user numbers are mostly bots. Or that those customers who are 90 days overdue are actually super unhappy and are never going to pay. But best not to push too hard, just put it in the data room and hope for the best.
. . .
I get why entrepreneurs do all this. They mean well. They want to show investors like me the shiniest stuff first and hope that by the time we dig in enough to see the less flattering bits, we’ll be so in love with the company that we’ll want to move forward anyway.
But for me, the opposite occurs. When I discover all the not-so-pretty stuff after investing a bunch of time, it makes me feel like the entrepreneur was trying to hide things on purpose. And that makes me wonder, ‘what else are they hiding?’ This doesn’t make me want to work with the entrepreneur – it makes me want to run.
So, here’s a Captain Obvious statement. Entrepreneurs only start doing this when things are not going great. Yeah, duh. But in their minds, they are not doing it to cheat anyone. They are doing it to save their company, their employees, and even their current investors. They still believe that with just a little more money, they can turn things around.
Believe me, I get that pressure. I’ve been in that seat myself. During a down period at my company, I remember walking into my office each day, counting the cars in the parking lot and thinking about the car payments, the mortgages, the tuition bills, and everything else riding on keeping the dream alive. Not just for me, but for our whole team. And that’s a tremendous amount of pressure.
But all that pressure still doesn’t justify fraud. Even if, in the moment, it can make some of these actions seem justifiable. None of what we’ve talked about so far is actually going to put you in the slammer. But once someone takes a bunch of steps like these, it might not be that hard for them to take that next step. The one that does cross the big line. They might fake financial data, use false references, or makeup user stats. And all that is definitely fraud.
. . .
Those are the stories we read about. I won’t repeat them here, though if you’re really interested, you can read about them in Fortune or elsewhere, and I’ve put links to a few of them in the show notes.
But the point is, I used all those examples because I wanted to put you in the mindset of the entrepreneur who ends up here. You think it’ll never be you – but so did most of those people in that Fortune article.
So instead of looking down on them, let’s consider how they got there, and talk about what you can do to keep from being in next year’s rundown of fraudulent founders.
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The first step is simply to be aware of the temptation. I think most people when they’re doing even the most innocent of transgressions, know that it’s a little iffy. Every time you’re feeling that way, ask yourself, if the person on the other side knew I was doing this, would they consider it sketchy? Or ask yourself, if the New York Times wrote about what I was doing for an article called “Creative Fake it Til You Make it Hacks,” would I actually want my name associated with it?
The second thing to do is to actively make truth a part of your company culture. And that doesn’t mean just lip service, like standing up at your all hands and saying, ‘We have a culture of honesty’ blah blah blah. I’m not saying you shouldn’t talk about honesty, but if you don’t support a cultural tenet with action and reinforcement, it’s not actually an element of your culture.
I’ve seen CEOs say they want nothing but honesty, but then they bite the head off anyone who delivers results that don’t meet their needs or expectations. And, similarly, they reward people who bring in the right numbers, without ever questioning them. So sure, they say honesty is important, but their actions tell a different story.
I was talking to one of my favorite CEOs about this recently, and he said, ‘But how do you motivate people to work super hard to deliver the numbers without pounding on people for bad performance?’ Yeah, I said, it’s hard. And that’s why I’m glad you’re the CEO and not me! Seriously, I don’t have a perfect answer, but I do believe that as a leader, you should treat your fellow employees like adults, and talk openly and thoughtfully about the competing desires of honesty and, well, good numbers.
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I think a discussion like this can be very helpful in setting and reinforcing a culture of honesty. Now I recognize that it’s not always cut and dry, and there are definitely going to be management challenges in both striving for honesty and pushing for results. But being up front about it, and establishing ground rules for communicating, pushing back, and validating numbers will help, even if it’s still not perfect.
At this point, I’ll also put in a plug for what I call ‘corporate hygiene.’ Doing things like using professional, industry-standard accounting, putting in proper financial controls, having governance by an engaged and effective board, and seeking good legal counsel for advice before you do something, not after – all these things can help keep you from courting disaster. And lucky for you, I’m going to talk more about good governance in the next few episodes when we kick off Season Three – so stay tuned.
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The final thing I’ll say about this topic is also the hardest thing to accept. And that is, not all problems can be solved. If your results are bad, you may not be able to raise more money. If you can’t raise more money, you may have to shut down. If you shut down, employees will lose their jobs, investors will lose their capital, and you’ll have to bury your dream. It happens.
In fact, it happens a lot, like nine times out of ten for seed stage companies and something like 40% even for series A companies. And yes, these numbers go up and down in various markets, but they’re still big numbers regardless of which market you’re in or which source of data you use.
But, as I’ve said before, you, meaning you, the person, will still survive. You are not your company. We investors are well aware of these stats too, and our business models are built to accommodate them. It’s not fraudulent to go out of business – as long as you didn’t commit fraud along the way. And if you stay on the path of honor, at least from what I’ve seen, your reputation will stay intact. That’s the most important thing you have as far as I’m concerned.
Which brings us back to the beginning, and the whole point of this episode. Entrepreneurship is hard, and it doesn’t always work. But that doesn’t justify doing things that are unethical or illegal for what you perceive as the greater good of keeping your company alive when things get rough. A felony committed for a greater good is still a felony, and you can still go to jail for it.
So please, consider taking a lesson from those entrepreneurs who have already taken the fall. Instead of looking down your nose at them, consider how they got to where they did and what pressures might have led them down that slope, one small slip at a time.
Then, consider what might lead you down that path. And then, think of ways to catch yourself before you commit any crimes. Work openly with your leadership team to talk about these cases, and how you all can create a culture that wouldn’t support actions like these. And remember, culture without aligned action is just a bunch of hot air. You have to follow through with acting in accordance with the culture you want to set, even if that can be hard and sometimes messy – and do all this even if it means your company doesn’t end up surviving. Because a wind-down is still better than a sentence.
. . .
HEIDI: And that concludes “The Case of the Fraudulent Founder.”
This episode closes out Season Two of The Startup Solution. I want to thank you for listening, and I hope you’ll join us for Season Three, starting on April 27, 2024. I’m Heidi Roizen from Threshold Ventures.
Here is the Fortune piece that prompted this episode: Founder Fraud Cases Are Stacking Up
I mentioned WeWork’s “creative” accounting; Axios provides more details here.
Fortune has more on the IRL debacle here.
And Forbes covers the Charlie Javice downfall here.
Finally, as I mentioned, Fortune’s newsletter Term Sheet is terrific and free! You can sign up for Term Sheet here.
