Quick Turnaround: The end of faking it in Silicon Valley

ERIN GRIFFITH

Faking it is over. That’s the feeling in Silicon Valley, along with some schadenfreude and a pinch of paranoia. Not only has funding dried up for cash-burning start-ups over the last year, but now, fraud is also in the air, as investors scrutinise start-up claims more closely and a tech downturn reveals who has been taking the industry’s “fake it till you make it” ethos too far.

Take what happened in the past two weeks: Charlie Javice, the founder of the financial aid start-up Frank, was arrested, accused of falsifying customer data. A jury found Rishi Shah, a co-founder of the advertising software start-up Outcome Health, guilty of defrauding customers and investors. And a judge ordered Elizabeth Holmes, the founder who defrauded investors at her blood testing start-up Theranos, to begin an 11-year prison sentence on April 27.

Those developments follow the February arrests of Carlos Watson, the founder of Ozy Media, and Christopher Kirchner, the founder of software company Slync, both accused of defrauding investors. Still to come is the fraud trial of Manish Lachwani, a co-founder of the software start-up HeadSpin, set to begin in May, and that of Sam Bankman-Fried, the founder of the cryptocurrency exchange FTX, who faces 13 fraud charges later this year.

Taken together, the chorus of charges, convictions and sentences have created a feeling that the start-up world’s fast and loose fakery actually has consequences. Despite this generation’s many high-profile scandals (Uber, WeWork) and downfalls (Juicero), few start-up founders, aside from Ms. Holmes, ever faced criminal charges for pushing the boundaries of business puffery as they disrupted us into the future.

The funding downturn may be to blame. Unethical behaviour can largely be overlooked when times are good, as they were for tech start-ups in the 2010s. Between 2012 and 2021, funding to tech start-ups in the United States jumped eightfold to $344 billion, according to PitchBook, which tracks start-ups. More than 1,200 of them are considered “unicorns” worth $1 billion or more on paper.

But when the easy money dries up, everyone parrots the Warren Buffett proverb about finding out who is swimming naked when the tide goes out. After FTX filed for bankruptcy in November, Brian Chesky, the chief executive of Airbnb, updated the adage for millennial tech founders: “It feels like we were in a nightclub and the lights just turned on,” he tweeted.

In the past, the venture capital investors who backed start-ups were reluctant to pursue legal action when they were duped. The companies were small, with few assets to recover, and going after a founder would hurt the investors’ reputations. That has changed as the unicorns have soared, attracting billions in funding, and as larger, more traditional investors including hedge funds, corporate investors and mutual funds have entered the investing game.

“There is more money at stake, so it just changes the calculus,” said Alexander Dyck, a professor of finance at the University of Toronto who specialises in corporate governance.

The Justice Department has also been urging prosecutors to “be bold” in its pursuit of more business frauds, including at private start-ups. Thus, charges for founders of Frank, Ozy Media, Slync and HeadSpin and expectations of more to come.

IRL, a messaging app that investors valued at $1 billion, is being investigated by the Securities and Exchange Commission for allegedly misleading investors about how many users it had, according to reporting from The Information. Rumby, a laundry delivery start-up in Ohio, allegedly fabricated a story of financial success to secure funding, which its founder used to buy himself a $1.7 million home, according to a lawsuit from one of its investors.

News outlets have also reported unethical behaviour at start-ups including Olive, a $4 billion health care software start-up, and Nate, an e-commerce start-up claiming to use artificial intelligence. A spokeswoman for Olive said the company has “disputed and denied” the reported allegations.

All of this creates an awkward moment for venture capital investors. When start-up valuations were soaring, they were seen as visionary kingmakers. It was easy enough to convince the world, and the investors in their funds — pension funds, college endowments and wealthy individuals — that they were responsible stewards of capital with the unique skills required to predict the future and find the next Steve Jobs to build it.

But as more start-up frauds are revealed, these titans of industry are playing a different role in lawsuits, bankruptcy filings and court testimonies: the victim that got duped. Alfred Lin, an investor at Sequoia Capital, a top Silicon Valley firm that put $150 million into FTX, reflected on the cryptocurrency disaster at a start-up event in January.

“It’s not that we made the investment, it’s the year-and-a-half working relationship afterwards that I still didn’t see it,” he said. “That is difficult.” Venture capital investors say their asset class is among the riskiest places to park money but holds the potential for outsize rewards.

The start-up world celebrates failures, and if you’re not failing, you’re viewed as not taking enough risks. But it is unclear whether that defense will hold as the scandals become more humiliating for everyone involved.

Investors are increasingly asking consultants like RHR International to help identify the telltale signs of “Machiavellian narcissists” who are more likely to commit fraud, said Eden Abrahams, a partner at the firm. “They want to tighten up the protocols around how they’re assessing founders,” Ms. Abrahams said.

“We had a series of events which should be prompting reflections.” Start-ups have many of the conditions most associated with fraud, Mr Dyck said. They tend to employ novel business models, their founders often have significant control and their backers do not always enforce strict oversight. It is a situation that’s ripe for bending the rules when a downturn hits.

“It’s not surprising we’re seeing a lot of frauds being committed in the last 18 months are coming to light right now,” he said.

When Ms. Javice was trying to sell her college financial planning start-up, Frank, to JPMorgan Chase, she told an employee not to share exactly how many people used Frank’s service, according to an SEC complaint. Later, she asked the employee to fabricate thousands of accounts, assuring her staff that such a move was legal and that no one would end up in “orange jumpsuits,” the complaint said.

After JPMorgan bought the start-up for $175 million in 2021, Frank’s investors were quick to take a congratulatory victory lap on Twitter. “So many more students & families will now have greater access to financial aid & #highered opportunities,” an investor at Reach Capital wrote.

“It’s so exciting to know you will now have an even bigger platform to make a positive impact on the lives of so many people!” was the praise from an executive at Chegg, which invested.

Ms. Javice faces four counts of fraud. This past week, JPMorgan accused her of transferring money to a shell company after the bank uncovered her alleged fraud.