The End of Faking It in Silicon Valley

SAN FRANCISCO - Faking it's over. Silicon Valley is filled with schadenfreude, paranoia and some schadenfreude.

Investors are scrutinizing start-up claims closely, and the tech downturn has revealed who is taking the "fake until you make it" mantra too far.

Consider what happened over the past two week: Charlie Javice was arrested and accused of falsifying data about customers. Rishi Shah was found guilty by a jury of defrauding investors and customers. He is a cofounder of Outcome Health advertising software. A judge has ordered Elizabeth Holmes to start her 11-year sentence in prison on April 27, after she defrauded investors of her blood-testing startup Theranos.

These developments come after the arrests in February of Carlos Watson (founder of Ozy Media) and Christopher Kirchner (founder of software company Slync), both accused of fraudulence investors. Manish Lachwani's fraud trial, a cofounder of software company HeadSpin set to start in May, as well as Sam Bankman Fried, founder of cryptocurrency exchange FTX who faces 13 charges of fraud later this year, are still to come.

The chorus of charges and convictions, along with the sentences, have given rise to the impression that the fast-and-loose fakery in the startup world has real consequences. In spite of the many high-profile scandals and failures (Juicero, Uber, WeWork), very few founders have ever been charged with criminal offenses for their business puffery.

A funding slump may be the cause. When times are good, such as in the early 2010s for tech start ups, unethical behavior is often overlooked. According to PitchBook which tracks start ups, between 2012 and 2021 funding for tech start-ups has increased eightfold, to $344 billion. Over 1,200 are "unicorns", worth at least $1 billion on paper.

When the easy money runs out, people will repeat the Warren Buffett saying about who's naked in the water when the tide is out. Brian Chesky updated the adage to millennial tech entrepreneurs after FTX filed bankruptcy in November. "It feels as if we were in a club and the lights have just been turned on," he said in a tweet.

Previously, venture capitalists who invested in start-ups resisted taking legal action when duped. Investors' reputations would be damaged if they went after the founders of small companies with little assets. This has changed since the unicorns, which have attracted billions of dollars in funding, have taken off. Larger, more traditional investors, such as hedge funds, corporates and mutual funds, have also entered the investment game.

"There's more money on the line, so that changes the equation," said Alexander Dyck a professor of Finance at the University of Toronto, who specializes in Corporate Governance.

The Justice Department also urged prosecutors to be "bold" in their pursuit of business frauds at start-ups and other private companies. So, there are charges against the founders of Frank and Ozy Media as well as Slync, HeadSpin, and more may be forthcoming.

The Information reported that the Securities and Exchange Commission is investigating IRL, an app for messaging valued at $1 billion by investors, over allegations it misled investors about its number of users. Rumby, an Ohio laundry delivery startup, 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.

Media outlets have reported unethical conduct at several start-ups, including Olive, which is a $4 billion software company, and Nate, a start-up that claims to use artificial intelligent. Olive's spokeswoman said that the company "disputed and denounced" the reported accusations.

This creates a difficult situation for venture capitalists. They were considered visionary kingmakers when start-up valuations were so high. It was relatively easy to convince investors, including pension funds, college endowments, and wealthy individuals, that they were responsible capital stewards with the skills necessary to predict the future.

As more frauds involving start-ups come to light, the titans of business are now playing a new role in court cases, bankruptcy filings, and testimony: they are the victims who were duped.

Alfred Lin, a Sequoia Capital investor, a Silicon Valley top firm that invested $150 million in FTX, reflected about the cryptocurrency catastrophe at a January start-up event. "It wasn't that we invested, but the working relationship that followed for a year and a half that I didn't see," he said. "That's difficult."

Venture capitalists say that their asset class has the potential to yield huge rewards, but is also one of the most risky. In the start-up industry, failures are celebrated, and those who don't fail are viewed as having not taken enough risks. It is not clear if this defense will last as scandals get more embarrassing for all involved.

Eden Abrahams is a partner in the firm. She said that investors are increasingly turning to consultants such as RHR International for help identifying the telltale signs "Machiavellian Narcissists", who are more likely commit fraud. Ms. Abrahams stated that investors want to tighten the protocols for assessing founders. "We experienced a series events that should prompt reflections."

Dyck says that startups have many of conditions associated with fraud. Often, they use novel business models. Their founders have a lot of control. And their investors don't always enforce strict supervision. This is the perfect situation to bend the rules during a recession. It's no surprise that frauds committed over the past 18 months have come to light now, he said.

The complaint stated that she then asked the employee for thousands of fake accounts and assured her staff that this was legal.

Frank's investors congratulated JPMorgan on its $175 million purchase of the start-up in 2021. Reach Capital investor wrote: "So many students & their families will have greater access to #highered opportunities & financial aid." Chegg's executive who invested said, "It is exciting to know that you will have an even larger platform to make a significant impact on so many lives!"

Ms. Javice is facing four fraud charges. JPMorgan accused Ms. Javice of transferring funds to a shell firm after discovering her fraud.

Outcome Health - a company that sold ads for drugs on screens in doctor's offices - raised $488 Million from investors, including Goldman Sachs and CapitalG, a Google-affiliated fund, as well as the family of Governor J.B. Pritzker. J.B. Pritzker, while making public statements of rapid growth and profitability. The company, in reality, had failed to meet its revenue targets and was struggling with its debt. It was also overbilling customers.

Investors poured money into the company anyway, and allowed Outcome Health co-founders Mr. Shah, and Shradha, Agarwal to cash out shares worth $225 million. Todd Cozzens, one of the smaller investors of Outcome Health, told us he wasn't deterred by red-flags such as missing revenue targets or other "sloppiness" because "they could clean that up."

He said, "This was an excellent business model and it worked well. But these founders became very greedy." They wanted more. Mr. Cozzens’ firm lost 90% of its investment.

Mr. Shah has been convicted on 19 counts of fraud, and Ms. Agarwal on 15. Mr. Shah's spokesman said the verdict was "deeply disappointing" and that he intends to appeal. The counsel for Ms. Agarwal said that they were reviewing and weighing her options in light of the verdict.

The complaint stated that when an investor looked into Slync’s finances, Kirchner informed the person Slync would be switching financial service providers. The investor sent $35 million.

Slync's spokesman confirmed that the company had appointed a new CEO, was cooperating with government investigations, and looked forward to "a just resolution" of the matter.

FTX has raised almost $2 billion in funding from major investors such as Sequoia Capital and Lightspeed Venture Partners. This gives it a market value of $32 billion. According to a new report released by the company this month, it was so badly run that there wasn't a list of all employees. Bankman-Fried once told his colleagues that FTX, the hedge fund that is a sister company, Alameda Research was "unauditable". He also said that his team would sometimes find $50 million worth of assets that they'd lost track. "Such life," he wrote.

Sequoia apologized to its investors for publishing a glowing profile about Mr. Bankman Fried on their website after the collapse of the company. The profile was also removed.

Mr. Lin said at the event that the venture capital business is ultimately built on trust. He said that if you do not trust the founders you work with, why would you invest in them?