VC-backed startups commit more fraud, and researchers think they know why

Weiss’ paper, co-authored with Emlyon researcher Nevena Radoynovska, discusses what may happen when founders face a gap between how investors want their startups to perform and how they are actually performing. They may turn to “façading,” as the paper calls it, in three increasingly dishonest stages: surface, reinforced, and deep.  

Surface façading is when founders lie about how successful the company is or is becoming. It’s common during the early stages of a company when it’s pitching its vision to investors. It’s a level of dishonesty higher than just pitching an aspirational vision or an astronomical total addressable market.

After the surface façade, the founder may move into “reinforced façading,” according to the paper, which involves creating fake evidence to back up the lies told.

The paper gave the example of a mobile testing app that created fake customer contracts and invoices, recorded fake revenue, and used those fake documents to convince VCs to back it at a unicorn valuation.

From there founders may enter “deep façading,” where they extend their lies to areas like making their tech seem more capable than it is, complete with fake demos. This involves entire “parallel realities” built on lies, Weiss said.

But investors aren’t always hapless victims, the researchers found. Beyond the outsized growth expectations that push founders toward fraud in the first place, some investors unwittingly “co-create fraud,” Weiss said, by continuing to back founders—sometimes the very same ones— who’ve previously been accused of fraud, thereby normalizing it to a certain extent.

In fact, the UT report found little evidence that alleged fraud prevents founders from raising funding for new startups, even when those fraud cases received major media attention. 

“New investors and the broader VC market do not penalize past misconduct,” the UT report said, which is “also consistent with the Silicon Valley culture that embraces failure regardless of the cause.”  

The study also found that startups whose boards were controlled by the founders were twice as likely to commit fraud compared to those with investor-controlled or shared-controlled boards.  

Even more interesting, it reported that after VC-backed startups go public, they are more likely to face securities class-action lawsuits within two years compared with private equity-backed companies that go public.

The fact that companies are staying private longer also contributes. Public companies undergo more scrutiny than private ones. “Founders do not have a professional body or association that could govern or enforce rules of entrepreneurial and investor conduct on how to be a good founder and what reasonable growth expectations are,” Weiss said. 

Weiss proposes that the SEC routinely investigate and conduct formal audits on startups after they hit a large “investment threshold.” Currently, the SEC typically waits for something like a whistleblower complaint or a lawsuit from investors or former employees to trigger an investigation.

Weiss’ paper also suggests that investors should take more accountability when pushing founders to hit extreme growth metrics.

“Investors should be held liable for corporate governance failures and violating their fiduciary duties,” he said. He wants to see more research into “entrepreneur-investor dynamics” that could help prevent fraud and also “balance the overemphasis on the entrepreneur as the sole perpetrator of wrongdoing.”

Fraud is rarely a solo act, in other words, and until investors are held to account for the pressure they exert, founders will likely keep facing the temptation to fake it until they make it.

This piece was updated.