Hype vs Fraud – How to spot the modern day ‘red flags’ when investing in a startup

Olivia Bishop

By Olivia Bishop – Reputation Management Lawyer at Slateford

No investor wants to live with the regret of missing out on the next big startup hit. Imagine, for example, having the recurring nightmare of those investors who missed out on buying shares in Apple in the early 90s. But how can you tell apart the future unicorns, vs the flops? Or worse, the fraudsters.

Chasing funding is integral to the start-up experience and the squeeze to succeed is real. However, while that start-up spirit and keen desire to grow is what so often captures an investors imagination, it is important not to be taken-in by inflated figures and false profit margins. The start-up community is unique in the sense that it is a struggle. It is so often that we hear about founders’ sofa surfing and drawing the most minimal of salaries for the first five years of operations. To build a business from the ground up, can involve risking everything you have and huge penalties for failure. Predictably, this can create the incentive to tweak data, adapt the narrative, or say anything that will get the deal over the line.

There’s a fine line between a business putting its best figures forward and fraud – the trick is spotting it. There are some common indicators that suggest a start-up will have issues in the future, the most common in disruptive businesses is the distance between expectations of the sales function and innovation teams. A gap between these two functions of a business leads to – often, but not always, inadvertent – misrepresentations.

Red flags

Everyone in business has experienced a sales call where the pitch given for a revolutionary new product has not quite matched performance when it comes to trying it out for real. This is the disconnect between the sales and the operations and while it may seem like a rudimentary example, it spills into investor risk very quickly.

When evaluating the potential of a start-up business, it is worth asking what the internal targets for sales and operations are, and whether the way the business incentivises its staff could risk those staff stretching the truth around their statistics. Having aggressive targets, combined with a disconnect between function vs sales too often leads to misreported figures.

Overlooking the internal workings of a business can also easily lead to a future reputational crisis, that could have been easily avoided. A classic example of this is where an investor could have taken a little more notice of the negative Glassdoor reviews which revealed the fact that staff were overworked with unattainable targets. If the company culture is projecting one thing, but (unattainable) targets are still being met – you must ask how they are being met – or if the data has been skewed.

The next thing to look at is whether the data being published is or even can be verified. Consider how susceptible it is to fraudulent activity, for example. Subscription models are often the most difficult structures to uncover and true performance can be masked in arcane and often esoteric metrics.

Regulation

An interesting point of the start-up market, is the fact that these new and developing businesses, are often operating in unregulated spaces. They take advantage of opportunities early on and this can lead to inflated figures, which aren’t being reviewed or scrutinised by any external parties. There are, however, numerous examples of instances where fast-growing businesses have come crashing down once policy catches up with the fact that a sector of the market is, as often happens, being taken advantage of.

It may be that in the future, we see regulators keeping a tighter eye on the activities of start-ups, but it is also important for any investors to be aware of possible incoming regulation when they are considering putting their money into a business. Be sure to ask questions that test the longevity of growth plans and have in mind that rules and regulations can change quickly.

The reputational impact on investors

Any investor that has fallen victim to start-up fraud needs to consider what matters to them the most. The start-up space is full of creative failure and embracing that makes the sector unique. But failure because of fraud can be a difficult pill to swallow. It is embarrassing and can affect your credibility as an investor.

Currently, there’s no effective legal protection for the damage done to the reputation of those who are victims of these types of crime. On that basis, all you can do is deal with the reputational crisis as it comes, and work with professionals to mitigate the damage done.

When considering any investment, you must look for the indicators early on. Ask questions about internal operations, dig deep into how the numbers have been produced, challenge sweeping statements and try to spot the indicators of crisis. Remember the age old saying – if something seems too good to be true… it probably is!