Massive wave of startup fraud looming

There is a huge wave of startup fraud looming. Massive.

We have seen the beginning of this in recent weeks - Ozy Media, Headspin, Theranos, Nikola vehicles, Ginko Bioworks, Biofacturing - but this will only grow in volume, size and audacity.

Loose cash sloshing around

The startup market is awash with cash. There are more VCs than ever, and they are all competing over the same limited pool of quality startups. Recently, super-VCs like Softbank and Tiger have emerged and are throwing unreal sums of money at startups, based on short conversations with very little due diligence (DD). Equally, thousands of Angel, Seed and A-round investors are competing to offer quicker deal turnaround times are forgoing sensible diligence.

With abundant loose cash comes a lowering of standards and safety procedures. We have seen this in the mortgage crisis of 2008 when the banks became increasingly desperate to issue mortgages and so lowered their lending standards and created one of the world's most destructive bubbles.

Recent scandals

Ozy Media, Headspin, Theranos, Nikola vehicles, Ginko Bioworks, Biofacturing - and arguably WeWork - have all hit the headlines recently for, in some way, 'embellishing' their success (revenues, viewers, metrics) - collectively worth billions of dollars. Jason Calacanis has covered many of these in his podcasts.

This is only the beginning.

Perfect storm - risk vs reward

The "new economy" is now ripe for fraud.

When the possible reward outweighs the risks, then things will flourish. The startup economy has hit this inflection point.

This is why.

The market is seeing arguably ridiculous valuations for startups across the board - simply driven by high demand, and limited supply.

Common 'normalised' valuations are working on a 20x multiple of revenue, with zero expectation of profit. This is for early-stage, unaudited companies.

Fake revenues = massive valuation

Scenario: It is possible to fake a $1m revenue by arranging someone (client, supplier, related party) to pay $1m to your company, and dressing it up as revenues. Then you can pay that $1m back to the person (supplier, partner), dressed up as COGS or other operational costs etc. This is referred to as round-tripping. It is basically a zero-sum exercise - except for taxes (and the impropriety of it). it is relatively simple to arrange.

With the current 20x valuation climate - there are enormous outsized upsides to this misrepresentation of revenue (ie. fraud).

If you can demonstrate $1m revenues, then you can get a valuation of $20m. Seems too easy.

And if you are a startup founder with your back against the wall, desperately looking for the next funding round - then this option will look increasingly attractive.

Based on this potential upside, you could even justify creating the scenario where a 'client' pays $1m, or even $10m to generate revenue, and doesn't even round-trip the cash back. Consider that initial spend as an upfront 'investment'. If you know that a $10m contribution will create a $200m valuation spike - it creates a healthy upside opportunity.

So you could easily see someone spending $10m cash to make $200m in value in this climate

While 99% of people would never even consider this as an 'option', there are enough people out there that would see this as a gaping invitation. People might be lured into this option either because they are forced to save their company, or they could have malicious intent.

VC's are creating a bubble

If valuation ratios stayed around the 1x multiple of revenue, then it wouldn't be worth the downside fraud risk of getting a 1x multiple for putting $1m into the machine. But if you can possibly get a 20x multiple for putting $1m into the machine, then a lot of people will take that risk...

The high valuations, overly keen VCs, quick and fast DD are making this fraud an attractive opportunity.

Taken to an extreme, if there were no VCs out there and all companies were bootstrapped, then there is zero motivation to create this round-tripping revenue boost. If companies were assessed on their ability to make profit (not revenue), and were reasonably valued, then these frauds would not be able to take place.

Menu of options

This is only one option to fake startup success and get an outsized valuation. There are many other ways.

With the VCs falling over each other to splash cash, then there will be people that will explore the ways to fake success.

Derek Gallimore is the founder of Outsource Accelerator - a fully bootstrapped, and thriving, B2B marketplace for the offshore outsourcing sector.