Fraud in Startups: Here’s What Every Investor Needs to Know

For many investors, fledgling enterprises present a lucrative opportunity to become part of emerging sectors with high growth potential so they could multiply their investments within a short time.

However, the booming startup ecosystem has paved the way for a few overly ambitious entrepreneurs who deploy deception and trickery to make it big in the business world.

Some of the largest startup frauds of the decade have left not only investors but also customers, vendors, business partners, and lenders in distress.

What type of risks do you stand to encounter by investing in a budding enterprise, and how can you safeguard your investment by identifying genuine business opportunities from the fake? Keep reading to learn more.

The Growing Threat of Startup Fraud

Various deceptive schemes involving new ventures have made headlines over the years, causing some investors to become weary of the startup culture and forcing legislators to relook at current regulations.

Here are some of the recent noteworthy incidents that demonstrate the potential risks involving startup fraud.

• FTX

The founder of the cryptocurrency exchange business was charged with stealing customers’ money, wire fraud, and money laundering, among other offenses, after filing for bankruptcy in 2022, just three years after establishing the startup.

• Theranos

Elizabeth Holmes, the CEO of the health tech enterprise, faced legal action in 2018 for misleading investors and customers with a product backed by baseless data and technology.

• Frank

Last year, JPMorgan Chase went to court against Charlie Javice, the founder of Frank, for inflating the company’s number of clients when selling the business to the banking giant.

The startup allegedly had under 300,000 users, although the data was manipulated to make it appear as 4.25 million in a bid to raise the business’s valuation to $175 million.

• Centricity

Michael Brackett, the founder of the AI startup Centricity, was taken to court in 2023 for fabricating business data to mislead investors.

Protecting Your Investments From Deceptive Startups

Adopting a cautious approach is a must when you want to become part of a thriving startup culture.

Here is what you should know:

Pay Attention to Detail

Business proposals can contain important clues that could signal a scam.

Keep in mind that a sound business idea must be backed by data and comprehensive plans for execution.

Any vague proposal or prospectus based on far-fetched concepts and assumptions should be treated with caution.

Critical questions to ask when reviewing the information presented to you include:

• What exactly is the business concept, and how well have the founders articulated it?
• What is the core value proposition?
• Who is the target audience, and how will they benefit from the product or service?
• Is the pricing strategy sensible?
• What is the route to market?
• How viable is the marketing strategy?
• Has the business already recorded sales, and what is the traction?
• What is the sales forecast and the rationality for its calculation?
• How would the competition respond, and what defensive strategies does the business have in place to secure its market share?
• What is the capital structure?
• From where is the initial funding sourced?
• How much have the founders invested?
• When is the startup expected to break even?
• How much does the enterprise seek from you, and how will it be utilized?
• How scalable is the business concept and proposed operational model?
• What is the exit strategy?

You should be able to answer these questions by reviewing the investor pitch deck and proposal submitted by the business.

Speak to the startup founders to find out additional details you may require, and pay close attention to how comfortable they are in answering your questions.

For instance, can they readily provide all the information, or is there hesitation or reluctance? The latter might mean they are hiding critical data or have not thought through their business idea in detail. Either way, it is best to let go of the investment opportunity in such instances.

Check the Founders’ Background

The responsibility of returning a profit for your investment ultimately rests in the hands of the founders of the startup. Therefore, ensuring they have the business acumen, skills, competence, and knowledge to drive the fledgling venture towards success is critical if you want to safeguard your investment.

A basic online search can get you plenty of useful information to assess their
background and credibility. For instance, you can run a background check on
Nuwber, check their social media profiles and browse news media and other
publications in which they have appeared.

Don’t forget to find mutual contacts to verify their work background and experience, and seek recommendations from people you trust. LinkedIn is an excellent platform for identifying shared professional connections.

Research the Market Potential

If you rely solely on the market data provided by the startup, you run the risk of making investment decisions based on fabricated or misleading information.

This is why conducting your own research is imperative.

Some of the areas to cover and verify include:

• The business concept’s true market potential
• Current competition, their scale, and activities
• Barriers to entry
• External risks involving political, economic, social, technological, environmental, and legal factors
• Opportunities for future growth

Diversify Your Portfolio

Investing all or most of your wealth in a single startup is a highly risky strategy that savvy investors avoid.

Remember, every new enterprise involves substantial uncertainties, even when they are run by experienced founders with genuine intent. 

Therefore, regardless of how lucrative a startup may seem, diversifying your investment portfolio by including low-risk assets is essential for every investor. 

To Summarize

The success stories of startups are often overshadowed by fraudulent ventures that deceive and rob stakeholders of millions of dollars.

This is why performing due diligence is critical for safeguarding your wealth when looking to maximize your returns through high-performing startups. You must review business concepts in detail without investing in haste. Ensure the founders have enough experience and expertise to drive business growth and do your own homework by researching the market.

Importantly, never put all your eggs in one basket. Instead, diversify your overall portfolio to minimize the risk of startup investments.