Fraud in startups: what stakeholders need to know
| DOI | https://doi.org/10.1108/JFC-12-2021-0264 |
| Published date | 20 June 2022 |
| Date | 20 June 2022 |
| Pages | 1191-1221 |
| Subject Matter | Accounting & finance,Financial risk/company failure,Financial crime |
| Author | Kimberly Gleason,Yezen H. Kannan,Christian Rauch |
Fraud in startups: what
stakeholders need to know
Kimberly Gleason
Department of Finance, American University of Sharjah,
Sharjah, United Arab Emirates
Yezen H. Kannan
Department of Accounting, Zayed University, Dubai, United Arab Emirates, and
Christian Rauch
Department of Finance, American University of Sharjah,
Sharjah, United Arab Emirates
Abstract
Purpose –This paper aims to explain the fundraising and valuationprocesses of startups and discuss the
conflicts of interest between entrepreneurs, venture capital (VC) firms and stakeholders in the context of
startup corporategovernance. Further, this paper uses the examples of WeWork and Zenefitsto explain how
a failure of stakeholdersto demand an external audit from an independent accounting firm in early stagesof
funding ledto an opportunityfor fraud.
Design/methodology/approach –The methodology used is a literature review and analysis of
startup valuation combined with the Fraud Triangle Theory. Thispaper also provides a discussion of
WeWork and Zenefits, both highly visible examples of startup fraud, and explores an increased role for
independent external auditors in fraud risk mitigation on behalf of stakeholders prior to an initial public
offering (IPO).
Findings –This paper documents a numberof fraud risks posed by the “fake it till you make it”ethos and
investor behavior and pricing in the world of entrepreneurialfinance and VC, which could be mitigated by a
greater awareness of startup stakeholders of the value of an external audit performed by an independent
accountingfirm prior to an IPO.
Research limitations/implications –An implication of this paper is thatregulators should consider
greater oversightof the startup financing process and potentially take stepsto facilitate greater independence
of participantsin the IPO process.
Practical implications –Given the potential conflicts of interest between VC firms, investment banks
and startup founders,the investors at the time of an IPO may be exposed to the risk that the shares of the IPO
firms are overvaluedat offering.
Social implications –This study demonstrates how startup practices can be extended to the Fraud
Triangle and issue a call to action for the accounting profession to take a greater role in protecting the
public from startup fraud. This study then offers recommendations for regulators and standards
entities.
Originality/value –There are few academic papersin the financial crime literaturethat link the valuation
and culture of startup firms with fraud risk. This study provides a concise explanation of the process of
© Kimberly Gleason, Yezen H. Kannan and Christian Rauch. Published by Emerald Publishing
Limited. This article is published under the Creative Commons Attribution (CC BY 4.0) licence. Anyone
may reproduce, distribute, translate and create derivative works of this article (for both commercial and
non-commercial purposes), subject to full attribution to the original publication and authors. The full
terms of this licence may be seen at http://creativecommons.org/l icences/by/4.0/legalcode
JEL classification –G32, G34, G38, L26, M41, M42
Fraud in
startups
1191
Journalof Financial Crime
Vol.29 No. 4, 2022
pp. 1191-1221
EmeraldPublishing Limited
1359-0790
DOI 10.1108/JFC-12-2021-0264
The current issue and full text archive of this journal is available on Emerald Insight at:
https://www.emerald.com/insight/1359-0790.htm
valuation for startupsand highlights the considerations for stakeholders in assessing fraudrisk. In addition,
this studydocuments an emerging role for auditors as stewardsof proper valuation for pre-IPO firms.
Keywords Startups, Entrepreneurial finance, Fraud Triangle, Stakeholders, IPO, Valuation, Fraud,
Venture capital
Paper type Conceptual paper
1. Introduction
In recent years, startups have become a key pillar of economic growth and job creation
(Haltiwanger et al., 2013;Adelino et al., 2017). However, because of their innovative nature
and because any innovativecorporate activity goes hand in hand with a high probability of
failure (Holmström, 1989;Tian and Wang, 2014), startups’default rates are high, making
them risky investments. Various research over the past ten years suggests that between
70% and 80 % of all startups do not reach a desired or projected r ate of return, whereas as
many as 40% of all startups are a complete failure, losing 100% of their original investment [1].
The extraordinary risk even prompted Securities and Exchange Commission (SEC) chair Mary
Jo White to comment on the subject:
An equally interesting statistic from one post-mortem analysis is that 70 percent of failed startups
die within 20 months after their last financing [...]. In other words, not only are these investments
highly risky, they fail quickly too.
In addition to high rates of failure, the nascent nature of the technologyunderlying both the
operations and productsof startups make investors’revenue or profitability forecastshighly
uncertain, which makes them difficult to value using traditional valuation models. The
nascent nature of the startups themselves also poses disclosure and governance risks; as
reporting and disclosure rules are extremely limited for the type of privately held
companies, most startupsare yielding low transparency [2].
Despite these risks, billions of dollars have been poured into venture markets to finance
startup business development. In the USA alone, venture capital (VC) assets under
management have more than doubled since 2013, from $267bn to $548bn at year end2020;
in 2020 alone, VC firms raised $74.5bn in new funds which will soon be deployed into
thousands of startups globally [3]. Besides traditional VC investors, investment banks,
mutual funds and sovereign wealth funds have also leapt into startup financing. Mutual
funds have been the most active of all new VC market entrants, with estimate ranges
showing that 14 separate mutual fund families invested between $7bn and $10bn into over
250 startups since 2009 (Kwon et al., 2020;Imbierowicz and Rauch, 2021). They do so with
the hope that the startups will be successfulin permitting them to achieve a successful exit
in the form of an initial publicoffering (IPO) or acquisition at the highest possible valuation.
The funding frenzy in VC markets, paired with an obsession for fast and aggressive
startup growth to achieve astronomical valuations, has led to a new kind of startup: the
“Unicorn,”which is a startup thatreaches a valuation of $1bn prior to an IPO or acquisition.
These companies had been a rare phenomenon up until as recently as 2013 when the term
was first coined by venture capitalist Aileen Lee [4]. While at that time only 39 startups
surpassed the $1bn valuationthreshold, most recent (as of December 2021) CB Insights data
show a total of 903 Unicorns globallywith a joint valuation of $2.9tn [5]. Achieving Unicorn
status facilitates investor attention through media and industry coverage of the startup,
which can stimulate demand for the startup’s shares; it also enhances the reputational
capital of the pre-IPO investors, who advertisethe number of Unicorns in their portfolios as
a status symbol.
JFC
29,4
1192
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