Fraud in startups: what stakeholders need to know

Abstract

PurposeThis paper aims to explain the fundraising and valuation processes of startups and discuss the conflicts of interest between entrepreneurs, venture capital (VC) firms and stakeholders in the context of startup corporate governance. Further, this paper uses the examples of WeWork and Zenefits to explain how a failure of stakeholders to demand an external audit from an independent accounting firm in early stages of funding led to an opportunity for fraud.Design/methodology/approachThe methodology used is a literature review and analysis of startup valuation combined with the Fraud Triangle Theory. This paper 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).FindingsThis paper documents a number of fraud risks posed by the “fake it till you make it” ethos and investor behavior and pricing in the world of entrepreneurial finance and VC, which could be mitigated by a greater awareness of startup stakeholders of the value of an external audit performed by an independent accounting firm prior to an IPO.Research limitations/implicationsAn implication of this paper is that regulators should consider greater oversight of the startup financing process and potentially take steps to facilitate greater independence of participants in the IPO process.Practical implicationsGiven 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 overvalued at offering.Social implicationsThis 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/valueThere are few academic papers in the financial crime literature that link the valuation and culture of startup firms with fraud risk. This study provides a concise explanation of the process of valuation for startups and highlights the considerations for stakeholders in assessing fraud risk. In addition, this study documents an emerging role for auditors as stewards of proper valuation for pre-IPO firms.