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The Mel Brooks movie, then Broadway musical, then a movie of a Broadway musical The Producers are the only such dramatic works I know of that were based primarily on a business model.  The plot is a simple scam in three acts: 1) most Broadway musicals fail; 2) greedy investors in Broadway shows want a lot of equity for a little money, and; 3) since the show is likely to fail anyway, why not produce a deliberate turkey but make money (strictly for the producers) by selling 500 percent of the stock?  Nobody will know they’ve been scammed because a deliberate failure will never pay any royalties.  Except, of course, Springtime for Hitler was an unlikely smash hit. Well similar events take place in technology startups every day, though usually without the smash hit.

I believe there is a lot of fraud in high tech startups, 95 percent of which fail.  With only a five percent chance of surviving, startups face a gauntlet of risks as described in this quote from uber-VC John Doerr in my show Nerds 2.01: A Brief History of the Internet:

“There are four categories of risk to look for in every project:

1) “People risk: How the team will work together.  Because inevitably one of the founders does not work out and drops out.”

2) “Market risk: This is an incredibly expensive risk to remove.  It is about whether the dogs will eat the dog food.  Is there a market for this product? You do not want to be wrong about market risk.”

3) “Technical risk: This risk we are quite willing to take on.  Whether or not we can make a pen computer that works, be the first to commercialize a web browser, or split the atom if you will.  That technical risk is one we are comfortable trying to eliminate or take on.”

4) “Financial risk: If you have all of the preceding three risks right (people, market, and technical), can you then get the capital that you need to grow the business? Typically you can. There is plenty of capital to finance rapidly growing new technologies that are addressing large markets.”

Of course Doerr completely forgot to include fraud risk — that investors would simply have their money stolen.

You see sometimes the founder’s a schmuck.

Tech fraud happens all the time and those who are fooled include the most sophisticated investors (big shot VCs are not at all immune).  Last year alone there were a pair of fraudulent startups uncovered that cost their investors more than $50 million each.  Just think of the many frauds that aren’t caught or that are hidden in the books of VC firms, forced to merge into healthier portfolio companies to obscure the shame.  Where’s the fiduciary responsibility in that?

Large or small, fraudulent startups all follow The Producers model — they count on the greed of their investors.  Often there is a premise that makes no technical sense but sure sounds good.  Take a flying car, for example: one of those has been raising money from private investors for almost 30 years with no return in sight.  Why do people continue to invest?  It just sounds so cool.

Rule #1: If it requires exceeding the speed of light for any reason, the business is probably a scam.

Investors in startups are supposed to be “qualified,” which under the Securities Exchange Act of 1934 means they are sophisticated investors with substantial assets — so many assets, in fact, that there is no need for society to protect them from fraud.  That hardly describes Aunt Susie after she cashes-in her 401K to invest in your perpetual motion company, does it?  Yet Susie gladly signed her stock purchase agreement which said she was prepared to lose it all.  And she did.

Rule #2: Only invest in startups money you can truly afford to lose, because you probably will.

Due diligence is the process of an investor checking-out a possible investment. Is it really a good deal?  Is the price right? Where does the opportunity sit on John Doerr’s risk list?  Few individual investors, however, actually perform due diligence.  They invest based on gut feelings and by reading documents sometimes created out of thin air by company founders.

Several years ago I lost what was for me a substantial amount of money investing in a financial patent startup.  It looked great on paper, the only problem being that the paper was forged, simply made up.  Nothing was as it seemed.  The company’s books literally didn’t exist. So I sued, spending a lot more money, only to have the founders declare bankruptcy and walk away.

Rule #3: Don’t invest in something you don’t fully understand.

Giving engineers the benefit of the doubt I’d guess that 10-15 percent of startups are fraudulent to some degree.  Some are outright scams while others are more misadventure — idiots playing with other people’s money.

If this is the case, then it surprises me that there aren’t many (any?) third-party companies that assess risk for private investors.  A friend of mine once almost bought a web company that was a market leader with ever-increasing traffic, it seemed, no matter what the economy.  Then it turned out those great numbers were guaranteed by a “black box” generating spoof hits as-needed.  Advertisers were paying for those phantom clicks, and getting nothing for their money.  Who uncovers activity like this?

I’m thinking maybe I will.

I’ve been thinking lately of offering an advisory service for potential investors in privately-held technology companies, analyzing in each case the five — yes FIVE — kinds of risk to see if that good deal really is good.  It’s not that I am so smart but that I have very smart friends whom I can bring-in to do the real work.

Now what to call this new business?  Maybe Chance-in-Hell.com, as in “Does this investment have a chance in Hell of succeeding?”

Or maybe Springtime for Cringely?

I like it.

What name would you choose?  And what stories do you have of fraud at technology startups?

Tags: fraud, startups

This entry was posted on Tuesday, December 1st, 2009 at 2:22 am and is filed under 2009. You can follow any responses to this entry through the RSS 2.0 feed.You can leave a response, or trackback from your own site.