In the latest example of a startup getting caught taking Silicon Valley’s “fake it until you make it” ethos far beyond the realm of ethics, events planning app IRL was recently sued by its own investor, SoftBank, after an investigation revealed that 95% of the app’s users were fake.
It’s the larger companies that usually get the most attention for screwing up — as this lawsuit highlights — but younger startups are now increasingly getting caught in the act, too.
In my reporting for this story, multiple investment firms told me that they didn’t really have a good answer for weeding out such instances of fraud because they invested “too early” and were focusing more on betting on the founders instead of verifying their user base or traction.
But even if you are betting on a founder, wouldn’t you prefer to invest in one who isn’t trying to deceive you? As I’ve said before in prior stories, ignoring issues early just sets you up for larger and, in many cases, unfixable issues later.
Sure, investment firms focused on later-stage startups do have more data to study — and resources like auditors — to conduct due diligence. But Angela Lee, a venture capital professor at Columbia Business School and the founder of 37 Angels, said there are actually numerous ways an early-stage focused firm can detect and avoid startups that are trying to deceive them.
“[An investor who] uses the excuse of ‘it’s too early, we don’t need their diligence,’ is a lazy investor,” Lee told TechCrunch+. “We are in the age of information; it is easier than ever to verify these things.”
Lee said an easy way to see if you need to dig deeper into a startup’s metrics is to gauge how founders answer questions during the pitch.
Entrepreneurs look to put a positive spin on things and put their most favorable numbers on their slides for the pitch, Lee said, and while they don’t necessarily intend to deceive, founders should be able to answer questions about the numbers and metrics they left out.
“There are 100 metrics they can show you, and they will pick the four that will make them look the best,” Lee said. “Our job as a VC is to ask about the other 96.”
Simon Wu, a partner at Cathay Innovation, said investors will not forget to ask about traction just because a startup didn’t bring it up. “Founders should be able to speak on why they omitted certain metrics and how they plan to [reach milestones],” he said.
“We are betting on the future of you; we are believing you are going to get there,” Wu said. “If you can paint the picture of how you are going to execute, that is where the imagination comes in.”
Wu said it can also be beneficial to have founders pull numbers in real time during the pitch, or download and send the raw data to let firms run their own checks on it.
These questions can be a good way to spot if there are other red flags about a company, fraud aside, Lee said. For example, if a company is selling to chief procurement officers (CPOs) but its founders can’t answer how often CPOs are looking to buy products, or what their standard customer would look like, it might be worth digging into their traction numbers or examining if there is a product-market fit issue.
When analyzing an investment, seed-stage venture firm TSVC starts by calling customers up to verify the startup’s claims — even if there are only a handful and aren’t paying yet, its general partner Spencer Greene told TechCrunch+.
Even if the company picks who the firm should call to verify, Greene said customers are surprisingly frank about how good or bad a business is. He pointed out that these calls don’t just verify the number of users, but they also give a good idea of how much a company would pay for a contract with the startup — to see if it aligns with the company’s pitch.
Startups shouldn’t feel they have to lie about how many of their users are paying, because early-stage investors aren’t expecting them to have a huge stream of revenue yet, he added.
“What I look for is engagement and if the customer is loving the product,” Greene said. “Maybe they’ll say, ‘Yeah, I’m not paying for it yet, but boy, I use it every single day, and it is crucial and I told all of my friends about it.’ We love to hear that.”
So while many startups could still get away with fudging the truth a little, founders should really reflect on how they are presenting themselves in this market.
Money is tight, and companies are getting caught because firms are taking their time to do proper due diligence. Given how many investors are being pickier these days, even a whiff of a potential issue could give a VC enough cause to run for the hills.