Nov 21, 2022 - Economy & Business

Assigning blame when startups break bad

Illustration of a lightbulb with a robber mask and cap.

Illustration: Gabriella Turrisi/Axios

Minutes before Elizabeth Holmes was sentenced to 11 years in prison, her attorney argued that a harsh punishment would deter tech innovation and investment. Judge Edward Davila would soon retort: "Failure is normal. But failure by fraud is not okay."

Why it matters: There's been lots of talk this month about investor due diligence, and the lack thereof, in the case of collapsed crypto exchange FTX.

  • Some in crypto and VC have, in turn, criticized the media for lavishing praise on FTX and CEO Sam Bankman-Fried without doing our own verifications.

The big picture: Venture capital relies heavily on trust, in part to enable entrepreneurial speed, which makes such investments particularly vulnerable to abuse. In fact, it's quite remarkable that there haven't been more cons.

  • Investors in FTX, for example, didn't receive balance sheets as part of their quarterly financial reports. But they trusted Sam Bankman-Fried because the exchange was throwing off cash, and had raised around $2 billion for a supposedly unleveraged business with only around 50 employees. Plus, lots of startups don't provide balance sheets.
  • Years ago, VC firms like Spectrum Equity and Foundation Capital trusted that the audited financials of a startup called Canopy Financial were legit. They never thought to check if the KPMG letterhead had been forged.
  • Oak Investment Partners once trusted one of its partners who said that a portfolio company was raising new funding. They never thought he was wiring the money to his own accounts.

The bottom line: Major frauds — from Enron to Madoff to Theranos — are obvious in retrospect. As are the failings of those who could have, and should have, known better.

  • But the best con artists are the ones who identify the system’s frailties and then exploit them. And, as Judge Davila reminds us, ultimate blame always lies with the determined grifter.
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