At the start of the summer, former Silicon Valley darling Elizabeth Holmes began an 11-year prison sentence for one of the decade’s biggest fraud cases involving Theranos, once valued at $9 billion. 

Holmes promised investors that her company’s 200 blood tests could detect a range of diseases, from cancer to diabetes, with a simple finger prick. She managed to skirt skepticism for years, inking deals with Walgreens, Safeway and major insurers, doctoring lab reports from pharma companies and faking test results in demonstrations of the technology.  The scandal ensnared a powerful circle of backers—including former U.S. Secretaries of State George Shultz and Henry Kissinger, former Wells Fargo Bank CEO Richard Kovacevich, Walmart’s Walton family, Rupert Murdoch and former Secretary of Education Betsy DeVos. Their money vanished with Holmes’ story.

Holmes wasn’t the only one to dupe big-name investors amid a bull market. Holmes had no venture capital firms as backers outside of Tim Draper. The lack of an experienced biotech investor on board should have been a red flag. 

Still, the Theranos scandal isn’t an outlier. During this last long bull market run, well-known VCs and big-name companies have fallen prey to the same kind of Silicon Valley fraud. Holmes’ case served as a keen reminder to the venture capitalist industry to slow down and scrutinize deals, even those with prominent anchor co-investors. That’s especially true—and difficult—amid red-hot markets that are ripe for deceit.

“It has been a topic of conversation for venture capital and growth investors,” says Zach Sivertson, a partner at Mercato Partners, a Salt Lake City private equity firm. “Really good firms saw this as an opportunity to review their diligence processes to see what can be improved and recalibrated after Theranos.”

Incubator for fraud

The investment world is sobering up after nearly a decade of gorging on record-breaking deals and dollars. At its peak in 2021, venture capital broke all sorts of records, with $128.3 billion raised and 960 startups being crowned billion-dollar unicorns.

That frothy market provided the conditions for potential fraud. In a bid to compete for capital, some founders oversell their capabilities and others overvalue their companies to hit the unicorn mark. Investors, faced with fierce competition for deals, were forced to move fast. For some, that meant due diligence went out the window. Deals sometimes closed within just two weeks, and firms that wanted to spend more time on diligence were seen as cumbersome and lost out. 

VCs operate on a culture of trust, and close-knit groups of investors often watch what the other firms bet on. “If one firm gets in, the others almost get FOMO,” Sivertson says. “You don’t want to miss out.” 

Firms began to waive the requirement for an annual audit, usually standard for Series A term sheets, because some founders deemed the requirement unnecessary and bureaucratic. In the case of crypto, it led to the development of “new investment rules” that pushed out traditional norms.

“As an investor, when the environment is frothy, you are much more likely to run into these problems,”  wrote Bill Gurley, a general partner at the Silicon Valley venture fund Benchmark. “Ironically, this is also the precise time when raising concerns will make you look like a washed-up veteran who is unable to adjust to the new ‘realities.’”

That’s what happened to investors in the case of many crypto frauds. Perhaps the biggest occurred in November when authorities charged Sam Bankman-Fried with fraud charges after misusing money in his $32 billion crypto exchange FTX. More than 1 million people lost their money, including one of the nation’s largest VC funds, Sequoia Capital—which lost a $150 million investment.  

There is a long list of other fraud cases. Startup founder Charlie Javice duped JPMorgan into buying her financial planning startup Frank for $175 million by inflating her customer numbers. She’s charged with fraud and conspiracy.  Mozido founder Michael Liberty was charged with fraud after allegedly stealing $55 million from investors in his $2.3 billion fintech startup, only to be pardoned by former President Donald Trump in 2019. Tech founder Adam Rogas was sentenced to five years in prison for faking documents that made it look like his fraud prevention and detection platform NS8 turned a profit. And in Utah, federal authorities accused BitClub Network last fall of defrauding a thousand investors out of $722 million between 2014 and 2019.   

How to avoid fraud

Gurley of Benchmark warns of situations that sound too good to be true, such as companies claiming to rewrite the rule book for a whole category of business without empirical evidence or actual results. Investors begin to suspend belief when speculation increases and everyone—investors, the press and politicians—begin to believe, he wrote in his blog.

Sivertson hasn’t personally backed a founder who committed fraud, but after listening to thousands of pitches from entrepreneurs at Mercato over the years, he’s gotten pretty good at spotting people who might be stretching the truth in a pitch. For instance, a founder who claims 15 customers but is scant on the terms or size of the contracts might be problematic. The same skepticism arises if a founder won’t talk about obstacles or bad news or declines to provide investors with data to back up claims.

“A company can be overstating or overselling their capabilities because they want to change the world, and at the same time, they have a misconception of reality,” Sivertson says. “I almost call it the ‘hype cycle’ of a company. It’s the responsibility of the VC to get to the reality of what they’re investing in.”

Mercato will hire external experts to review software code and functionality to verify claims made by the company and even ask for source code. The firm also will do reference checks with people not provided by the founder. Sivertson likes to talk to engineers at the startup about pitfalls, timelines and what they’re seeing in the trenches.  He can sort out the real story of a company that way.  “They’re not salespeople,” he says.

Gurley says one of the biggest mistakes that can lead to bad behavior is allowing a venture-backed startup founder to run another corporate entity that has overlapping interests. “If there was a recipe book for corporate fraud, this would be the first chapter,” Gurley writes. “Just say no. Plain and simple.”

Will it change?

Public investors may be less tolerant than private investors seeking high-risk, high-reward investments. These high-profile fraud cases have prompted the U.S. Securities & Exchange Commission to propose new regulations that would make it easier for investors to sue venture capital firms, private equity firms, hedge funds and private investment funds for oversight for failures at the startups. Meaning firms would bear more responsibility for the startups they back in the future.

Investment firms would need to better analyze their portfolio companies’ business models and underlying financials and improve transparency on any conflicts of interest. The National Venture Capital Association blasted the rule, calling it “profoundly flawed” because it makes the VC liable for problems in the future. 

So far, regulatory changes have supported red-hot markets by allowing companies to stay private longer and raise more money faster. Without incentives, onlookers aren’t convinced the VC world will change much despite the fraud cases. The business model is built on risk, and investors may push the limits to find that win. For now, the venture world continues to provide a soft landing for those who push the envelope. 

Editor’s Note: This article was updated to remove a reference to WeWork and Adam Neumann.