Between AI washing, fraud, and general misrepresentation, navigating the murky startup landscape is more difficult now than ever. Worse, the consequences of such deceit can be devastating, resulting in significant financial loss and trust erosion.
According to recent data published by Harvard Law School, 90% of all startups fail within their first five years, with 75% of venture-capital-backed startups failing in a similar timeframe. In other words, unfortunately, failure is nearly a given.
What’s worse is that while most founders are well-intentioned and represent their capabilities and backgrounds honestly, some aren’t so much.
Startup investments fail for various reasons, including financial, operational, and market frailty. Before FTX and Delphia’s fraud scandals, venture capital firms focused their due diligence efforts on evaluating startups’ business models, market potential, and financial health, investigating founders incidentally. However, when millions of dollars are on the line in VC, due diligence is crucial to uncover more insidious issues.
What’s Lurking Under the Surface
There’s much on the line for startup founders, occasionally leading to last-stitch exaggerations and poor decisions. Years of rapid growth and high returns in the startup space bred fraudulent activities, like manipulating financial data to misrepresent business prospects and over-inflating AI capabilities (otherwise known as AI washing), as in FTX and Delphia, respectively.
AI washing is a particularly dangerous trap, one many venture capitalists routinely fall for. Studies show that startups emphasizing AI earn between 15% and 50% more investment than those who don’t. Such information is relatively simple to find as long as one conducts thorough startup due diligence.
The Missing Link: Diligence & Success Go Hand-in-Hand
A strong link exists between conducting reputational background checks and VC firms’ financial viability and investment strength.
90% of venture capital firms lose money, with the top 20 VCs responsible for 95% of profits.
7 of the top 10 performing VC firms conduct pre-investment background checks. 6 of those 7 do so with Vcheck.
There is a growing understanding that a startup founder’s integrity and track record are just as important to their business’s viability. After all, venture capitalists report that the strength and competence of a startup’s management team are among the most essential factors in its success.
According to Forbes, reputational checks have become a cornerstone of the due diligence process, and VC investors are doubling down on efforts to vet founders. Vcheck’s analysts have noticed something similar: As a whole, Vcheck has experienced a 26% increase in due diligence requests from venture capital firms YOY and a 14% increase in Q1 2024 over Q4 2023.
Maybe more interestingly, some of these report findings were large red flags.
Nevertheless, this change reflects a growing awareness of the risks associated with fraudulent activities and the need to safeguard investments by thoroughly vetting potential portfolio companies and their management teams.
Despite overwhelming supporting evidence, due diligence background checks are not yet common practice across all VC firms. Despite failing investments, many firms still forego background checks and reputational due diligence on startup founders.
The Future of Due Diligence in VC
Time is as much of an investment as capital in the VC space. The minimal time and capital investment associated with due diligence checks mitigate millions of dollars in spending on the front end, allowing venture capital firms to enjoy a strong portfolio and sustainable growth.
Blind investments are a thing of the past. As technology advances, VC firms must adapt their due diligence practices to keep pace with new challenges and opportunities. By staying vigilant and leveraging innovative tools, they can enhance their ability to detect fraud and protect their investments in an ever-evolving startup landscape.
Contact Vcheck to learn more about startup due diligence and protecting your investments from fraud.
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