Before FTX and Delphia’s fraud scandals, venture capital culture was highly characterized by an ‘ends justify the means’ mindset. VC firms focused their due diligence efforts on evaluating startups’ business models, market potential, and financial health, scoping out founders only incidentally.
Unfortunately, rapid growth and high returns bred fraudulent activities, like manipulating financial data to misrepresent business prospects and over-inflating AI capabilities (otherwise known as AI washing), as was the case 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 15-50% more investment than those who don’t.
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 erosion of trust.
The Missing Link: Diligence & Success Go Hand-in-Hand
There is a strong link 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.
In the VC space, time is as much of an investment as capital. 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.
There is a growing understanding that a startup founder’s integrity and track record is just as important to its business viability. After all, venture capitalists report that the strength and competence of a startup’s management team are among the most important 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 a similar shift: 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.
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. Many firms still forego background checks and reputational due diligence on startup founders despite failing investments.
The Future of Due Diligence in VC
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.