How to fool investors & other startup scams

The ed-tech unicorn has been on a cost-conserving mode; it asked more than 600 employees in May to leave the company. Months before, it had discovered that it had been overpaying some vendors over the past year, according to two people familiar with the details. “The nexus was flagged when a new employee, a project lead, joined the team," one of the people cited above said. When the employee was found rushing the payment processes for the vendor, the antennae went up. An interrogation revealed that the employee had received around 10% of the total ₹2 crore contract upfront as a bribe and had been promised twice that amount after full payment, the person said.

In an internal email accessed by Mint, Vedantu notes that there was a “tacit understanding" between various vendors and “certain employees", causing the firm to cancel several vendor contracts. In at least one instance, the company was able to recover the bribe. Vedantu declined to comment on the extent of the scam or how many employees were involved. “As a philosophy, we have zero tolerance for corruption or acts leading to it," a company spokesperson said.

This is not the only instance. The dirty tricks department is on an overdrive in the startup world. From kickbacks to inflated bills, circular transactions to shell companies, instances of fraud are showing up all too often. While Vedantu appears to have caught a con running into lakhs of rupees, some of the other startups have unearthed “material" scams running into crores.

“We are seeing an increasing trend of fraud in start-ups perpetrated by internal stakeholders (management or employees) as well as external stakeholders such as vendors and other third parties," said Amit Rahane, partner, forensic and integrity services, Ernst and Young.

In recent instances, fintech business BharatPe fired its cofounder Ashneer Grover accusing him of engaging in misappropriation of company funds. In another instance in April, the board of fashion e-commerce startup Zilingo fired its co-founder and chief executive Ankiti Bose, citing “financial irregularities". BharatPe and Zilingo did not provide additional comments beyond their public statements.

The boom is partly to blame, as the easy money only encouraged easy ethics. To compound this, many investors were lax in diligence in recent years. This was especially true in 2021, when deals would close in a matter of a week. Even after their investments, most investors pushed for “growth at any cost", executives said.

“Many did not conduct extensive due diligence in the last two years because of the funding frenzy," Saket Bhartia, managing director, Kroll, forensic investigations and intelligence, said. What that means, says Bhartia, is that the next few quarters might throw up more revelations of fraud and governance issues.

The circular transactions

A common way that investors were fooled last year was when their portfolio companies padded up revenues, four people who have seen this pattern play out said, asking to remain anonymous.

One way to do this is when a company, under pressure to show higher revenue, sells goods to a fictitious customer. For instance, Company A sells goods to Customer B for ₹100. How is the money routed back? Vendor C—an entity related to B— charges Company A ₹110 for an unrelated service, such as for designing the company’s website. Company A ends up with a higher topline which it can report to its shareholders or pitch to new investors (paying for the unrelated service is an expense that impacts Company A’s operating margins and thereby, profitability).

It is also important to distinguish between an employee defrauding the company, and a company deceiving its shareholders, an early-stage investor said, asking to remain anonymous. Typically, this is a matter of disclosure and can be assessed by the action taken by the company once fraud is flagged.

Sometimes the distinction can get blurred. In another oft-used technique, Company A may approach a real vendor which has an existing business relationship with a customer. It may encourage the vendor to route supplies to the customer through Company A’s marketplace so that it is able to show higher revenues to its shareholders.

To persuade the vendor, the marketplace may agree to provide a discount. But, here’s the catch: the movement of goods is only on paper. “If there is no movement of goods from vendor to the marketplace to the customer, then the transaction was clearly bogus," one of the people cited above said, declining to name the marketplace. In both examples cited above, Company A is making a loss and likely showing poor cash flow, but a growing topline.

But this kind of fraud might be increasingly hard to pull off, thanks to the goods and sales tax (GST) regime which traces all transactions, said Kroll’s Bhartia. If a startup showed that it had sold goods to a fictitious customer, the tax department has enough data on hand to demand that the customer pay GST.

In a scathing note issued in March, the income tax department accused a Thane and Pune-based unicorn involved in the sale of construction materials—which later emerged as Infra.Market—of allegedly booking bogus purchases and creating shell companies. It said the startup had made huge unaccounted cash expenditure and obtained accommodation entries totalling over ₹400 crore. (Tax authorities use the phrase “accommodation entries" to refer to fake entries.)

“Directors of the group have admitted to this modus operandi and disclosed additional income of more than ₹224 crore in various assessment years, and consequently offered to pay their due tax liability," the statement said. This might just mean the tax department suspected Infra.Market of evading tax by underreporting income.

The shell entities the department allegedly uncovered also suggest a round of circular transactions. “During the search operation, a hawala network of some Mumbai and Thane-based shell companies was also unearthed. They were allegedly created only for the purpose of providing accommodation entries," the tax department said. Preliminary analysis showed that the total fake entries allegedly provided by these shell entities exceeded ₹1,500 crore, the department said. Infra.Market did not respond to requests for clarifications.

Startup executives have created fake entities for other purposes too. In February this year, a leaked Alvarez and Marsal audit report on BharatPe had alleged that one of the shareholders had routed company hires through an entity created by a relative. The board of the company later accused its co-founder and his family of misappropriation of company funds.

The fraud triangle

But why do founders cross the line? Academic studies going back to half a century say that scams are usually found at the intersection of ‘pressure’, ‘opportunity’ and ‘rationalization’. Executives under pressure to do more or show more growth may view an opportunity for deception as a temporary fix. Or they may simply rationalize their behaviour: Why shouldn’t they be entitled to this money if they have founded the company? Often, this starts as a small misdemeanor and over time, it adds up to fraud.

Shareholders or founders may also find that they are actually cash poor. They may not have taken ‘secondaries’ (meaning avoided selling some of their equity for cash payout) and earn a lesser salary compared to their peers. “Here is when embezzlement can happen. We start seeing founders charge the company with high personal expenses because they think that they deserve this," Kroll’s Bhartia said.

And so, investors are asking questions about founder salaries and auditing practices, and also scrutinizing how startups report revenues, acquire customers.

As a funding squeeze shifts investor focus from ‘growth at all costs’ to ‘profitability’, instances of startups deferring costs to the next quarter are also growing, say executives.

If a startup needs to pay a vendor, they may defer it to next month if they can, so that they are able to report higher margins for that month to their investors, one of the people cited initially said, asking to remain anonymous. This may blindside incoming investors ahead of a fundraise. Founders tend to defer costs out of the hope that they may be able to absorb the expenses in the next quarter, if they are able to manage higher sales.

“Lapses in corporate governance may be a starting point for fraud as it’s not easy to distinguish between an irregularity and serious fraud without a control framework," EY’s Rahane said.

In one example, a marketplace may double or add items to a customer’s bill to show higher gross margin value, but may not have actually shipped the goods. It happens a lot more when there is cash on delivery, a person who had seen this play out said, asking to be anonymous.

“A good way to assess would be to match the sold goods reported by the company with the goods shipped by the logistics company. Typically, there are discrepancies with FMCG startups," the person said, asking to remain anonymous.

In another instance, this person had found a company reporting revenue from a customer that far exceeded the total turnover reported by the customer in its own financial statements. Sometimes, the customer payment is due 90 days after the revenue is booked, making revenue reconciliation harder, the person said, calling for deeper forensic diligence post-investment.

“Hyper growth or de-growth in revenue is usually a red flag, though it may not be fraud," said Bhartia. “Other red flags include frequent change in management and auditors, and incomplete audits – or if companies change the parameters of the metrics that need to be reported to investors often," he added.

Some instances are harder to call out. For example, say a company has an option to buy three target entities and finally picks one. But the company had an investor who was linked to the target company through personal connections, or may have even benefited from the trade financially, indirectly. Even if the company had a reason to purchase the target company, it would certainly be unethical, if not fraud, if this connection is not disclosed, two investors said.

The mad investor rush

Ten years ago, an investor made several trips with a food delivery executive as part of his diligence process before making an investment into the food delivery startup. Now, this is work outsourced to third party vendors, where a junior associate makes a few calls, the investor lamented.

The ecosystem to conduct diligence and forensic work has grown, allowing for investors to seek better outside help in scrutinizing potential investments. But investors typically have sought to run a forensic investigation only after they have begun to suspect fraud, a second investor said.

Only a few startups have one of the big four as an external auditor, this investor added. Thus a lot of discrepancies, which could have been caught if there were stronger controls within the startups, have cropped up only after external auditors have started examining accounts.

“The pandemic saw a shift toward greater reliance on third-party vendors, with little or limited oversight, thereby widening gaps in compliance and control leading to fraud, waste and abuse," EY’s Rahane added.

Some of this has come to a halt in recent months because of the pullback in the funding ecosystem and the overall difficult macro environment.

One investor, whose portfolio company was in the news for having conducted a forensic investigation, said that the balance was shifting back in favour of investors—and doing more diligence. “I am happy that we are back to doing things the way it used to be", he added.

“It boils down to the integrity of the founder," the first investor cited above said, adding that it was better to walk away than hitch a ride with a dishonest founder or management.