Startup founders: Don’t cross the line between optimism and fraud

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In early September, former Theranos CEO Elizabeth Holmes requested a new trial, arguing that a key prosecution witness had expressed regret about his role in her criminal conviction.

It’s worth revisiting why she’s facing jail time for her actions while other founders who obliterate billions of dollars simply walk away from their failed companies. Many reemerge seemingly unscathed, like a phoenix from the ashes, and raise millions more for their next big ideas.

The key difference: Not crossing the fine line between optimism about the future, which all tech founders must have, and fraud, which can land a founder behind bars.

To be clear, Holmes is not alone in her plight, she’s just the most recent, high-profile poster child of a founder who crossed the line. And there are many examples of founders who have tiptoed right up to, if not over, the threshold — and gotten away with it.

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It’s important for leaders in the startup community to learn from the lessons of the recent past — when times were good and funding was abundant — because as the economy slows and money becomes tight, the urge to move beyond optimism may grow stronger. You can always start a new company. It’s much harder to bounce back from a loss of trust and reputation.

The difference between optimism and fraud

Microsoft co-founder Paul Allen once said: “Any crusade requires optimism and the ambition to aim high.” 

Optimism is part of the founder’s creed. It’s required to create something out of nothing. James Dyson must be quite the optimist. He reportedly worked for five years on 5,127 prototypes before he created the world’s first bagless vacuum cleaner and a multi-billion dollar empire in the process.

Optimism is essential for not only the resilience and grit to get to a working product, as well as product market fit, but also to get a startup off the ground. Founders must paint an optimistic vision of the future — the total addressable market and their product’s potential — to raise money from investors.

The key thing to keep in mind is that while it’s okay, even advisable, to express a bold vision of the future, misrepresenting what happened, or didn’t, in the past will get you in trouble. That’s fraud.

For example:

  • Optimism: Describing the potential of your product and projecting revenue in the future based on reasonable (even if highly optimistic) assumptions.
  • Fraud: Falsifying test results or actual revenue/profit numbers.

Sophisticated investors can evaluate the reasonableness of future projections based on their knowledge of the market and a founder’s track record or lack thereof. They make bets all the time on optimistic founders. That’s their business model. 

But the system breaks down when numbers get fudged. No matter how tempting it is to raise another round or secure another customer, never set foot on the slippery slope of fraud.

Mistakes happen

As a lawyer, I’m glad I’ve never had to defend a client against allegations of fraud. One of my jobs is to help clients understand and steer clear of the fine line between optimism and fraud described above. 

When I talk to clients about these issues, one of the concepts I try to get across — shared with me by a mentor I truly respect — is the difference between truth, lies and mistakes.

For example, when making financial projections, telling the “truth” involves using standard, generally accepted formulas. A third party evaluating such projections should be able to reverse-engineer a conclusion and understand the various assumptions underlying it. The third-party may come to a different conclusion based on how they see the market opportunity, but there should be no mystery involved. A “lie” would be fudging aspects of past performance, omitting key facts, or knowingly misrepresenting other information.

But even when a founder is telling the truth, it doesn’t mean the projected outcome will arise. It often doesn’t. Sometimes mistakes happen. Founders are juggling many balls, and they can’t foresee every eventuality. Even large institutions devoted to evaluating the future (that is, the so-called “experts” tasked with telling us where the stock market is headed) routinely get it wrong. They’re (typically) not lying.

In fact, we become accustomed to them getting it wrong. And much the same dynamic is at play when it comes to founders who are asked to make their best guess as to the future at any given moment.

Mistakes aren’t fraud. They’re often an unavoidable part of telling the truth.

Best startup practices for making predictions

Projecting the future is an essential part of being a startup founder. Here are a few best practices for making projections that will help you raise money, make smart strategic decisions, and avoid risks, such as allegations of fraud.

  • Be crystal clear about the assumptions underlying your projections.
  • Create different scenarios — best case, likely case, and worst case — to establish credibility.
  • Benchmark projections against industry averages. There is a lot of information available about, for example, average growth rates for SaaS companies.
  • Get financial and legal help. Work with experienced CPAs and legal advisors who can help you steer clear of common mistakes.

When it comes to setting your own valuation, be sure to use a trusted third-party source to conduct the valuation or, if you are hard set on being a DIY-er, at least use an investor-trusted valuation methodology (Berkus Methodology, Scorecard Method, Risk Factor Summation Method, Venture Capital Method, to name a few). Tie your optimism to real numbers and competitor values. Don’t just say, “We are worth $5 billion,” with only optimism to support how you came to that valuation. 

Don’t be afraid to sprint forward with an optimistic vision for your company. That’s the secret sauce for your future success. But along the way, don’t get tripped up by the fine line between optimism and fraud.

Kristin A. Corpion is founder and chief legal officer at CORPlaw.

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