🕵️ How to Get Away with Scams: Startup Edition
Many startup employees and founders have been engaged in scams for quite some time now. Here’s a look into how they manage to do so.
Startups and cryptocurrency: Apart from Covid these were probably the two most overused words last year.
But this year, the connotation has changed.
While last year investors were singing praises about them, they are quiet this year. After all the cracks in their models and operation have been exposed.
Though we have covered the crypto crash and scams, we have not yet looked into the scams going on in India's startup ecosystem.
So, let's get right into it.
😲 An Abundance of Startup Scams
Before we get into the specifics of the startups who scammed people, or the psychology of scamming, let's look at the type of startup scams.
Now, technically, startup scams can be as simple as a corrupted employee pocketing extra money to something as complex as a founder lying about the whole premise of the startup (remember Theranos?).
But we are broadly going to be looking at two kinds of scams: Revenue-based Scams and Cost-based Scams.
💸 Revenue Based Scams
Since investors don't expect startups to be profitable right from the start (or for a considerable period of time), the metric that they usually track is revenue.
Other metrics like users etc are also important but one of the most important metrics is revenue.
And this is also really important for founders as revenue plays a major role in determining a startup's valuation.
So, a lot of startups start finding ways to pad their revenue. Wondering how that is possible?
Through circular transactions.
Circular transactions are basically a way of pushing around money without any actual sale or transaction happening.
Let's assume Anjali, founder of Startup A, wants to boost revenue. She can make a fake bill of sale showing she sold goods worth Rs. 1,000 to her friend Rahul's Company B.
But ReadOn, even if the bill is fake, Rahul still has to pay money no? So, Anjali does make money, right?
Yes, Rahul does have to pay for the fake sale, but Anjali doesn't really get the money. Because Rahul's friend Prem who owns Company C makes another Rs. 1,000 bill in the name of Anjali for any random fake services.
So, the money Anjali had received goes back to Rahul through Prem.
And both Anjali and Prem can increase their revenue without making an actual sale.
The same thing can be done with a vendor as well.
So, the company basically burns money to increase revenue, cheating investors two-fold.
But thanks to GST norms, such scams are becoming difficult.
In fact, Infraa.Market, an infratech unicorn, was accused in March by the income tax department of allegedly making such fake entries worth Rs. 1,500 crores.
The startup had created several shell companies to show these fake transactions.
Zilingo CEO Ankiti Bose was also apparently padding the e-commerce startup's sales and revenue and using that to get leeway from investors. The company's impressive $1 billion revenue is in reality less than $10 million.
It is unclear how she was padding the revenue but it could be through booking sales for which the startup had not yet received the money.
Another way of committing Revenue-based frauds is booking the year's expected revenue upfront without creating appropriate provision of it going down.
Wait, but how can you book revenue upfront?
Suppose a company sells subscription services. You pay the full amount of the subscription up front. But the company cannot record this entire amount as revenue. Why?
Because what if halfway through the subscription period, you decide you don't want the service. You want a refund.
So, for subscription services revenue should be booked as and when it is earned.
If it is a Rs. 12,000 annual membership, Rs. 1,000 should be recorded every month.
This often causes discrepancies in the books, confusing the investors about the company's revenue.
According to sources who spoke to The Ken, Byjus' also allegedly has been following the upfront revenue booking policy.
And apparently this is why Deloitte, an auditing company, is not signing its 2021-22 financial reports.
📃 Cost-Based Scams
Cost-based scams usually occur when a founder or an employee at a startup inflates bills and pockets the extra money.
For instance, suppose you are a startup that needs a 1000 t-shirts for your employees.
One employee is given the responsibility of ordering these t-shirts.
Now, the employee manages to negotiate a deal where each t-shirt is set to cost Rs. 400.
However, he tells the vendor to make a bill which shows that each t-shirt costs Rs. 800.
So, he gets Rs. 800×1000 from the company, whereas the t-shirts actually cost only Rs. 400×1000. The vendor and the employee then pocket the extra money.
Something similar allegedly happened at Vedantu recently. The company realised it has been overpaying some vendors because some employees had negotiated deals with them and were taking around 10% cut from them.
Such inflated bills are difficult to catch and could end up drowning a budding startup.
Because of such practices that can't really be caught unless strict due diligence is done, investors often don't realise what exactly went wrong with the startup they had invested in.
Because they had only been seeing rosy reports until everything unravelled.
But shouldn't investors also be more careful?
Yes, absolutely. But in the last few years' unicorn boom and easy money period, investors were focused on deploying money quickly to get huge returns. This means they often skipped due diligence or that their due diligence wasn't that diligent.
But now with a funding crunch, this due diligence is set to make a full comeback, probably exposing more such scams.
In fact, Sequoia Capital, whose portfolio companies Zilingo, BharatPe and Trell were all surrounded with controversy, has decided to come up with guidelines to prevent such frauds.
It will implement whistleblower policies, conduct governance training, ask for more disclosures and internal audits and ensure adequate independent board representation.
However, will these steps be enough to stop startup scams? Or should the government also get involved in regulating startups?
⚡In a line: Startups have been fooling investors and customers both by cooking the books.
💡 Quick question: Will stricter due diligence help the startup ecosystem or stifle their growth?
🍿 Food for Thought: Investors and the startup ecosystem in general has become obsessed with valuations and unicorn status. Is this driving more founders towards committing frauds or is it just plain greed?
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