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

In early September, former Theranos CEO Elizabeth Holmes filed for a new trial, arguing that a key prosecution witness expressed remorse for his role in her criminal conviction.

It’s worth revisiting why she faces jail time for her actions, while other founders who destroy billions of dollars simply walk away from their bankrupt companies. Many emerge seemingly unscathed, like a phoenix from the ashes, raising millions more for their next big ideas.

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

To be clear, Holmes isn’t 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 up to, if not over, the threshold – and got away with it.

It is important for leaders in the startup community to learn from the lessons of the recent past – when times were good and money was plentiful – because as the economy slows and money becomes scarce, the urge to move on than optimism can become stronger. You can always start a new business. It is much more difficult to recover from a loss of trust and reputation.

The difference between optimism and deceit

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 is necessary to make something out of nothing. James Dyson must be quite the optimist. He reportedly worked on 5,127 prototypes for five years before creating the world’s first bagless vacuum cleaner and a multi-billion dollar empire in the process.

Optimism is not only essential for the resilience and courage to come up with a working product, but also to get a start-up off the ground. Founders must paint an optimistic view of the future – the total addressable market and potential of their product – to raise money from investors.

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

For instance:

• Optimism: Describing your product’s potential and expected future revenues based on reasonable (even highly optimistic) assumptions.
• Fraud: False test results or actual sales/profit figures.

Experienced investors can judge the reasonableness of future projections based on their knowledge of the market and a founder’s track record or lack thereof. They bet on optimistic founders all the time. That is their business model.

But the system collapses when numbers are tampered with. As tempting as it may be to raise another round or bring in 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 fraud charges. One of my duties is to help clients understand and avoid the thin line between optimism and fraud described above.

When I talk to clients about these issues, one of the concepts I try to convey – shared with me by a mentor I really respect – is the difference between truth, lies and error.

When making financial projections, for example, telling the ‘truth’ involves using standard, commonly accepted formulas. A third party evaluating such projections must be able to build 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” is distorting aspects of past performance, omitting important facts, or knowingly misrepresenting other information.

But even if a founder speaks the truth, it does not mean that the expected result will materialize. Often not. Sometimes mistakes happen. Founders juggle a lot of balls and they can’t foresee every possibility. Even large institutions concerned with evaluating the future (that is, the so-called “experts” tasked with telling where the stock market is headed) are routinely wrong. They (usually) don’t lie.

In fact, we get used to them being wrong. And much the same dynamic is at play when it comes to founders being asked at any given time to make their best guess about the future.

Errors are not fraud. They are often an inevitable 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 some best practices for forecasting that will help you raise money, make smart strategic decisions, and avoid risks such as fraud allegations.

• Be crystal clear about the assumptions underlying your projections.
• Create different scenarios – best case, probable 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 of SaaS companies.
• Get financial and legal help. Work with experienced CPAs and legal advisors who can help you avoid common mistakes.

When it comes to determining your own valuation, make sure you use a trusted third-party source to carry out the valuation or, if you are a do-it-yourselfer, at least use an investor-trusted valuation methodology ( Berkus Methodology, Scorecard Method, Risk Factor Sum Method, Venture Capital Method, just to name a few). Link your optimism to real numbers and values ​​of competitors. Don’t just say, “We’re worth $5 billion,” with nothing but optimism to support how you arrived at that valuation.

Don’t be afraid to sprint forward with an optimistic vision for your business. That is the secret sauce for your future success. But along the way, don’t get tripped up over the thin line between optimism and deceit.

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