Let's Talk About Fraud
Reviewing the fraud case of one-time unicorn HeadSpin
Google Ventures, Dell Technologies, Tiger Global. All respected investment funds backed a recent unicorn (start-up reaching $1 billion in value). It was the perfect setup for success, until fraud was uncovered.
HeadSpin’s former CEO Manish Lachwani was charged and arrested earlier this month on several counts of fraud by the SEC and US Justice Department. Between 2015 and 2020, Lachwani raised several rounds of financing from well-respected investors based on fake and altered invoices demonstrating a consistent and exponential growth in revenue. We review the filings to summarize what happened and discuss lessons learned.
How It Happened
The initial 18 page complaint indicates the fraud perpetrated by Lachwani was nothing new, as he used the common financial scam of altering invoices and falsifying financial records. Main points of the indictment include:
Lachwani controlled access to all records and financial information. Control of records always makes fraud easier as there is a lack of procedures for verifying revenue or invoices.
Fake or altered invoices were created. Most detailed investor due diligence involves reviewing customer invoices, so Lachwani had the backup needed to support his fraudulent revenue numbers.
Investors appear to have built a degree of trust with the CEO. Not uncommon but appears the trusting relationship may have reduced the number of questions for Lachwani despite his ability to consistently beat revenue estimates. We all know the phrase “trust but verify”, but it tends to be forgotten when things appears to be going well.
What Were The Problem Indictors?
The details of the accusations indicate why it is important for companies and boards to constantly be asking questions. Below are a few key areas for investors or board members to understand:
Employees did not speak up for almost 4 years. Corporate politics are always a challenge for growing companies, especially where a CEO is leading the charge toward unicorn status. Hesitancy to raise concerns or question motives for fear of job loss is common, as few employees want to risk missing out on equity grants worth millions.
Overcoming politics is difficult when there is the potential for employees to have significant equity gains. Boards and investors should periodically talk to employees without management present. One of the best ways to learn about a company is listening to front line employees. Key here is to listen.
No audit was done. Of all the items mentioned, this one was a big surprise. A company with a $1 billion+ valuation, several influential investors, and there was never a third-party audit?
If a company is at the point of raising a Series A, investors should consider asking about the timing for a third-party audit.
Discussions regarding development of financial procedures were ignored. A company constantly exceeding its revenue estimates should be scaling its corporate and financial policies. What worked at $5 million of revenue no longer works at $50 million.
Top line growth translates to a need for greater reporting, so boards and investors should be asking how the company is scaling its internal operations as it grows revenue.
How Is This Helpful?
What happened at HeadSpin is not a one-time event. The drive for executives and founders to report good results is stressful, at times leading to poor decision making. The following points are important take-aways which may have caused a different outcome:
Hire a third-party financial consultant or CFO advisor to ask the hard questions, put the right procedures in place, and do periodic detailed reviews of the financial reporting1.
Trust but verify. Know this is an overused phrase but that does not diminish its importance.
Even the most experienced investors make mistakes so do not simply follow the money but carry out your own research and diligence.
Always open to discussing on how we can help. Contact us at: www.caymont.com