Groups » How Venture Capitalists Can Protect Themselves from Investment Fraud

Entrepreneurs and small business owners offer the innovation, drive, and persistence that help turn small ideas into large economically successful business ventures. Shows like “Shark Tank” have helped to educate Americans about the type of investment propositions and partnerships that are formed on a daily basis in the United States. Venture capitalism connects great ideas with cash strapped entrepreneurs who can create millions to billions of dollars in profit for investors.

There are many investment and legal risks involved with being a venture capitalist (VC), but in this article, we will focus on two predominant issues, and what VCs must be aware of to insulate themselves from legal liability and capital loss.

Awareness and Prevention of Anti-Money Laundering

The potential for criminal money laundering through venture capital group investments is moderate to high, even for investment groups that closely monitor sources of investment and funding. Throughout the world, criminal enterprises are constantly seeking a funnel for cash to be invested in legitimate business opportunities as a way of making illegally earned cash untraceable, and fully legal as capital investments. Not only have organized crime groups and terrorists mastered the maneuver, but wealthy domestic business owners have found methods of reducing the paper trail of taxable income through foreign and emerging market offshore investments.

Venture capitalists must have more than a fundamental awareness of the signs of money laundering. In 2015, the United States Treasury Department issued a statement that an estimated $300 billion dollars per year of illegal funding was funneled through laundering schemes to support terrorist networks and crime syndicates. Anti-money laundering laws (AMLs) are designed to prevent the illegal transfer of criminally generated income, while protecting venture capitalists and investors from liability and legal action resulting from charges of laundering and securities fraud.

Red Flags and Serial Entrepreneurs

Talent, innovation, and success are hallmarks for certain entrepreneurs, and venture capitalists love to bet investment dollars wisely on a CEO or team that has provided significant results in the past. It seems like the most reliable type of investment, particularly if the CEO has a consistent track record of winning big returns for investors.

One of the problems with serial entrepreneurs is that they can’t “win” forever, no matter how illustrious their victories have been. One of the first rules of venture capitalism is that “past performance is not indicative of future returns,” and investors must learn to evaluate every new opportunity as a potential risk, regardless of previous successes. In fact, a serial entrepreneur with multiple victories is overdue for a lapse in judgement or error that frequently comes with overconfidence, making them a higher risk potential, in some cases, than new entrepreneurs penetrating the market.

The rule is to consider a serial successful entrepreneur as a red flag, despite performance indicators that encourage investment and blind faith in the returns from the entrepreneur’s new venture. Every home run hitter will strike out eventually, and it holds true with investing with overconfident heavy hitters who think they cannot fail. For more information, read “Why Serial Entrepreneurs Don’t Learn From Failure” by Deniz Ucbasaran, Paul Westhead and Mike Right, for the Harvard Business Review.

Fraud Protection for Investors

Despite best practice and cautious consulting with other investors and legal professionals into every venture capitalist career, a little litigation may fall. Fraud lawsuit defense lawyers are an asset to independent or group venture capitalists for clear reasons – not only is litigation costly from an expense perspective, but it can also detract investors in terms of time and management of fraud charges and other legal issues.

Venture capitalists are frequently the target of disgruntled entrepreneurs who, when refused funding, can become quite destructive and legally vindictive in terms of false accusations. There are high stakes involved for entrepreneurs who do not secure funding or investment for their startup, and sometimes the rejection of funding from one VC group is enough to create a ripple of hesitancy among other investors, which can spell big trouble for an entrepreneur.

Fraud cases frequently stem from accusations about misappropriation of funds within a venture capital organization. A recent 2016 high profile case prosecuted by the Securities and Exchange Commission (SEC) involved investment adviser G. Steven Burrill, an audit partner at PricewaterhouseCoopers (PwC), who failed to detect a capital fund manager who was stealing funds from the portfolio. The PwC auditor either disregarded or failed to note millions of dollars removed from the Burrill Life Sciences Capital Fund III, which were suspiciously categorized as “advanced management fees” in the investment fraud case.

In 2014, GeekWire Magazine reported that the number of individuals employed within venture capital professions had dropped 60 percent since 2004 from 14,777 in 2003 to less than 5,891 in 2013. The collapse of the global economy specific to several countries and emerging markets did much to teach venture capitalists the cost of being “too optimistic” in overseas growth. The surviving venture capitalist groups are far more cautious in terms of prospects, approvals, and legal screening of investment opportunities in an ever increasingly competitive (and hazardous) investors market.

Mergers and acquisitions, including seed funding for startups, is an exhilarating but risk aligned method of growing capital. Venture capitalists can, however, continue cautiously to nurture slower but more secure growth investments, while leveraging protection against illegal ventures and securities violations.

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