The Social Factor: How VC and PE Investors Can Scan Online Activity and Spot Problem Founders Before They Blow Up the Portfolio
In the venture capital and private equity world, traditional due diligence is centered around assessing a target company’s financial health, competitive landscape, business model, and overall potential.
These metrics are still highly relevant. But today there’s a new and necessary layer to the due diligence process: online and social media screening.
People now live much of their lives online. And it’s possible to use AI technology to screen the online activity of company founders and management teams and see if that activity indicates a risk for fraud, harassment, threats, or other misconduct. Indeed, this kind of due diligence has become a front-burner task for investors in the wake of the numerous frauds and improprieties that are currently rocking the private equity and venture capital universe.
An epidemic of bad actors
Recently, the Securities and Exchange Commission charged the cofounder and former CEO of Slync, a Texas-based software company, with fraudulently selling more than $67 million worth of securities to multiple investors and using $28 million of it for his own benefit. Among his personal purchases were a $16 million Gulfstream private jet and a half-million-dollar Ferrari Superfast 812, the SEC charges.
Also this year, a federal jury convicted three former executives of Outcome Health, a private healthcare-advertising company, of engaging in a fraudulent scheme to misrepresent the company’s business successes. According to the SEC, Outcome Health overstated its revenue by millions of dollars while raising approximately $487 million from investors. Nearly half of the funds raised went directly into the pockets of Outcome Health’s co-founders.
Several years ago, Fisher Investments saw clients pull out nearly $1 billion in investments after a viral video emerged online of its CEO making lewd and sexist comments. The SEC, for its part, is also ramping up its review of social media posts for signs of potential fraud and market manipulation when investors communicate online.
And then there’s the most high-profile fraud case of recent years, that of Sam Bankman-Fried, CEO and cofounder of the crypto platform FTX Trading. The company raised more than $1.8 billion from equity investors, including prominent VC firms like Sequoia Capital. The SEC says that although Bankman-Fried promoted FTX as a safe crypto trading platform, he orchestrated a years-long fraud to secretly divert FTX customer funds to his privately held crypto hedge fund. The SEC also says he used customer funds to make undisclosed venture investments, lavish real estate purchases and large political donations.
Investment firms on the backfoot
The recent surge in startup fraud and misconduct has put venture capital and private equity investors in an uncomfortable position. They have to explain to their limited partner investors—such as pension funds, college endowments and wealthy individuals—why they trusted these founders and how they were duped by them. Getting fleeced is a very bad look and it can severely hurt victimized VC and PE firms, not only in the present but in the future, when they go out to raise a new fund.
With all of this weighing on them, investment firms are now desperately seeking new solutions they can use to spot warning signs that indicate founders and management teams are prone to misconduct. One of those solutions is social media screening. Limited partners are also increasingly scrutinizing online activity as part of their due diligence process before deciding which funds to invest in.
In today’s business landscape, due diligence is rapidly expanding beyond the examination of conventional financial metrics to include the detection of past behaviors that indicate the potential for fraud or other detrimental conduct. In fact, this sort of expanded due diligence may soon be a requirement.
That’s because the SEC is now considering the implementation of new regulations around how private investors like private equity firms, hedge funds and venture firms vet their deals and do their due diligence.
SEC weighs new due diligence rules
Concerned by the rising tide of startup fraud, the SEC is said to be finalizing a rule aimed at making it easier for LP investors to bring lawsuits against venture capitalists, PE firms and hedge funds for misconduct, negligence or recklessness. If passed, the rule would expose investment firms to litigation from LPs if proper due diligence is not done during a completed transaction and hit firms in their pocketbook.
Investment firms these days increasingly find themselves working with founders and management teams who behave in ways that are detrimental not just to the financial health of the firms’ portfolios but to their overall reputation. These investors are learning that founders and management teams need more than an impressive resume to successfully lead a company. They should be basically ethical people who know how to inspire an organization and guide it to greatness.
Backing founders like that is not just the right move, it’s the profitable one. Because when investment operations teams skip character references and screening protocols, it opens the door to costly workplace misconduct like fraud, harassment and sexual abuse. One study found that corporate fraud alone destroys 1.6% of equity value each year—$830 billion in 2021.
The coming era of AI-powered online screening
Fortunately, as bad behavior increases, new tools are emerging to help investment firms expand their due diligence and protect themselves and their LP investors. They now have access to screening solutions that analyze a person’s online public interactions and identify possible misconduct. These solutions are used not only to screen management teams and founders but also coinvestors. They provide valuable insights into a person’s behavior and shed light on how they might behave in the workplace.
These solutions are customizable, fast, easy to use and more cost-effective than traditional due diligence methods. By examining online behavior, such as social media activity, these screening solutions can flag misconduct like fraud and harassment. Investment teams can then review these reports to assess the suitability of potential partners.
Integrating online screening programs into due diligence processes offers many benefits to investment teams, including increased efficiency, reduced risk of partnering with bad actors and enhanced business decisions based on additional information.
Every investor is looking for a competitive advantage and AI-powered online screening tools are just that. They help firms pick the winners and avoid the losers. Screening solutions run in the background with over 99% accuracy and deliver results in days, providing enhanced insights quickly and inexpensively. They save time on due diligence and help firms weed out bad actors before they partner with them—and suffer the consequences.