The Dark Side of Unicorn Chasing: How Venture Capital Has At Times Incentivized Unethical Practices
This is part of blog series titled "What's Wrong with Venture?" where I explore the struggles and difficulties in the startup and VC world.
In the high-stakes world of startups and venture capital, the race to achieve unicorn status (a privately-held startup valued at over $1 billion) can incite unethical behavior. This relentless pursuit of rapid growth can create perverse incentives, pushing startups towards unethical behaviors. This post highlights a few examples and why it specifically happens with VC backed companies.
The Unicorn Obsession in Startup Discovery
The term "unicorn" was coined by venture capitalist Aileen Lee in 2013 to describe rare startups that achieve a valuation of $1 billion or more. Since then, it has become a benchmark in startup discovery, where the search for the next big thing dominates the venture capital landscape. However, this obsession with high valuations often drives startups to prioritize growth at any cost, leading to ethical lapses and unsustainable business practices.
The power law suggests that VCs are going to return most of their fund on only a few startups, the 100Xers that can take a $2m and make it worth $100m (don’t forget about dilution as future rounds are raised).
Throughout the past decade there have been a number of companies that have gotten to unicorn status only to reveal that the executives and founders engaged in fraud or extremely foolish and risky behavior that results in either huge losses or the collapse of the company.
Example 1: Theranos
Theranos, founded by Elizabeth Holmes, is a prime example of a startup succumbing to the pressures of unicorn chasing. Promising to revolutionize medical testing with a device capable of conducting multiple tests with just a few drops of blood, Theranos attracted hundreds of millions in funding and reached a valuation of $9 billion. However, the reality behind its technology was far from the promises. To meet investor expectations, the company engaged in deceptive practices, including falsifying test results and misleading patients and doctors. Eventually, the company's fraudulent practices were exposed, leading to its collapse and criminal charges against Holmes.
Example 2: FTX
FTX, the cryptocurrency exchange founded by Sam Bankman-Fried, engaged in unethical behavior by misappropriating customer funds to support its affiliated trading firm, Alameda Research. Reports revealed that FTX secretly transferred billions of dollars in customer deposits to cover Alameda's risky bets, leading to significant financial instability. This misuse of customer assets, combined with a lack of transparency and misleading financial practices, ultimately led to FTX's collapse, eroding trust in the cryptocurrency market and causing substantial losses for investors.
Example 3: WeWork
WeWork, the co-working space startup, is another example of a company that prioritized growth over sustainability. Under the leadership of CEO Adam Neumann, WeWork expanded rapidly, fueled by billions in venture capital. The company's valuation soared to $47 billion. However, WeWork's business model was fundamentally flawed, and its rapid growth masked deep financial instability. When WeWork attempted to go public, its questionable practices and financial losses were exposed, leading to a dramatic fall in valuation and Neumann's ouster.
Example 4: Frank
Charlie Javice, the founder of the student financial aid startup Frank, engaged in unethical behavior by significantly inflating the company's user numbers to attract investors. Javice falsely claimed that Frank had over 4.25 million users, a figure that was crucial in persuading JPMorgan Chase to acquire the startup for $175 million. In reality, the actual number of users was substantially lower. This deceit was eventually uncovered, leading to legal action against Javice and highlighting the damaging consequences of dishonesty in the startup world, where inflated metrics can lead to misguided investments and erode trust in the industry.
Perverse Incentives and High Growth in Startup Help
The common thread among these examples is the perverse incentives created by the relentless pursuit of high growth. Venture capitalists often push startups to scale rapidly, seeking quick returns on their investments and hammering home the power law. This pressure can lead founders to cut corners, misrepresent their progress, and engage in practices that they would otherwise avoid.
The emphasis on achieving unicorn status also distorts priorities. Instead of focusing on building sustainable and ethically sound businesses, startups may prioritize short-term growth metrics that impress investors. This can result in a fragile business model that is prone to collapse once the truth comes to light or external conditions change. Additionally, these founders are constantly compared to the winners in a fund’s portfolio. They look around and realize that the only way they’ll be able to raise their next round is if they’re growing by 50, 100, or even 200% year over year.
Ethical Growth: A Better Approach to Startup Help
To counteract these perverse incentives, the startup ecosystem must prioritize ethical growth over hyper-growth. Investors should adopt a more balanced approach, valuing long-term sustainability and ethical practices alongside growth potential. Founders, on their part, should resist the temptation to overpromise and underdeliver, maintaining transparency with stakeholders.
Wouldn’t you rather a founder tell you they had a flat year, reduce needless burn, and then come back with vengeance instead of overextending their capital?
Funds need to also do extremely thorough due diligence into user statistics and traction metrics. If an analyst needs to go through data and bank statements to ensure that the company is legitimate, then so be it. VCs are investing other people’s money and need to make sure that
Moreover, the industry should celebrate startups that achieve success through ethical means, providing role models for future entrepreneurs. By redefining what it means to be a successful startup, the venture capital community can help create a healthier, more sustainable ecosystem.
Don’t Forget that 5-10x is a Great Return
Many VCs allow comparison to be the thief of joy. They let the 100x cloud their vision and this gets back to the founders who then try to take their company to that height. Like Icarus, these companies burn their capital and their wings at alarming rates, when the alternative could be a nice flight around the Mediterranean.
If 75% of companies in a VC fund exited at an average return of 5x, you could turn a $100m fund into around $250m (accounting for fees and an estimated dilution of 30%).
So many founders start to buy in after a big check and get foolish with their money in part because of investor encouragement.
Not All VCs
It’s worth noting that many VCs out there understand the insanity over the past decade and aren’t ones to encourage unethical or even overly risky behavior. Find the measured VC who understands that high growth is hard to maintain and will help you even when things get difficult. Kindness can easily shine through if you look for it. Talk to portco founders and others who know those VCs as well.
In Sum
The dark side of unicorn chasing reveals the perverse incentives that can arise when startups are pressured to achieve rapid growth. High-profile examples like Theranos, FTX, WeWork, and Frank illustrate the dangers of prioritizing valuation and metrics over integrity. To build a more ethical and sustainable startup ecosystem, both investors and entrepreneurs must shift their focus from chasing unicorns to fostering sound, responsible businesses. By doing so, they can ensure that the next generation of startups contributes positively to society while still achieving remarkable success.
By integrating ethical practices into startup discovery and startup help, the industry can move towards a future where success is measured not just by valuation, but by the positive impact and sustainability of the business.