Entrepreneurs are often working very hard to start up their company with few safeguards in place and many very holistic processes. They often will ask for support from friends and family in the form of cash or “in-kind” effort or sweat equity.
Assuming the company survives, as it grows and transforms, there will be times when accounting is loosely managed, problems arise that create managerial disagreements or disgruntlement and/or times when people feel that although they agreed to work for sweat equity, they feel they are unfairly compensated.
Start-ups can survive and eventually thrive by overcoming all these issues, but these situations make it clear that the potential for fraud in the form of theft or embezzlement is very high and facilitated by the issues described above.
Fraud is often due to three factors that arise; called the Fraud Triangle. These factors described in relation to entrepreneurship and start-up companies are:
1- Motivation: the need for extra cash for some reason. While gambling and drug addiction can be motivating factors, a slowing of the economy, faster spending of funds during start-up, someone using mortgages, credit cards or loans to fund a company can put a small business employee/founder in a place where a dire need for cash arises and thus create a motivating factor.
2- Opportunity: While a lack of checks and balances is a big factor in fraud, a small company may not be able to even afford or have the staffing for checks and balances. That or loose procedures for accounting can create opportunities for “disappearance” of funds to occur and not even be obvious to the partners of the company until the perpetrator and/or funds are long gone. This is not an exhaustive list, but a few examples of easy ways this can be done include fictional suppliers, overbilling and diversion of funds, or simply diversion of revenue by not reporting them.
3- Rationalization: Any person committing fraud uses rationalization to justify their actions. A start-up that may be leaning heavily on sweat equity, perhaps longer than expected (a common occurrence) may present their employees or partners the opportunity to rationalize that the funds are owed for work done or that rewards and remuneration have not come as quickly as promised.
Investors understand these issues can arise and are watchful for indications for potential misuse of their investments. Having a good accounting system and a team that has great credentials as well as more than a few months of association are two good indicators of trustworthiness. However, these are not ironclad; it is ultimately up to the founder and their board to oversee and assure that protections from fraud are in place early and managed well.