The VC legal arsenal to combat entrepreneurial fraud

Spotting red flags

A 2024 study found that 84% of fraud cases globally exhibit early telltale signs such as:

• Inflated or fabricated metrics: Be wary of performance indicators - e.g. customer numbers and revenue -  that seem too good to be true. Verify metrics through third-party data or direct customer sampling.
• Delayed or incomplete financial reporting: Watch out for poor practices like relying on basic accounting software or a one-person finance department to manage large businesses are big red flags. If a startup resists or delays sharing full financials or only offers “adjusted” figures without backup, consider hiring a third-party accountant to review the books.
• Weak governance and oversight: Overreliance on founders without checks and balances often leads to bad decision-making. Warning signs include a lack of independent directors with subject-knowledge expertise, the absence of an audit committee, and an inexperienced chief financial officer - or worse, no CFO at all.
• Conflicts of interest: Ask founders about any undisclosed conflicts and scrutinize financial records for related-party transactions. Consider talking to early former employees, who can be the sources of candid information.
• Fabricated founder credentials: Founders exaggerating their education, experience, or achievements point to broader ethical problems. Verify their credentials thoroughly - if necessary, contact universities and past employers.

Deal structuring

Investors should capitalize on the current investor-friendly climate to secure stronger safeguards in term sheets and investment agreements that can span the entire life cycle of a startup.

However, forcing tough terms on founders can erode trust and dissuade them from sharing the challenges they face. A balanced approach that is assertive yet respectful keeps communication lines open and encourages long-term cooperation.

Capital protection

Investors should prioritize the following safeguards:

• Liquidation preferences ensure investors recoup capital first in the event of bankruptcy or a fire sale.
• Anti-dilution protections prevent dilution of investors’ equity stakes in down rounds.
• Veto rights grant investors the ability to block major decisions such as new share issuances or large acquisitions, that could significantly affect the company’s value or risk profile.
• Drag-along rights facilitate easier exits for lead investors by preventing minority shareholders from blocking a potential acquisition or merger.
• Pro-rata rights allow existing investors to maintain their ownership stakes during subsequent funding rounds.
• Regulatory ripcords enable investors to exit or restructure investments when significant regulatory changes occur.
• Escrow accounts hold funds in reserve until key milestones such as user growth are verified.

Governance, audit, and information rights

 To deter fraud and misconduct, investors should push for:

• Board composition rights bestow the power to choose independent directors with sector expertise, a CFO, and an audit committee for later-stage or larger financings.
• Swamping rights allow investors to take board control in the event of material underperformance or egregious founder breach.
• Bad leaver clauses ensure that founders who commit fraud, willful misconduct, or other defined infractions face termination and potential forced stock repurchase at a nominal price.
• Audit and information rights require quarterly and annual financial reporting, with annual audits by a reputable firm once the company reaches a certain size.
• Inspection rights authorize investors to check the company’s books and records as well as to visit facilities.
• Conflict disclosures require founders to reveal all business interests and potential conflicts, with clear policies for recusal and managing conflicts.
• Compliance milestone-based funding and incentives link earn-out or deferred funding tranches to governance and compliance milestones like timely financial reporting

Post-investment best practices

A well-implemented compliance program  involves much more than check-the-box policies and can save portfolio companies an estimated 5% to 6% in annual revenue that would have been lost to fraud.

The US Department of Justice’s 2024 Evaluation of Corporate Compliance Programs, a gold-standard guide for best practices, recommends the following:

Codes of business conduct and policies

 Effective codes and policies communicate a zero-tolerance stance on misconduct and serve as building blocks for training and whistleblower programs. While these policies are increasingly adopted by mature multinational companies in Southeast Asia, their value for startups and early-stage firms is frequently understated.

Policies should address financial controls like automated approval workflows for expenditures and segregation of duties to ensure appropriate assignments of responsibility. They should also cover conflict of interest disclosures.

Anti-bribery and corruption safeguards such as due diligence protocols for high-risk third parties - e.g. distributors and contractors - and strict rules on gifts, hospitality and entertainment, also go a long way.

Policies need to be updated annually to reflect regulatory changes and lessons from past violations. These should then be reinforced through interactive training.

Whistleblower programs

 Anonymous reporting channels are vital for uncovering fraud early, with 43% of detected cases originating from tips. These channels are low-cost yet high-impact tools that can uncover misconduct before it escalates.

A Deloitte survey involving organizations in Asia Pacific found that 91% of respondents implemented whistleblower programs in 2024, up from 87% in 2023. However, speaking out in Southeast Asia can be less common due to cultural norms that discourage challenging peers or superiors.

To reassure employees and allay fears, whistleblower programs must include robust anti-retaliation measures that ensure anonymity and enforce strict penalties for reprisal. 

That said, be equally cautious about how these reporting channels could be abused for personal grievances or to make false allegations.

Training and mentorship

 To create a culture of compliance, founders and employees should be trained on fiduciary duties and corporate governance. Training should be interactive, based on real-world examples, and tailored for employees who face greater risks. For example, sales teams should learn about anti-bribery laws.

Mentorship is perhaps the most powerful tool in an investor’s arsenal. Instilling accountability can help avoid a “growth-at-all-costs” mentality that can encourage fraud.

Remediation and recovery

Even the most diligent safeguards can fail. How investors respond once fraud is discovered can determine whether an investment can be rescued or should be written off.

The first step is to assess how credible, complex, and severe the allegations are. This will inform whether a full investigation is warranted.

If a probe is launched, clear and confidential communication with all stakeholders - appropriately protected throughout by legal privilege - is key. Co-investors should be provided with important updates, and communications with regulators, the media, and other stakeholders (e.g. employees, customers, and suppliers) should be managed carefully.

Staying proactive at this time mitigates further risks such as asset diversion or evidence tampering.

If misconduct is confirmed, investors face tough decisions. Alongside legal counsel, it’s time for frank discussions with the founders and management.

Minor infractions can be resolved through personnel or procedural changes, while severe violations like egregious fraud may require removing responsible personnel, restructuring leadership, or reporting to authorities. The entire investigation process should be documented, including findings and any disciplinary or remediation measures taken.

It’s best to engage legal counsel and other consultants early on to lead the investigation, communicate with co-investors to present a united front, and maintain oversight to ensure continued operations.

Better than cure

Building a culture of integrity benefits not only investors but also founders who are committed to building sustainable businesses.

By using these safeguards, the startup ecosystem in Asia can transition from reactive crisis management to a future where fraud prevention and remediation are the norm, not the exception.