The Importance of Due Diligence in a World of Fraud

The topic of due diligence is one we cover in some capacity frequently in the DealQuest Community and on the DealQuest Podcast. In light of recent news about startup CEOs being charged in fraud cases, I feel we should delve a little deeper into other aspects of due diligence. It’s essential to examine the significance of due diligence and how to avoid falling prey to fraud. 

THE IMPORTANCE OF DUE DILIGENCE IN PREVENTING FRAUD

Performing due diligence can be challenging, especially when dealing with sophisticated fraud schemes or individuals actively trying to deceive others. Even without fraud, information can be misrepresented, and factors like deal flow, deal pace, and pressure to close deals can make it difficult to spot red flags.

As an investor or entrepreneur, the importance of due diligence cannot be overstated. In light of recent news about a startup CEO charged in a $175 million fraud case, it's crucial to examine how due diligence can help prevent such situations and ensure that your investments are sound.

There are various types of due diligence to consider. This can include, but is not limited to: 

• Financial
• Legal
• Regulatory
• Cultural
• Strategic Alignment

 Despite the best efforts of investors and due diligence professionals, however, fraud can still slip through the cracks. Take the notorious Theranos scandal, for example. Despite significant investments from sophisticated venture capitalists, the company's fraudulent blood-testing technology went undetected for years. The question remains: How can investors avoid falling for fraudulent schemes?

PROTECTING YOURSELF AND YOUR BUSINESS WITH DUE DILIGENCE

One answer lies in the depth and thoroughness of due diligence. In the case of the $175 million fraud, the company's valuation seemed to be primarily based on the number of customers they claimed to have assisted. Yet, it appears that financial due diligence may not have been sufficient in uncovering the fabricated data.

For technology companies, particularly those that do not generate significant revenue initially, it can be challenging to determine the veracity of user numbers or the effectiveness of the technology. In such cases, it's essential to have an independent evaluation and to rely on the expertise of lead investors.

 Even lead investors can be misled, however. As we've seen in cases like Enron, sophisticated fraud schemes can be difficult to detect. To minimize the risk of falling prey to fraudulent activities, investors should be vigilant in their due diligence efforts. This can include testing samples of a company's data or closely examining the cost of delivering services.

It's important to note that outright frauds in business deals are quite rare, and most deals that don't work out are due to other factors such as misaligned expectations or economic downturns. Nonetheless, the risk of a deal turning sour due to fraud can have significant consequences for a business, as evidenced by high-profile cases like Theranos.

Due diligence is not foolproof, but it is an essential tool in mitigating risk and making informed investment decisions. The key is to strike a balance between trusting the professionals and conducting your own thorough investigation. After all, it's better to be safe than sorry when it comes to investing your hard-earned money. 

• • • 

For my full discussion, and more on this topic:
Listen to the Full DealQuest Podcast Episode Here 

Corey Kupfer is an expert strategist, negotiator, and dealmaker. He has more than 35 years of professional deal-making and negotiating experience. Corey is a successful entrepreneur, attorney, consultant, author, and professional speaker. He is deeply passionate about deal-driven growth. He is also the creator and host of the DealQuest Podcast.

If you want to find out how deal-ready you are, take the Deal-Ready Assessment today!