What Europe’s EU Inc. framework for boosting competitiveness can and should learn from startup fraud in the US

The European Parliament and the Council of the European Union are currently debating EU Inc, draft legislation seeking to establish a single set of rules for starting, operating, and growing a business across EU member states. The proposed framework is designed to make business registration and operation within the EU faster, easier, and more harmonised.

The proposed “28th regime” promises company registration within 48 hours for under €100 via fully digitalised procedures – including for raising capital and accessing the stock market, and simplified liquidation proceedings to make dissolving and relaunching a business more seamless. The proposal is part of the broader EU Startup and Scaleup Strategy, whose ambition is to narrow the innovation gap between the EU and its global competitors, notably the United States.

The European Union arguably has a significantly smaller venture capital market, fewer unicorns, and lower valuations for comparable companies relative to the US. Yet in its desire to catch up with its North American partner, we suggest the EU treads carefully to avoid reproducing some of the very features that have made the Silicon Valley startup model vulnerable to fraud.

At this moment, the Silicon Valley star-turned-villain, Elizabeth Holmes, is the protagonist of a new documentary You Can See Everything. The documentary chronicles the 34 days in 2023 before the founder of the former biotech startup, Theranos, entered federal prison to serve a 135-month sentence for defrauding investors. As scholars who have studied criminal deception and investor fraud in Silicon Valley, it’s clear that Elizabeth Holmes and Theranos are just one of many startup fraud cases. The problem is deeper than we usually acknowledge.

The startup fraud problem in Silicon Valley

Startups are important drivers of technological innovation, progress, and hope for the future. But systemic features of the startup ecosystem also make them particularly vulnerable to misconduct and fraud. Together, a culture of “creative destruction”, highly liquid private capital markets, little formal oversight, and technological hype cycles create conditions for fraud to prosper.

These features are on display in high-growth startup contexts like Silicon Valley, where the immense pressure to churn out unicorns (i.e. achieve $1 billion in valuation in less than seven years) can push founders to blur the line between reality and fiction.

In our recent study of startup fraud in Silicon Valley, we argue that investor pressure to demonstrate product-market fit, technological readiness and an exponential growth trajectory can incentivise entrepreneurs to engage in fraud, especially when a gap between investors’ expectations and startup reality forms and widens.

What we’re seeing is not the typical Ponzi scheme or a shell company. For the most part, the entrepreneurs we studied started real businesses with genuine ambitions. Along the way, they began justifying fraud as the only way to keep investors and other stakeholders committed to their company when technology, customer contracts, or regulatory approvals didn’t materialise as expected.

Startup fraud involves varying degrees of sophistication with one key commonality. Entrepreneurs create a façade – a shiny startup image of an exponentially growing company to mask a lack of performance. Less sophisticated forms of fraud can involve reporting revenue from expired and non-renewed client contracts or faking bank statements to falsely substantiate early revenue growth.

Entrepreneurs create more sophisticated façades during a startup’s growth stage, when founders need to raise large rounds and investors expect to see rapid scaling. In the case of Theranos, Elizabeth Holmes and Ramesh Balwani staged fake product demos before investors. They showed investors around research and development labs, took a drop of investors’ blood, and reported the results of the blood tests as if they had come from Theranos’ “transformative” technology. In reality, the tests were conducted behind closed doors using conventional methods on third-party machines. The forensic analyses reported during Elizabeth Holmes’s trial even mention the use of code names to refer to the third-party machines internally so that Theranos’ own employees wouldn’t suspect the deception.

In even more sophisticated schemes, startup founders enlisted their employees to impersonate high-profile customers or venture capital investors during investors’ due diligence calls. They registered false phone numbers, made introductions, and had the fake client (a real company employee) present glorious endorsements of the startup. In the most severe cases, entrepreneurs fully faked official audit reports from auditors such as KPMG and falsely affirmed that their company complied with current regulations.

The fact that investors’ due diligence processes – designed to fact-check startups and their aspirational claims – can themselves be hijacked underscores the severity of the problem. Investors want to see exponential growth fast, and entrepreneurs find creative ways to give them what they want, even if it means crossing the line into criminal offences. Full verification of every founder claim is far beyond the scope of common due diligence processes. Yet it is ever more necessary given extreme growth pressures. As a result, the regulatory body in charge of overseeing public firms, the Securities and Exchange Commission (SEC), is increasingly stepping in to fact-check private startups.

Unfortunately, the SEC tends to intervene once fraud has already occurred and somebody has blown the whistle.

What makes startup fraud all the more concerning is that it is highly likely to become more widespread. Startups are staying private for longer, delaying going public (if at all), and flying under the radar of public and regulatory scrutiny all while raising ever higher amounts of capital.

There is also growing concern that we’re in the midst of an AI hype cycle. AI startups and companies are fuelling impressive expectations for returns on investment, with valuations reaching $965 billion for Anthropic and growing concerns that the bubble might soon burst. Studies have shown that risk-capital-backed startups founded during hype cycles are more likely to commit fraud. Moreover, with new AI capabilities, producing deepfakes can make it even easier to fabricate financial data, impersonate customers and investors, and construct shiny façades of high growth. EU Inc.’s ambition to fully digitalise procedures across a company’s lifecycle could introduce key vulnerabilities in this respect.

An opportunity for EU Inc. to curb startup fraud

As debates over EU Inc. unfold, it’s important to acknowledge that the EU is not without its own high-profile startup fraud cases, including Germany’s Wirecard, the payment-processing unicorn Unzer, and the Swiss-German crypto startup Envion AG, which are collectively deemed responsible for €2.3 billion in investor losses. With Europe seemingly eager to learn from the US startup model, it would do well to avoid replicating those very systemic features of Silicon Valley: limited oversight, highly liquid private capital markets, and ambition for fast growth at all costs that can blind investors, customers, and even regulators with stardust.

Curbing startup fraud requires action at multiple levels that target punishment, detection, and prevention. EU Inc. presents a unique regulatory moment to build in corrective measures from the start.

In terms of punishment, the involvement of judiciary bodies in criminally prosecuting startups is an important signal that regulators are serious and that fraud carries consequences beyond monetary fines. Not all prosecutions are as headline-worthy as that of Elizabeth Holmes. Yet increasing criminal investigations into startup fraud underscore the fact that the problem is more common than we think and far from the responsibility of a few bad apples.

In terms of detection, creating a mandate for regulatory agencies to oversee and investigate startups could help surface more fraud cases earlier in the process rather than after fraud has prospered for years. At this stage, EU Inc. simply invites member countries to consider establishing specialised judicial bodies to oversee disputes over company law. In the meantime, the European Securities and Markets Authority could expand its role in investigating fraud and bringing cases to the attention of the courts.

Safeguarding and bolstering protections for internal whistleblowers are also important measures for alerting EU regulators of fraud. In our study, many instances of fraud were detected by employees or board members, reinforcing the need to protect insiders with vital knowledge of company operations. Encouragingly, whistleblower protection laws are already more comprehensive in the EU than those that exist in the US.

Strengthening board independence to ensure close oversight of founder-CEO activities can additionally help curb fraud. A recent study found that startups with founder-controlled boards were 88% more likely to commit fraud compared with those where board control is shared or controlled by VCs.

Finally, the verifiability of company records (past and current performance data and developmental milestones) is also key. Third-party certifiers beyond traditional auditors have a place in the startup ecosystem to support existing due diligence processes that appear to be fallible. Developing a denser ecosystem of actors charged with verifying startups’ financial claims can support efforts by regulatory bodies and public prosecutors, who are currently under-resourced to address the scale of startup façading.

Perhaps the hardest task is to weaken the incentives for entrepreneurs to commit fraud in the first place. This implies rethinking sticky values like “growth at all costs”, “fake it ‘til you make it” and “move fast and break things”. EU Inc.’s focus is on harmonising complex regulations and easing the cost of starting a business. We think it’s at least as important that the legislation enshrine a set of values for entrepreneurs, investors, customers, board members, and other ecosystem actors to build businesses for the long run, rather than to prop up startups artificially for quick, spectacular returns.

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