The fraud case at the Israeli company Joonko is just an example of what is happening in the international high-tech industry • Beneath the surface, more and more evidence is accumulating about entrepreneurs who raise millions of dollars from investors, without due diligence or background checks • Globes following the holes that enable huge frauds of technology investors.
Michael (pseudonym) is a successful Israeli entrepreneur who raised tens of millions of dollars from a well-known Israeli fund for a high-tech company he owns. However, in parallel with the idyllic family life and the successful technology business, Michael visits a casino in one of the gambling capitals every few weeks, and on each of these occasions he bets amounts that can reach hundreds of thousands of dollars.
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Moti (pseudonym) writes in his resume and talks about exits and successes in job interviews – but does not bother to mention the companies he has closed and the debts to investors he still has left.
David (pseudonym) is a young entrepreneur who told partners and investors in his startup that he graduated with a degree in computer science at the Technion, but in reality he only completed a few courses and in fact never completed more than a semester at the reputed institution. When they heard this, the investors withdrew their money from the company and now David’s partners are suing him for the damage caused to them.
These are just some of the cases discovered by Git Grands, an Israeli who has been living in Barcelona for the past few years and runs the company Hirewall for background checks on job candidates, entrepreneurs and managers. Most of her clients are not Israeli – since the practice of professional background checks is almost never used here.
“Such tests are not done in Israel, and when they are already done, it happens with the ‘neighbor’ method, through conversations with friends from the unit, or with friends who know friends,” she tells Globes. “It is rare that in this way the important red flags are raised.”
Background checks should, for example, reveal hidden debts, expand overseas or check the family circle as well. More than once conflicts of interest or surprising discoveries are discovered. “Not long ago, we found out that the entrepreneur revealed his origins in an episode. He claimed to have been in the US, but ‘forgot’ to say that he was being investigated by the Federal Bureau of Investigation,” she says. all this time”.
A twilight zone that breeds charlatans and frauds
Scammers, crooks and liars operate in every industry, this is probably a fact. However, in the high-tech sector, a number of cases have recently accumulated that prove again and again how it has become a no-man’s land, a twilight zone that breeds charlatans and enables a series of investor frauds. Last week it was the Israeli company Joonko, where forgeries of bank account statements and international money transfers were allegedly discovered.
Earlier this year, the investment bank sued J. times. Morgan the American start-up Frank. This, after the initiator of the Frank student portal, Charlie Javis, systematically inflated the customer numbers in the system. The fraud was discovered completely by accident when it turned out that the number of users was suspiciously the same as the maximum number of rows in the Excel spreadsheet.
To which must be added the cases that have already received legal treatment and have proven how young and charismatic entrepreneurs can drag top investors after them until they perish. Elizabeth Holmes, the charismatic founder of Theranos, was accused of defrauding investors after it turned out that the blood sampling machine she built never worked.
Elizabeth Holmes, Theranos
The scam: developed a blood test machine that never worked
The red flags: a lack of medical experts on the board, which was made up mostly of former military personnel and diplomats
Trevor Milton, the entrepreneur of the electric truck company Nikola, was accused of securities fraud and fraud of fundraising documents, after it became clear that most of the technological developments did not exist and were not created. The truck, based on hydrogen fuel, was filmed in a promotional video on a sloping road to make viewers think it was driving itself.
The fraud: He deceived investors about the technological achievements, when his product – an electric truck that runs on hydrogen – did not work at the time
Red flags: recognition of customers and future revenues as existing, and odd expenses like paying rent for an employee the CEO didn’t want to leave
A series of failures that are revealed again and again
A background check on the entrepreneurs who founded Joonko would have revealed a number of red flags: of the three entrepreneurs who founded it, only one remains, CEO Ilit Raz who managed the company and coordinated the entire financial side. In addition, the entrepreneur was previously fired from a company that was not mentioned in the LinkedIn profile of And she left another company after two months on the grounds that she was terminally ill, according to a publication revealed in Globes (Rez denied the incident, AG).
The lack of thorough background checks for entrepreneurs is not the only “hole” that allows the existence of the wild west in the high-tech industry. A series of failures that are repeatedly discovered in investments, exits and issuances testify to a large corporate and regulatory vacuum that allows any entrepreneur or investor to tell almost any story.
“The industry operates without any control,” an investor who asked to remain anonymous tells Globes. “I am one of those who hires a medium-sized accounting firm that also specializes in cross-checking data and thorough checks before I invest in a company, but I know that many of my colleagues in the industry do not do this.”
It was not for nothing that the high-tech industry grew out of a shroud of secrecy, as if it were a black box. Today’s large public high-tech companies also began as small start-ups operating partly under the radar, fearing that the existing giant companies would find out about their technology and quickly develop a competing product. In any case, most of the founders working in the industry came from positions in the intelligence corps, where secrecy is the bread and butter of their rule.
When faults are discovered – such as cases of fraud, inflated numbers or just business failure – things are almost always closed between the investors and the entrepreneurs in a room. Investors in the market testify that forgeries of documents were discovered in two other Israeli companies recently – but no one had an interest in revealing it. It is more important for investors to keep their good name than to air their dirty laundry, and under the cloak of a private company the scams do not leak.
There is also a justified reason for the lack of formality: “We operate in an industry that deals with innovation, with attempts to develop technologies or products that have never existed, so there is a great value to flexibility,” explains Rotem Shaham, director of the American PSG Foundation. “All these companies start in relative chaos and then they become organized organizations – but there is a certain point where you have to find the balance between flexibility and organization and order. The Israelis have a lot to learn from the Americans – words like supervision or control, processes and reports. For us it’s curses.”
Not only are thorough background checks not acceptable in the high-tech industry – due diligence processes before investing in a company are also done separately by accountants or lawyers, usually without a guiding hand, and with only a cursory check. Furthermore, there are no clear rules on how to perform proper inspections and each investor performs it, as he sees fit without uniformity or rules dictated by a regulatory authority.
On top of that, many of the tests done during the 2020-2021 corona bubble were conducted under pressure from investors to get deals done as quickly as possible. “More than once entrepreneurs would ask us to give them a discount in the due diligence as a condition for closing the deal,” an investor who asked to remain anonymous tells Globes.
“If the document is fake, there is no way to get over it”
However, even if the test was conducted religiously and legally, there is no guarantee of its success. “A due diligence is not a police investigation – but an inspection designed to give a certain assessment of the company’s legal and business situation,” says attorney Itai Frishman, a high-tech partner at the Mitar firm. correct If the document is fake, they have no way to prove it.
“They scan the documents and check their legal appendices but do not talk to the customers or verify the reliability of every detail recorded in the company’s books. Those who wish to conduct a larger investigation will have to spend up to hundreds of thousands of dollars, but this is usually not economical for the investors or the start-up companies – Up. The solution has to come from somewhere else – from investing in companies that have from the beginning accountants, and lawyers who specialize in the field, an external or internal CFO in more advanced stages, who serve as gatekeepers and as an additional means of control over the management.”
The financial due diligence is no different from the legal one. CPA Amir Shani, from the Somak Chaikin KPMG firm, explains that the role of the due diligence is not to detect fraud, but to examine for the investor various aspects of the company’s activities. It is prepared with the knowledge that the accountant has already examined, modeled and checked the invoices, even if this was done retrospectively.
“It is important to understand that the auditing accountant, i.e. the company’s permanent accountant, has an extremely important control role, in fact being an external party to the company – but he also has no ability to detect sophisticated forgeries if they have been made.” Shani says that he encountered quite a few private companies that chose a stricter reporting standard and prepared quarterly reports, similar to public companies, even though they are not required to do so. Such a reporting culture, he claims, improves transparency for investors and shareholders.
To this must be added the fact that while in Israel there is a legal obligation to submit an annual financial report to the shareholders. There is no such law in the US, so in principle Israeli startups registered in the US can avoid submitting reports in the country of origin.
“Mix types of income and create a script”
The company’s official accounting reports also represent only a part of reality and are almost never referred to by the company’s board of directors. This is because in the start-up worlds investors and entrepreneurs do not wait a year or two for a report to come out to examine the performance. These are held regularly on the basis of indices that are outside the accounting rules and in practice are referred to by the same name, but are perceived by different investors and entrepreneurs subjectively: this is the annual recurring revenue index (ARR).
“Even when everyone says ARR, there is a lot of room for interpretation – and this can create big gaps in expectations between investors and entrepreneurs “, says Noam Liran, founder of the company Sightpool, which is trying to create a uniform standard in the industry by a single reporting system for annual recurring income. “In the past, boards of directors really liked to use ‘commitment income’ – which is a term that allows me to recognize the income even if it goes into my bank account for a year, as long as the customer is committed to it today. The problem is that this index shows growth even when in practice the money has not arrived, and sometimes it does not arrive.
“Sometimes different types of income are mixed – and the optimistic scenarios are taken in each type of index. The solution is usually to apply a uniform standard across the entire management and between it and the board of directors, even if we continue to use the ARR index.”
“Often we see entrepreneurs who consider contracts for which customers have not yet announced a renewal – as recurring revenue,” says one of the investors. “But what will happen if, for example, the customer calls to cancel on the last day? As long as the contract is not renewed, it cannot be considered in the revenue basket. Maybe it really is time to return to the well-known and good revenue index: it does not measure the growth of a startup in real time, But at least you can’t play it.”
According to Nicole Friel, a partner in the American venture capital fund Ibex, “Investors do not need and cannot be police officers or fraud investigators, but there is definitely a place for supervision and control. Just as companies today pass a security resistance test (SOC-2), there is no reason not to pass them an inspection at a cost of several tens of thousands of dollars at a professional inspection firm. Most likely, even before the government regulator takes a step on the matter – the private funds will lead an independent move towards their companies to make sure that their entire financial base is sound.”
The statements are not enough, and what about the regulation?
The question of regulation hovers over the private high-tech market every time frauds are exposed. This is what happened after the revelation of the events at Theranos, FTX or the poor corporate governance at WeWork. Recently, Gary Gensler, the head of the US Securities and Exchange Commission, applied greater control over crypto investments and resulted in the suspension of trading in a number of currencies defined by the authority as high risk – including startup companies, including Ituro, for example.
Even earlier, last year, Gensler called for increased supervision of private equity funds, venture capital and hedge funds – and to require them to disclose their losses, the management fees they take from the institutional entities, as well as oblige them to report on extraordinary corporate governance cases that exist in the portfolio companies.
“The venture capital funds do not remain liable – they spend millions of dollars on their own lobby in the US and oppose his policies,” says Prof. Anat Alon-Beck, a corporate law researcher from Case Western University in Ohio. “Gensler, for his part, is interested in bringing standards from the public market to private. He wants to prove that an investor who didn’t do proper due diligence violated his fiduciary duty to investors, as if he were a director of the public market.”
Jeremy Lieberman, managing partner at the law firm Pomeranz, which specializes in investor claims in public companies, even claims that the situation in the public market is also depreciated: “Even the statements of the companies to the stock exchange are not enough – and the Securities Authority concentrates on them instead of what should really be checked. The time has come for every company that goes public to go through a real due diligence process by a qualified body and at its own expense and to make sure that the company’s activities are indeed as they say.”
July 7, 2023 Published by The Globes News Israel.