Pumping up loan volume by secretly lending to friends and family. Selling insurance policies without legally required licenses or training. Marketing a blood test of dubious reliability. Spending investors’ money on strippers, vacations and sports cars.

There’s certainly been no shortage of bad behavior among Bay Area startups in the last year, with a rolling series of ethical, legal and regulatory scandals that has swept up young companies like Lending Club, Zenefits, Theranos, Hampton Creek and Skully — all of which declined to comment.

To be sure, wayward conduct isn’t limited to startups — just look at Wells Fargo now, or companies like Enron and Worldcom in the past. But the recent frequency of startup scandals raises questions about whether the lure of becoming a “disruptor” is tempting founders to cross the line into dishonest and sometimes unlawful conduct. Some VCs are even wondering if they share part of the blame by showering too much capital too fast and too soon on entrepreneurs who may be unprepared for dealing with the complexities of running a business, and then pressuring them to scale up too quickly.

“These are businesses tackling hard problems that can’t be solved with a quick influx of capital — there are regulatory hurdles, safety concerns, and partners and customers still getting accustomed to new applications of technology in their industries,” said Mamoon Hamid, co-founder and partner at Social Capital and a well-known tech venture capitalist. “Long-term companies will take longer to build, but we also believe that the years spent and hurdles cleared will make them more defensible in the long run.”

“Being a disruptor” can come to be seen as a get-out-of-jail-free card, occasionally convincing startup founders that they’ve been freed from both laws and basic precepts of honesty when they seem inconvenient. It’s precisely to avoid those circumstances that young companies, particularly startups, need venture capitalists who are willing to hit the brakes on ideas or practices — and the funding that comes with them — that seem like “company killers,” Hamid said

That compliance with legal and regulatory requirements is particularly crucial in the areas of healthcare and biotech, where health and even lives are at stake. Failing to do so tripped up both Zenefits and Theranos.

“Some people may think that being a disruptor means you can break the law, but I don’t,” Julia Papanek, a biotech venture capitalist at Canaan Partners who has led investments in CytomX, Labrys Biologics, Dermira, ALDEA Pharmaceuticals, Chrono Therapeutics, and Glooko.

“In health care, where patient safety and security are paramount, it is a red flag when founders want to go at odds with the FDA,” she said. Trying to avoid the regulators, she added, is not a sustainable solution.

“The FDA has a range of different meetings and programs available for companies to seek out their guidance,” Papanek said. Some companies learned the hard way that avoiding the FDA has consequences: 23andMe was forced to stop selling its tests in 2013 because it had gathered customers’ DNA before it had required regulatory approvals.

“It is just not worth it,” she added.

A few IPOs might help

In the past, the eventual scrutiny that would accompany an IPO was enough to keep startups on the straight and narrow, some VCs said.

“Startups are like airplanes being built while in flight. An IPO can be an event to pause and clean house from IT systems to security to audits,” Papanek said.

But there are fewer IPOs these days, so companies expect they’ll be staying private longer. During the easy-money days of 2014 and 2015, plentiful capital allowed them to do so.

After the spigot of easy venture capital cash dried up in late 2015, pressure grew on the most promising new ideas to continue to attract capital. That’s been blamed by some observers for decisions to skirt “conventional” regulations (like Zenefits) or to scale by any means necessary to please new investors (like LendingClub).

It’s too easy to blame startup misbehavior on the greatly tightened funding climate or a temptation for their VCs to turn a blind eye, said Ann Skeet, the director of leadership ethics at the Markkula Center for Applied Ethics at the University of Santa Clara.

Skeet said a a friend of hers who is a venture capitalist said one way that “VCs can differentiate themselves is by having an ethical reputation and encouraging ethical practices.”

It isn’t only small, scrappy startups that can run afoul of the many regulations crisscrossing the business world. Larger, more established tech companies can also struggle with these issues.

For example, in the fall of 2014 and the winter of 2015, there were a rash of reports of ethical issues at Uber Technologies. Concerns surfaced about how Uber was using rider data, interacting with the media and treating drivers. The swift backlash is a testament that both investors and consumers generally want to be associated with companies that take the high road in their daily dealings.

“It does suggest that the market is a powerful player in the realm of ethics,” Skeet said.

Peter Renton, who wrote a book about the startup Lending Club, said the scandal at the San Francisco fintech holds cautionary lessons. What happened at Lending Club, which disclosed that it made loans to its ex-CEO and his family members to inflate loan volume, shows that startups should never cut corners, no matter how small they might be at first.

“You just need to look at Lending Club to see the consequences of bad actions,” Renton said. “This has been a wakeup call to the entire fintech sector. Strong internal compliance is no longer something to do reluctantly. It can be a real selling tool, particularly in the online lending space.”

Source: San Francisco Business Times, Riley McDermid
Photo: “VCs can differentiate themselves by having an ethical reputation.” Ann Skeet, Director of leadership ethics at the Markkula Center for Applied Ethics at Santa Clara University. (Todd Johnson, San Francisco Business Times)