The customer is always right—especially when it comes to due diligence

September 23, 2020 | By Patrick T. McCloskey

Last week Adam Rogas, a co-founder and the former CEO of NS8, Inc. (“NS8”) was charged with securities fraud for allegedly falsifying customer revenue spreadsheets and bank statements, thereby allegedly causing grossly inflated financial statements to be provided to the investors in two private placements that raised total gross proceeds of $123 million.

According to the civil enforcement complaint filed by the Securities and Exchange Commission (“SEC”) and the criminal complaint filed by the US Attorney’s Office, although due diligence for the second offering (i) uncovered a discrepancy in the total balance of an NS8 bank statement and (ii) included a physical site visit at NS8’s offices to verify bank deposit balances, the alleged falsifications still managed to elude detection until after the closing of the second funding round.

The charges filed against Rogas are the latest allegations in what seems to be a disturbing trend of brazen frauds involving inflated customer revenues to attract investments in private securities offerings.

Just months ago, civil and criminal securities fraud charges were filed against Shaukat Shamim, the founder of YouPlus, Inc. who is alleged to have provided a venture capital fund with falsified bank statements to show deposits that purportedly came from paying customers. According to the SEC’s complaint, the falsified bank statements were sent in response to a follow-up request seeking to substantiate financial information that was previously provided.

Four days after the charges against Shamim, Daniel K. Boice, the founder of Trustify, Inc., was charged with civil and criminal securities fraud for allegedly providing false information to investors related to Trustify’s customer revenue and client base. The SEC’s complaint specifically alleges that after Boice told a venture capital fund that an established investment bank would be the lead investor in a Series B round, Boice allegedly caused a fake email, purportedly coming from the managing director of the investment bank, to be sent to the venture capital investor.

In all three of these cases, the proverbial antennas seemed to be up, but falsified documents obscured detection of an exaggeration of customer data, a critical focus for investors.

In Angel Investing—Start to Finish, co-authors Joe Wallin and Pete Baltaxe explain that “[e]ntrepreneurs know how important customer traction is to investors, so the pressure to present numbers in a positive light can be extreme.” Taking this phenomenon into account, early stage investors and their financial advisors should give customer revenue special attention as part of their business due diligence.

Wallin and Baltaxe devote an entire section on business diligence for customer traction, but one particular component should be especially helpful in this context: customer interviews. Although early stage customer diligence is typically done to assess a startup’s prospects and potential, it may also be helpful in smoking out shenanigans on inflated customer revenue, especially in extreme cases.

As the expression goes, the customer is always right. A significant customer should be able to confirm not only the amount such customer has paid to a startup for products or services, but also when it made those payments. This data can then be cross-checked with deposits reflected in the startup’s bank statements and then reconciled with the applicable financial statements. While communicating with key customers may not tick and tie every dollar of customer revenue, it should help reveal material discrepancies in this area, especially for startups with high customer concentration.

As Wallin and Baltaxe acknowledge, founders may be reluctant to put prospective investors in direct contact with their customers during business due diligence. The co-authors offer guidance on how to deal with this resistance, but another method may prove useful for a prospective investor: ask the founder to peruse the above referenced complaints and then ask whether they blame you.

This post is for general informational purposes only and does not constitute legal advice. No one should rely on the information in this blog post without seeking appropriate legal, accounting, tax or other appropriate advice from an attorney, accountant or other professional properly licensed in the applicable jurisdiction(s).