Startups Are More Vulnerable to Fraud. Here’s Why.

In the wake of the Theranos scandal, some commentators have asked whether entrepreneurial companies are particularly inclined to deception and downright fraud. Startups are often focused on disrupting existing markets, occasionally bending the rules while doing so. Their employees need to overcome demanding challenges, including the need to draft processes and responsibilities from scratch. In short, countless firms face strong pressures and tempting incentives to deceive.

But are they also more likely to be deceived themselves? After all, they have to forge business relations with potential customers, suppliers, and investors, all of whom are considerably more powerful and sophisticated than the startup. Recently, our team interviewed 40 founders and venture capitalists and conducted two experiments to uncover whether startups, compared to more mature firms, are more likely to be the victims of fraud.

In our experiments, performed with Christian Schlereth at WHU – Otto Beisheim School of Management and Craig R. Carter at Arizona State University, we simulated a negotiation episode between two firms. The buying firm, a tablet manufacturer, was interested in procuring an innovative hard disk drive model. We recruited 250 experienced purchasing and sales managers and allocated them between the experiments. In one, participants were sellers for the hard disk maker. In the other, participants were buyers for the tablet manufacturer. We divided each study’s sample into three sub-groups: We informed the first group that the firm they were negotiating with (that is, their counterpart’s employer) was a startup. The second group was negotiating with a mature firm. The third group did not receive any information regarding firm age (our control condition).

During each experiment, participants first read a short case describing the negotiation parameters, the negotiators’ role, and their task (experimental vignette methodology). Subsequently, they received a message from their negotiation counterpart (which had actually been written by us; all participants within a given study received exactly the same message) and needed to select one out of several response options. Among these options was a non-deceptive message as well as deceptive ones.

Roughly 50% of the participants negotiating with a mature firm deceived. A similar proportion of participants in the control condition did the same. But when we told participants that their counterpart was working for a startup these numbers skyrocketed. Two thirds of the buyers and almost three in four sellers opted to deceive the startup.

In order to help startups to guard themselves against deception, we set out to identify the causes of this spike in deceptive behavior. Did the notion of startups as rule-breaking entities, promoted by incidents such as the Theranos fallout, encourage participants to deceive them? This effect was indeed visible in our data, but played only a minor role. Simultaneously, we asked participants how experienced they perceived their negotiation counterpart to be, and found a striking difference. Albeit the (scripted) counterpart behaved in exactly the same manner towards every participant, participants believed that the counterpart was less experienced when she was working for a startup. In other words, participants used the newness of the counterpart’s employer as proxy for the counterpart’s experience – and adapted their behavior accordingly. This prejudice puts startups at a considerable disadvantage. In short, highlighting firm newness is a signaling strategy that can backfire, as others subconsciously regard such a message as invitation to deceive.

Instead, we recommend that employees of startups make an extra effort to demonstrate expertise. But how best to do this? Many startups attempt to hire renowned industry experts to gain legitimacy. Such hiring decisions lead to positive legitimacy spillovers from the new hire to the startup. However, they also cause negative spillover effects: Due to the startup’s lack of legitimacy, the new hire’s personal legitimacy, as perceived by others, suffers. It gradually recovers as the startup strives to become a fully established industry player.

We also believe that contractual safeguards should be used by startups whenever possible. Compared to more mature firms, the pool of potential business partners is considerably smaller for startups. Thus, many cannot afford to turn down offers even when they are not fully convinced of the veracity of their partner’s statements and promises. In such situations, contingent contracts and other contractual safeguards can serve as remedies.

Startups rightly face increased scrutiny when negotiating with partners because of their perceived “fake-it-till-you-make-it” ethos, especially in the light of several recent high-profile scandals. But our research suggests that, if there is to be fraud during a negotiation, it is new companies that are more likely to be the mark—and should they take steps to safeguard themselves accordingly.