Protecting investors from unlawful behaviour by founders of startups
According to analysts, only 10% of startups are successful. Almost 90% of them fail—20% in their first year. On the record, such failures are often attributed to the founders’ failure to identify the customers’ needs, i.e. a real gap in the market, or blamed on competition and the uniqueness of the service or product. In less guarded moments, e.g. in online forums, much heavier accusations have been levelled against founders, such as the claim that most startups are designed to defraud investors or launder money.
Comments of this sort can be dismissed as penned by anonymous haters and enviers who lacked the ingenuity or courage to make it in business for themselves. And no one can claim fairly that most failing startups involve fraud, embezzlement, or other malfeasance.
Nevertheless, such phenomena do sometimes occur in startups, and can affect a large group of investors.
A startup is an innovative venture
The source of this problem can be traced to the very nature of startups. The prevailing view is that a startup generally operates in new, unexplored areas of the market—a market niche that has not yet been discovered and developed. It is regarded as a venture created to make new products and services under conditions of extreme uncertainty. It is assumed that a startup will create a completely new, unknown market. And as the American expert Steve Blank has argued, a startup is not just a small version of a large company. Many of the methods and instruments for valuing classic corporate forms may not be applicable to a startup, in terms of the adequacy of their market offering, organisational efficiency, the reasonableness of decision-making processes, and profitability of operations.
With this story in mind, it is obviously much easier to convince investors to put up money for a venture that is difficult to market and scale. It is also easier to argue that a startup’s organisational model and production process, how it selects business partners, and its internal management and controls, need to work differently than in a mature company. Investors are persuaded not to be too worried about the possibility of failure by a startup (in business and financial terms), because in principle, making customers aware of their needs and creating a market must consume much more time and resources than expanding in an existing market.
This can create an incentive on the part of startups to take fraudulent actions or obtain funds under false pretences, supposedly raising funds to establish or expand the startup’s activity. This is often compounded by the investors’ carelessness. Contrary to what classic finance theory would suggest, investors in startups often don’t seem like rational actors. Behavioural economists argue that investors often make decisions without using all available information. They are not guided by fixed preferences, and take an inconsistent attitude to risk.
And it should come as no surprise that, as researchers have found, investments in startups carry the highest level of risk and should only be open to experienced investors. There is no shortage of consultants promising to safely guide investors through the process of ex ante controls, rational decision-making on whether to invest in a startup, entering into an investment agreement, monitoring the investment, and exiting it at a convenient time. There are too many examples of how the lust for profit and the desire to take advantage of a “bargain,” along with credulity and wilful ignorance of general correlations between risk and rate of return, have caused investors to turn a blind eye to statistics, fall into a trap, or indiscriminately continue funding a fictitious venture.
Undoubtedly, this all poses a challenge for legal practitioners and the justice system.
When a startup is an economic fraud
In Poland, it seems to be less of a problem for the justice system when economic fraud can be attributed to the “organisers” of startups (Criminal Code Art. 286 §1—we write more about this species of fraud in the article “Identifying and responding to economic fraud”).
In light of the current case law (e.g. Supreme Court of Poland judgment of 21 February 2024, case no. III KK 283/23, and Szczecin Regional Court judgment of 19 July 2022, case no. III K 201/19), obtaining financing or a loan for a startup should be considered fraudulent:
- When it is based on a falsified business plan, seducing investors with a fake picture of reality (e.g. on the amount of revenue that the startup can generate)
- When the business costs are grossly inflated, and the founders are fully aware that the venture cannot feasibly earn a profit
- When some of the obtained funds were used for the startup’s business (e.g. on salary for employees and associates, taxes etc), but only to give the investor a mistaken impression that the startup is conducting a proper business and meeting the targets set out in the loan agreement
- When most of the funds raised were spent contrary to the purpose specified in the loan agreement, typically for the needs of a different entity.
Such activity provides grounds for imposing criminal liability on the perpetrator, but also liability for damages up to the full amount of the financing fraudulently obtained from the investor.
Of momentous practical significance here, it is irrelevant to assessment of the criminal nature of an act defined in Art. 286 §1 of the Criminal Code that the wronged investor did not properly verify the startup’s financial condition, the feasibility of its commercial concept, or its manufacturing capacity. Even extreme irresponsibility on the part of the wronged investor does not defeat the elements of a fraud committed by the “organiser” of a startup. Just because due diligence by the investor would have exposed the founders’ misrepresentation, this does not alter the assessment of the perpetrator’s conduct for purposes of criminal or civil liability for misrepresentation. Thus, under the current case law, even a gullible investor who could objectively be blamed for irrationality or greed has a chance to obtain damages, if the investor was deceived within the meaning of Criminal Code Art. 286 §1.
Mismanagement in a startup
The investor’s situation is much more difficult when the venture fails not because of fraud, but due to mismanagement by the founders, or when the startup’s growth concept promoted by the founders proved to be completely wrong, i.e. when at some point it became obvious that the market was not interested in buying what the startup had to offer.
In such cases, the startup’s organisers will defend against any liability to the investor, pointing to the nature of a startup—namely that in principle it operates in conditions of extreme uncertainty and it could be predicted in advance that there was only a 10% chance of success. The founders will no doubt plead that they acted within the limits of reasonable, acceptable economic risk. And this argument can persuade the court unless the investor presents evidence to the contrary.
So is an investor powerless if it suffered only from the founders’ mismanagement?
The Polish Criminal Code recognises the offence of mismanagement (also called abuse of trust, Art. 296). Such an act can be committed unintentionally (Art. 296 §4), for example through recklessness or negligence (failing to exercise due diligence). It is a defence to such liability to show that the defendant acted within the limits of acceptable economic risk, although such a defence can also be undermined.
Thus, in the Polish legal system, legal instruments do exist to protect investors from the consequences of mismanagement of a startup. But how effective are they? This depends on the facts of the specific case and the investor’s determination to show (with the help of experts in the relevant fields) that pursuing the startup’s business concept would exceed the limits of acceptable economic risk.
This poses a difficult task for the justice system, but hopefully the courts can handle it. As we can see from the cases cited above, the courts are beginning to recognise the nature of startups, along with the need to protect investors’ legitimate interests.
Adam Studziński, adwokat, Jan Ciećwierz, Dispute Resolution & Arbitration practice, Wardyński & Partners
