Entrepreneurship

Startups
toby JörgFraud. Are
Here’s More Why. Vulnerable
R. Rottenburger
and Lutz Kaufmann
October 12, 2018

Billy Currie Photography/Getty Images

Summary.   Startups are often focused on disrupting existing markets,

occasionally bending the rules while doing so. These 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 them being considerably more powerful
and sophisticated than the startup. Recently, our team interviewed forty 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.
To safeguard, themselves, we recommend that employees of startups make an
extra effort to demonstrate expertise. We also believe that contractual safeguards
should be used by start-ups whenever possible. close
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.

JR
Jörg R. Rottenburger, PhD, is the executive
assistant to the managing director sales and
marketing, at PERI GmbH.

LK
Lutz Kaufmann is a professor of international
business and supply management at WHU –
Otto Beisheim School of Management.