These three startups were recently accused of misstating their financial information, highlighting how little such companies may have to disclose to their VC backers and other investors

Headspin Founders Manish Lachwani and Brien Colwell

Recent alleged financial misstatements at a trio of startups highlights the much lower reporting standards for private companies.
Unlike public companies, private ones aren't required by law to have their results independently audited, and they aren't mandated to release quarterly or annual reports.
What information such companies do disclose to their investors is typically governed by the contracts the two parties sign when investors buy stakes in the companies, but those agreements can allow the companies to limit the information they share with earlier backers or those with fewer shares.
Although financial shenanigans can take place at both private and public companies, the fact that there's less information available to investors about private companies can make it harder for investors to assess their performance, startup experts told Business Insider.
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One of the benefits private companies enjoy is they don't have to follow all the rules that govern publicly traded ones, particularly when it comes to disclosing their financial information.

Those companies' investors may not have accurate or up-to-date information about them — and their management teams might be able to engage in financial shenanigans or even fraud a bit more easily — sometimes causing the investors to take big losses.

That even goes for the expert investors famous for conducting due diligence before they put up millions to fund tech startups — venture capital firms.

In recent weeks, at least three startups have been reported to have engaged in alleged financial improprieties. The CEOs of two of those startups — Trustify and Youplus — have been indicted by federal prosecutors on fraud charges for misrepresenting their companies' financial results. The CEO of the third — HeadSpin — was ousted from his company in May, after its board launched an internal investigation into its financial results, according to The Information.

HeadSpin plans to return to investors $95 million of the $117 million in venture funding it has raised to date, according to The Information's report. It also plans to reduce its valuation by nearly 80%.

Oddly enough, although some of the VC firms that invest in a startup may have the right to review its financial condition and performance, other investors in the same fundraising rounds may not have that access. By contrast, a publicly traded company must reveal its financial condition not only to all its shareholders, but also to the general public.

"Public companies have to put out there to the world lots and lots of information," said Herb Fockler, a partner in the corporation group at Wilson Sonsini, a Silicon Valley law firm well known for working with startups and venture investors. That information has to be audited and corporate leaders face severe civil and criminal penalties if they lie about or misstate it, he said. Compared with private companies, having to abide by such rules "makes it a lot easier to find stuff about public companies," he said.

Although financial malfeasance and misstatements can happen at public and private companies alike, the recent incidents involving HeadSpin, Trustify, and Youplus highlight the different, lower financial reporting standards for startups and other private companies, and the difficulty investors in such companies can face in trying to keep tabs on them. Those differences in reporting requirements have become more important to the public at large as everyday citizens and investors have become increasingly exposed to startups through mutual funds that invest directly in such companies or through pension funds that invest in them by backing venture or private equity funds.

Private companies face less strict financial disclosure laws

Federal laws and regulations require public companies to disclose their results quarterly to the public at large and to have their financial statements audited by independent accountants annually. Such companies have to disclose the results of those audits, including any problems the auditors find, whether in their numbers or in the systems they use to prevent fraud. They also have to disclose to the public in a timely manner whenever they have reason to believe that their financial statements may have significant errors.

The legal obligations for private companies are less strict, less well-defined — and not as well enforced, Fockler said. Federal securities law requires companies — public and private — to disclose "material" information to potential shareholders whenever the companies sell stock, and bars them from making misstatements about it. Certain state corporate and securities laws also require corporations to disclose financial information to their investors.

But what counts as "material" information is fairly vague, Fockler said. Also, private companies generally aren't required to have their financial information audited or to disclose it to the public at large. And such companies often limit access to their financial results to only certain investors.

"I doubt that companies are sending out monthly financial statements to a lot of their investors," regardless of whatever obligations they may technically have under state laws, he said.

Investors and companies are often in a 'tug of war'

Instead, the extent to which startups disclose their financial results, to whom they disclose them, whether they have them independently verified is generally left up to what they negotiate with each of their individual backers, venture capital experts told Business Insider.

Often — but not always — investors will demand to see startups' financial results and even their contracts with clients before giving them new funding.

"Potential investors can ask for anything they want, and companies may or may not give them everything they want," said Sean Foote, a managing partner at Transform Capital. "There's a bit of a tug of war there."

Post-investment financial reporting requirements are typically included in the investor-rights agreements that startups sign with investors when they get new financing. Generally the companies' board members have pretty wide-ranging access to their financial information and records. The contract terms also could require companies to provide to investors things such as quarterly and annual reports and even monthly financial updates. The terms also often require companies to have their annual reports audited.

But those audit requirements are often left out or waived for early-stage companies, the experts said. When a startup has little to no revenue, spending its often limited funding on independent audit usually doesn't make much sense, they said.

"It's just expensive" to get an audit, said Robert Hendershott, an associate finance professor at Santa Clara University's Leavey School of Business. And at young companies, "there's usually not that much going on."

It's much more common for mature startups to have audited financial statements. Typically when such companies have substantial revenue, investors will demand that they bring in accountants to verify their numbers. Audited reports are particularly important for such startups when they are preparing to go public or to be acquired, the experts said.

Some investors can be left out

But even when startups have audited financial information, it's not unusual for at least some investors to have no access to them, or even to the unverified financial updates. Typically companies limit disclosure of their financial information to shareholders who meet certain thresholds in terms of the amount they've invested or the number of shares they own.

Those thresholds usually go up as the company gets larger, raises more money, and new investors are brought in. So, even longstanding investors in the company can find themselves no longer getting updated information on its results.

"Particularly if you're a smaller investor, asking for copies of audited financials is often going be met with silence," said Stephen Palley, a partner at the law firm Anderson Kill, who works with startups and investors.

The thinking behind such limits is that responding to financial information requests from dozens of smaller investors is not worth startup managers' time, the experts said. Instead, such investors are supposed to trust that the board of the company will oversee its managers and make sure they're acting in their interests, and to understand that those managers need some freedom of movement to use their judgement to run the business, Palley said

But the result of such an approach is that in some cases even shareholders with substantial investments in startups can be excluded from updated financial information about them. In one particular case, a startup initially denied access to its financial records to one of Palley's clients, even though the client was one of the company's larger investors and had a stake that was worth more than $1 million.

"It took a lot of screaming and gnashing of teeth" to get the financial information, Palley said.

The lack of information can be costly

The inability of investors to keep close tabs on startups can be costly. In the case of Youplus, federal prosecutors have accused CEO Shaukat Shamim of bilking investors out of $17 million, which he allegedly used in part on personal expenses such as luxury clothing. Prosecutors charge Shamim gave them a fake bank statement that indicated the company had 35 clients and $600,000 in revenue; in reality, according to the Department of Justice, it had just one client and $65,000 in revenue.

Similarly, federal prosecutors charged that Trustify CEO Daniel Boice raised $18.5 million in funding from investors by falsely overstating the company's revenue and the amount of cash it had on hand and understating his own compensation. Prosecutors also charged Boice with diverting "several million" of the dollars he raised for the company to his own personal bank accounts.

At HeadSpin, its board launched an internal investigation in March, a month after it raised $60 million in Series C financing, according to The Information. The board brought in accounting giant KPMG to audit HeadSpin's books and then a forensic accounting firm to scrutinize certain transactions, according to the report. The investigation found that the company had just $15 million in annual recurring revenue last year, despite giving investors a forecast that it would have $100 million, The Information reported.

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