The VC legal arsenal to combat entrepreneurial fraud

This article was co-authored by Jeremy Lua and Rebecca Tan.

Driven by the recent eFishery scandal and shifting market conditions, early-stage investors are changing their approach to due diligence and risk tolerance. The venture capital industry appears to be course-correcting, with prominent firms committing to instituting measures to combat fraud.

Drawing on our extensive experience advising investors through fraud cases across Southeast Asia, we outline some practical legal safeguards that investors can implement to protect their capital.

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In an environment where even seasoned investors can get blindsided, these frameworks provide both armor and visibility.

Spotting red flags

A 2024 study found that 84% of fraud cases globally exhibit early telltale signs such as:

• Inflated or fabricated metrics: Be wary of performance indicators – e.g. customer numbers and revenue – that seem too good to be true. Verify metrics through third-party data or direct customer sampling.
• Delayed or incomplete financial reporting: Watch out for poor practices like relying on basic accounting software or a one-person finance department to manage large businesses. If a startup resists or delays sharing full financials or only offers “adjusted” figures without backup, consider hiring a third-party accountant to review the books.
• Weak governance and oversight: Overreliance on founders without checks and balances often leads to bad decision-making. Warning signs include a lack of independent directors with subject-knowledge expertise, the absence of an audit committee, and an inexperienced chief financial officer – or worse, no CFO at all.
• Conflicts of interest: Ask founders about any undisclosed conflicts and scrutinize financial records for related-party transactions. Consider talking to early former employees, who can be the sources of candid information.
• Fabricated founder credentials: Founders exaggerating their education, experience, or achievements point to broader ethical problems. Verify their credentials thoroughly – if necessary, contact universities and past employers.

Deal structuring

Investors should capitalize on the current investor-friendly climate to secure stronger safeguards in term sheets and investment agreements that can span the entire life cycle of a startup.

See also: The VC playbook for managing investor relations

However, forcing tough terms on founders can erode trust and dissuade them from sharing the challenges they face. A balanced approach that is assertive yet respectful keeps communication lines open and encourages long-term cooperation.

Capital protection

Investors should prioritize the following safeguards:

• Liquidation preferences ensure investors recoup capital first in the event of bankruptcy or a fire sale.
• Anti-dilution protections prevent dilution of investors’ equity stakes in down rounds.
• Veto rights grant investors the ability to block major decisions such as new share issuances or large acquisitions that could significantly affect the company’s value or risk profile.
• Drag-along rights facilitate easier exits for lead investors by preventing minority shareholders from blocking a potential acquisition or merger.
• Pro-rata rights allow existing investors to maintain their ownership stakes during subsequent funding rounds.
• Regulatory ripcords enable investors to exit or restructure investments when significant regulatory changes occur.
• Escrow accounts hold funds in reserve until key milestones such as user growth are verified.

Governance, audit and information rights

Post-investment best practices

Remediation and recovery

Better than cure