For small and mid-sized businesses, the vulnerability to fraud can be compounded because of the sometimes informal nature of the organization and the fact that fewer staff members can result in less oversight — and a lack of checks and balances. Most of the handbooks for entrepreneurs stress the importance of making the right hiring decision. Basic pre-employment background checks are recommended for any employer especially for those employees who will be handling cash, receivables and merchandise of value. But what if one’s vulnerability stems from a key hire who shows no such history of dodgy dealings and is assumed to be trustworthy in all respects?
Startups are especially vulnerable particularly in the early stages of their formation. According to the Association of Certified Fraud Examiners (ACFE), companies with fewer than 100 employees lose an average of $154,000 as a result of fraud each year (when fraud is perpetrated). 88 percent of U.S. companies that reported some type of fraud also reported declines in financial performances. In addition, three-fourths of the crimes against businesses in the U.S. were carried out by insiders.
For some it can be worse; it can take down your entire business. This is what happened to Elizabeth Vargas, CEO and Founder of Edge Music Network (EMN), a Newport Beach, California-based music video streaming service delivering on-demand video content through a syndication platform. She knows the harsh reality of being taken advantage of by internal employees, having been forced to restart her business from the ground up. Today, Vargas has risen above the setbacks and has built a cutting-edge platform that is set to make its mark in one of the world’s most valuable industries—but her journey was not without the challenges of devastating theft, intellectual property infringement and fraud.
Not being a technologist herself Vargas hired a chief technology officer (CTO) when she launched the firm in 2011 to design and architect her music video platform and to hire the needed partners to execute the platform. She drew no salary. Unbeknownst to Vargas the CTO set up his own shadow company which he used to manipulate transactions and siphoned fees and payments. It took two years for the fraud to be detected forcing Vargas to scrap most everything and restart the business with a platform that was not encumbered.
“One of the first steps to preventing fraudulent employee behavior is to make the right hiring decision.”
“I paid this CTO a very large salary—$20,000 a month; he was the highest paid person of my seven person team. I trusted him with all the pass codes to all the servers we employed. My CPA paid invoices he submitted not aware that many of these contractors were companies that he owned,” said Vargas, who added that the amount stolen over two years amounted to $600,000. “I kept asking for my passcodes which he wouldn’t give me,” she added. That led to an audit and to his eventual dismissal, but not before a final indignity. Technically a contractor, not an employee, the CTO produced detailed logs of his hours worked and claimed Vargas’s firm had violated IRS rules for engaging contractor services. He demanded $150,000 for alleged violations which he threatened to take to the IRS. On advice from legal counsel she paid the sum to be rid of him. In the months following he contacted every one of Vargas’s linked-in contacts seeking work. She wrote to each of these telling them of her bad experience.
Putting humpty dumpty back together was not easy. Vargas lost several financial investors whose confidence in her was shaken. She flew to China with a new proposal to meet an investor who had promised only a 15 minute interview. He liked it enough to offer seed money to start afresh. Upon her return to California the first thing she did was to hire a reputable CTO to help re-architect a better technology platform.
“I set an Upwork program that manages all one’s contracts. I learned the ins and outs of the technology I sat next the new CTO asking every question about how the system works I hired new lawyers to better protect myself and hired marketers to rebuild our brand,” she says. In learning about the new streaming platform she also learned about transcoding and discovered that the former CTO had been getting kickbacks from contractors who were not only overcharging for the transcoding but were pitching him ideas which he bought with her money but which he used for his shadow company.
When asked whether the fact that Vargas was a woman entrepreneur who may have known her market but not the underlying technology was a factor in the fraud, Vargas responds,” I hesitate to bring that up because I never want to be that woman, but I cannot discount that. The men who were signing contracts with my former CTO were probably laughing their asses off. I remember one conversation with a supplier that was condescending. I told him you cannot speak to me this way, I pay your bills.”
Undaunted, Vargas reckoned that the best revenge was to pull off a successful relaunch which took place in January 2015. EMN subscribers have grown from nothing to 35,000 monthly, the company has an exclusive rights for Universal Artists and the company depends upon subscription and advertising revenue, some of which is Google-dependent. Ten percent of bottom line profits are dedicated to charity. The company is breaking even at present but revenue is expected to grow as the number of millennial subscribers increase. “We are very lean and agile compared to other streaming companies,” she says. “What happened to me is not that unusual. I have spoken with many entrepreneurs who have had similar devastating setbacks. I am hoping that my experience will guide others. Sometimes when you hit bottom that’s the best place to be in order to pick yourself up and go forward.”
Some of the lessons learned for small and medium business owners include:
- Know the business inside and out. There is no substitute for being eternally vigilant, knowing every aspect of how the business functions and how the revenue model works.
- Hire for character as well as talent. One of the first steps to preventing fraudulent employee behavior is to make the right hiring decision. Basic pre-employment background checks are a good business practice for any employer, especially for those employees who will be handling cash, high-value merchandise, or have access to sensitive customer or financial data. It isn’t foolproof as Vargas’s experience attests, but see No.1.
- Conduct internal audits and surprise audits. Work processes, inventories, and accounting should be subject to regularly scheduled and announced internal audits. In addition, unscheduled — or surprise — internal audits also should be conducted. Work processes, inventories, and accounting can be altered in advance of regular audits, but knowing a surprise audit may occur removes temptation and increases the chance for fraud detection.The key to retaining these employees is identifying the warning signs early and taking a proactive, rather than reactive, approach to improving the employee experience within your organization.
- Employ external auditors. At a regular interval, external auditors should be employed to review company accounts, contracts, and inventory and work processes. This may be required by law, but it makes sense to set up external audits early in the history of your business so compliance with applicable laws and regulations can be achieved as your business grows. Fraud and loss come in different forms, such as chargebacks, merchant-identity fraud, buyer-identity fraud and merchant-credit risk. Attacks can also come from fraudsters who masquerade as legitimate buyers and sellers.