Once Bitten, Twice Shy: Evidence from Venture Capital and Scam Startups

Abstract

Scam startups are on the rise in recent years. However, little is known about the impact of those startups on venture capitals’ (VC) investment activities. In this paper, we first construct a novel dataset of scam startups using the release of news from the Securities and Exchange Commission (SEC) and the U.S. Department of Justice (DOJ). We then investigate how venture capitalists react after they are cheated by scam startups using a difference-in-differences framework. The main finding is that VCs update their beliefs on new startups after the scams outbreak because the bad signals have been released. VCs reduce investments in new startups and the number of deals compared to a control group of VCs that have not been cheated. The effect is mainly driven by a decline in investment in the industries of scam startups. VCs strengthen screening and monitoring process afterwards. We also find that limited partners (LPs) provide less capital to VCs after they financed a scam startup.