Are you keeping up with the news story about the prominent college athlete who was either cruelly duped by a perpetrator pretending to be his girlfriend or who conspired with the perpetrator to generate publicity for his gridiron career? Assuming the football player’s version of events is the correct one, at what point should he have suspected his virtual girlfriend to be imaginary? Perhaps we will never know what happened here and I don’t pretend to know what happened; however, I do believe that distinguishing between ‘what is real’ and ‘what is not real’ can be extremely difficult for entrepreneurs who tend to be very optimistic people. Being an optimist is a great strength! Optimists move forward with their ideas and business ventures despite encountering a myriad of naysayers along the way. Being an optimist can also be a humbling weakness. Optimists can be easily duped by others if the appropriate safeguards are not in place. The football story reminds us of the vulnerability that business owners and investors face when entrusting others with their cash.
The cost of business fraud is enormous. According to one study, “Fraud eats up 5 to 6 percent of a company’s revenue each year and hits small businesses the hardest.”[i] Another study determined: “Small firms can suffer more than their giant counterparts. A 2012 study by the American Association of Certified Fraud Examiners (AACFE) found that businesses with fewer than 100 employees that were affected by fraud suffered a median loss of $147,000, compared with $100,000 for companies with 1,000 to 9,999 employees.”[ii] As a CFO who typically works with privately held, family-owned businesses, I have seen my share of business greed. These cases often involve embezzlement and misappropriation. What hurts most is the perpetrators are usually caught too late and they are rarely punished. The victim, sometimes a business owner and sometimes an investor, is left holding the bag – an empty money bag I might add! It can take a long time to financially catch up from a bad situation. Here are two recent, personal experiences of business fraud:
An interior design company was positioned to grow its customer base. The ownership team hired a confident bookkeeper to manage the financial records. He was well compensated and highly trusted. After several years of his involvement, I was asked to provide strategic oversight to the company. To gain a clear understanding of the financial condition, I convened the team regularly to discuss finance structure and performance. During the meetings, the bookkeeper agreed to action items, but would not complete those items afterwards. He defended his inactivity with excuses. Eventually, the ownership team became very frustrated and investigated the bookkeeper’s workspace. They discovered the bookkeeper had been embezzling company funds by creating expense reimbursements to fictitious vendors. It was also learned he spent a good portion of his workday surfing inappropriate websites. A difficult situation could have been averted if only the proper controls had been in place. The bookkeeper was fired, but the damage had already been done. The President suffered financial losses and, for a long time thereafter, suffered from an inability to trust anyone else with her books.
A specialty electronics retailer was anxious to grow its number of nationwide locations. To open each new store, the management team, which consisted of the majority owners, sought investment dollars from investors whose individual store investment was rewarded based on that store’s performance. The management team aggressively committed to a growth plan that relied on new stores being routinely added and every store being profitable; the only problem was only half of the stores were profitable. The company was bleeding cash. Investment dollars were routinely misappropriated to cover store losses, fund project overruns, and pay excessive management salaries. This comingling of funds made it difficult for the management team to keep agreements with the investors who had invested in profitable stores. Dividends were owed, but cash was insufficient to pay the dividends. A growing chorus of impatient investors wanted to understand why their dividend checks were not forthcoming. Once the facts were on the table, the investors, some of whom were attorneys, threatened to file criminal charges against the management team; ultimately, the investors took control of the business.
The examples of business fraud are plentiful. What can business owners and investors do to minimize the likelihood and severity of financial fraud? They should create an environment that includes a mix of fraud controls in the areas of employee due diligence, bottom-up accountability, top-down oversight, and risk mitigation:
- Employee Due Diligence—runs a background check on new hires. Interviews past employers. Look for inconsistencies on resume. Avoids hiring the cheapest resources on the market. Enforces company policies on drug screening, internet usage, etc.
- Bottom-Up Accountability—creates and enforces finance department procedures that focus on maintaining transparency, separating work duties (invoice entry, check writing, vendor/account reconciliation), and building employee competency. Outsources transactional and reconciliation work.
- Top-Down Oversight—ensures clear cash oversight comes from the top. What checks did I write? To whom? Was there anything unusual to investigate? Uses 3rd parties to review the books and look for fraud.
- Risk Mitigation—considers purchasing employee theft insurance.
As an entrepreneur, or as one who works with entrepreneurs, you have every right to be optimistic about the future! Just remember to temper that optimism with pragmatism because when money comes along, greed may soon follow. We would like to hear your experiences with business fraud as well as any safeguards that you have put into place.