Trust but verify is a method that most VCs use when deciding which companies to back, writes Daniel Gusev, Partner, Gauss Ventures.

Applying this process isn’t always easy – especially in the world of financial innovation. This is a sector which is overcrowded with both new ideas and charismatic entrepreneurs that don’t think twice about talking up their unicorn status potential while simultaneously concealing serious weaknesses to their business model. 

Sometimes VCs get caught up in the excitement of backing a company and choose to ignore warning signs.  Unwise decisions are made and due diligence is bypassed, leading to economic and reputational repercussions that have lasting  effects on both the investment community and the fintech ecosystem.

A case in point is the Wirecard scandal. The German payments processor was once the superstar darling among investors and analysts for its perceived, unassailable growth. In just over a decade, the firm transformed itself from a minor fintech player to one of Europe’s biggest and most impressive companies.

Yet behind the figures and great PR were a series of fraudulent activities that eventually came to light with help from a team of investigative journalists at the Financial Times. What is truly remarkable is that despite long standing rumours and ongoing regulatory probing surrounding Wirecard’s dubious accounting, there were investors still ploughing money into the firm.

For example, in April 2019, SoftBank Group injected €900 million into Wirecard to help the fintech expand into Japan and South Korea, as well as create and provide key financial services for its impressive list of portfolio companies, which included superstars like Uber, OpenDoor Labs, WeWork, Alibaba and more.

SoftBank’s investment came at a time when Wirecard was embroiled in controversy. While making plans to expand into Asia, Wirecard faced an inquiry in Singapore over fraud allegations in the region – as well as in Germany.

Of course, the fintech firm denied the claims, but why did SoftBank look the other way when it knew that an investigation was underway ? No doubt it was eager to cash in on the potential of this perceived European unicorn, and blatantly ignored the warning signs. The rest, as they say,  is history.

After declaring its financial results in mid-June and announcing that the €1.9 billion that had gone missing from its balance sheet didn’t actually exist, Wirecard’s fraud was exposed and the firm was finally held to account. Intense scrutiny from prosecutors led to the eventual resignation and arrest of its CEO.

Wirecard’s repercussions will be heard for years, where exchanges allowed a traded company to repeatedly deceive investors with fraudulent data that was never checked. In part, one can dismiss this as a single event, but it happened during an unprecedented rally where fintechs were born to right the wrongs of the old guard – as Wirecard was lauded for its appearance on the DAX index and moving above Commerzbank – a venerable institution.

At the same time other fintechs competing with Wirecard often raised concerns that the data did not add up.

Checkout for example looked conservatively at Wirecard announcements – and rightly so. Where Wirecard was publicly audited, Checkout is still a privately owned company. Hence, it’s not the regime required by an exchange or having a leading audit firm that guarantees a no-risk outcome – but understanding the gritty details of the business the company is in – that raises or settles down suspicion.

Performing due diligence on investments

Most fintechs being unregulated entities up to a moment, provide semi-transparent documentation. In this case a VC has to rely on the judgement of the soft qualities of the team and the hard qualities of the market the company is targeting – and that of its legal counsel to check the legal documentation drafted for the round.

We try to follow our hard earned experience to check the story and add up with every investment we make. We also learn from our mistakes where additional scrutiny should have been appreciated and update our due diligence processes accordingly.  The VC domain attracts countless new companies and to efficiently process those we work with, we follow this step by step procedure:

• Maintain a checklist for first conversations you have and a detailed due diligence process for those companies you are interested in

• Have a great relationship with your legal counsel – whose judgement you rely on in drafting or adjusting documentation

• Return regularly on a monthly basis to check progress companies make

• Verify based on our understanding and knowledge of the domain – so tend not to invest outside of the world you believe you know

As fintech investors, we are passionate about nurturing great innovation, but we also know that creating a sustainable and successful company requires more than just smart ideas and charismatic leadership.

There must be transparency and a reality check in respect to what is truly achievable and beneficial to industry and consumers.

Wirecard’s disrepute has dented the reputation of fintech to some degree. After all, this is a sector that is meant to replace the traditional world of financial services with one that is better, more transparent and relevant to consumers and institutional clients.

If we want to preserve what fintech truly stands for – due diligence must always be at the heart of every investment decision we make.

By Daniel Gusev, Partner, Gauss Ventures.

Follow Gauss Ventures on LinkedIn and Twitter.

Gauss Ventures is a UK-based venture capital firm investing in early-stage fintech and data economy industry firms.