The high-profile case of AI startup Joonko and its founder, Ilit Raz, who raised approximately $27 million based on misleading information and forged invoices, demonstrated that exaggerating business data is no longer merely a marketing tactic, but has turned into criminal prosecutions threatening founders with lengthy prison sentences. With the rise in AI-related securities class action lawsuits, investors and regulators have become much stricter in scrutinizing the fine line between future projections and current facts.
Where Does Usual Promotion Cross the Line into Fraud?
This is not about how ambitious pitch decks are, but rather about the presence of deliberate misrepresentation in facts and figures that directly impact investors' decisions. The most prominent gray areas that cause confusion among founders include:
- Letters of Intent and Trials: Labeling non-binding letters of intent or unpaid free trials as "confirmed recurring revenue" or "signed enterprise contracts."
- Customer Counts: Counting free trial users or unofficial test accounts among the active, paying customer base.
- Growth Metrics and Retention Rates: Omitting significant customer churn or presenting one-time project fees as recurring revenue.
- Product Capabilities: Promoting partially human-supported workflows as fully autonomous artificial intelligence systems, or claiming proprietary technologies that the company does not actually own.
Limitations of Protection in Directors and Officers (D&O) Insurance
Founders typically rely on Directors and Officers (D&O) insurance policies to defend themselves against investor disputes; however, defending against fraud allegations is fundamentally different from covering intentional misconduct. Three essential clauses require careful attention in insurance policies:
- Fraud Clause: Most policies exclude losses arising from deliberate fraud, criminal behavior, or obtaining illegal personal profits, noting that mere allegations do not automatically trigger these exclusions.
- Final Adjudication: Insurance companies may fund defense costs during the proceedings; however, a founder's guilty plea or a judicial conviction may trigger cancellation exceptions depending on the policy wording.
- Clawback Clause: Some policies grant insurance companies the right to recoup advanced defense costs if the lawsuit is ultimately dismissed based on proven fraud.
Practical Steps to Avoid Legal Liability
Before presenting any investment proposals, startup teams should adopt precise mechanisms to regulate and accurately document data to ensure complete transparency before investors and regulators.
- Establish an internal, documented guide for the team that clearly explains how metrics are calculated, strictly distinguishing between paying customers and trial users.
- Continuously collaborate with financial and legal advisors to link claims to actual supporting records, including contracts, invoices, and customer status reports.
- Completely separate actual Annual Recurring Revenue (ARR) from collected cash or unactivated contractual obligations.
- Regularly date figures and update material changes before investors rely on them to make decisions.