Fake Customers & Investor Lawsuits

Hey y’all — everyone’s talking about the improved image generation capabilities in ChatGPT, but that’s not actually the most interesting startup story of the week.

This is:

11x, a high-flying AI SDR startup that landed a $50M Series B from a16z last fall, allegedly inflated their ARR and flat out lied about having certain companies as customers.

I take everything on TechCrunch with more than a few grains of salt, but they are now reporting that a16z is allegedly considering taking legal action (they’ve denied it), which would be an almost unbelievable step for one of the most founder-friendly big firms in Silicon Valley.

The whole thing is pretty wild (especially if it’s all true), and touches on some important questions about founder morality, and what justifies an investor to turn on a founder.

Let’s dig in…

Fake Customers & Investor Lawsuits

What (Allegedly) Happened

There are two main pieces here:

1. 11x claimed it had customers it did not have (and used their logos on its site)

2. 11x’s reported ARR may have been inflated due to how they structured their contracts with customers

Then there are other allegations of things like an intense work environment, high churn, and a poor quality product which are more disputable. We won’t explore those.

The concern about logos seems pretty clear cut — 11x listed ZoomInfo and Airtable (at minimum) as customers in various places on its site. However, both only took part in short trials and churned.

Bad and unethical, yes, but likely able to be attributed to human error (you’re not updating the homepage every day). So, why is ZoomInfo threatening to sue?

Well, they allege they’ve been telling 11x for four months that they do not give them permission to use the logo or list them as customers… this quote from ZoomInfo is pretty aggressive:

You’re not going to get called out for something like this if you’re a tiny company, but if you raise over $50M then you have to expect folks at ZoomInfo are getting questions from friends about their experience using your product, leading to confusion.

The ARR piece is a little more complicated but still seems clear cut. Here’s a great post from a former customer on what they were doing.

Basically, they only signed customers to annual contracts and included an opt-out clause after 3 months.

This meant that, once they announced their Series A (led by Benchmark) they likely received a ton of new customers and got to count these annual contracts as ARR before the customers had the option to churn, leading to an insane growth rate that prompted a quick Series B.

They allegedly did not separate the revenue from people within the pre-opt-out period from the actual customers who were enjoying the product, and instead used a metric called CARR (contracted ARR) as a catch all, but say that investors were given the option to review all finances.

So, for example, CARR might say $14M but only a few million of that had passed the 3 month mark.

I won’t speculate on what was or wasn’t shared with investors and, again, my first assumption of most stories about startups from trad media publications like TechCrunch that are not actually written by tech / startup people is that they are hit pieces, but one ex-employee did say they were “absolutely massaging the numbers internally” so who knows.

What’s Fair for Founders?

Last summer I wrote about whether founders are allowed to lie or not.

The initial reaction is “of course not!” and while there are ethical lines you don’t cross, a lot of getting your company off the ground happens in somewhat of a grey area.

There are basically three rules:

1. You can’t push over the invisible line (Elon is a master at avoiding this).

2. You can only exaggerate in certain ways but not others (a Theranos-style lie is not ok).

3. Your reasoning for lying must be authentically that you’re trying to make the future real (who’s the judge of that is left up for debate).

The last rule is key.

Here’s an example.

In 2016 Amazon launched some grocery stores called Amazon Go where you could just pick up your items and walk out. I went to one in Seattle. It was weird but honestly great. No lines.

The implication was that the cameras in the store were hooked up to an AI system that charged your Amazon account automatically based on what you left with.

Well… in reality it turns out it was pretty much just a lot of people in India manually labeling the video feeds and processing the payments.

Their marketing around it being AI was a lie.

But it was ok. No one organized an Amazon boycott after finding out a few years ago.

Why? Because it was effectively an MVP where they were testing whether the store concept itself was viable. If the answer was yes, they’d invest in building the (likely quite expensive at the time) AI-powered system.

It didn’t violate rule #3.

In 11x’s case, as their profile grew, the logo issue pushed over the invisible line and the CARR issue likely violated rule #3.

Is It Ever Justified For Investors to Sue Founders?

The other big question from all this is whether a16z (and other investors) would be justified is taking legal action against 11x due to the allegedly inflated ARR, or anything else.

I’d bet that a change in executive leadership is more likely than any legal action.

a16z’s reputation, and my own experience working with them through crises, is that they back founders they believe in 100%.

And, even if 11x did defraud them, venture firms so rarely sue their own portcos that the reputational hit a16z would take by taking action likely doesn’t come close to what they’d earn back.

So basically, it might just be a quick $50M write off. But, when you’ve got $42B AUM, you can afford that way easier than a hit to your brand.

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