Investors are often criticized for their role in start-up scandals.

• Not long before being engulfed in scandals, high-profile start-ups like Theranos and WeWork received inflated valuations from their investors.
• The financing of so-called unicorns has come under scrutiny due to the debacles and other issues that have arisen, prompting questions about whether investors are adequately evaluating these companies.
• A proposed reform suggests that start-ups should allow limited outside investment trading before going public, promoting transparency and exposing companies to market scrutiny.

Prior to Theranos' collapse due to the disclosure that its main technology was not functioning as promised, investors had placed a staggering $9 billion valuation on the company.

In 2019, Adam Neumann's office-sharing start-up faced a wave of scandals and its valuation was subsequently lowered from $47 billion to an undisclosed amount.

What led sophisticated venture capital firms, hedge funds, and money managers for prominent American families to get their investor bases so wrong?

Private companies are not thoroughly investigated, and there is a lack of transparency, according to Matthew Wansley, an assistant professor at Yeshiva University's Cardozo School of Law in New York, in an interview with CNBC's "American Greed."

According to Wansley, an expert on venture capital who previously worked as general counsel at a start-up, investors often face a reverse incentive to do too much digging before writing a check. If they ask too many tough questions, they risk losing money on their investments or getting shut out of a current or future funding round.

When a start-up attains "unicorn" status with a private market valuation of $1 billion or more, it becomes even more challenging, as it starts attracting the attention of a broader group of investors.

Wansley stated that if a company is highly sought after for investment, one way to gain an advantage over investors is by requesting less stringent due diligence.

That, in turn, can feed a founder’s worst impulses.

Wansley stated that if you work at a private company and fewer individuals are monitoring your actions, it becomes easier to hide wrongdoing and do so for an extended duration.

WeWork gone wild

Few start-ups have taken that to more of an extreme than WeWork.

The publicity of Neumann's extravagant lifestyle, which included owning six homes and using a $60 million Gulfstream jet for surfing vacations, nearly destroyed WeWork. Despite never being charged with wrongdoing, the revelations about his lifestyle were damaging to the company.

Journalist Maureen Farrell, co-author of "The Cult of We," stated in an interview with "American Greed" that his hairdresser would fly around with him. She added, "It was just a level of extravagance that's kind of unimaginable, even for a paper billionaire."

In 2017, the extravagance of the company took off after receiving a $4 billion investment from Japanese conglomerate SoftBank and its billionaire founder, Masayoshi Son. Ultimately, SoftBank would invest some $18.5 billion into the company.

Neumann later admitted that the investments went to his head.

Neumann stated on "Squawk Box" that the valuation was another way for people to confirm that they were correct, as he told CNBC's Andrew Ross Sorkin at the New York Times DealBook Online Summit in November.

Son eventually turned against Neumann and orchestrated his removal as CEO. SoftBank rescued WeWork with a bailout, retaining its largest shareholder status at the time of its IPO in October.

The $47 billion valuation of WeWork, primarily due to SoftBank's investments, has significantly decreased to less than $7 billion. Despite not yet achieving profitability, WeWork recently announced that it will have to revise its financial statements for the sponsor of the special purpose acquisition company that made it public.

Despite the outcome of the deal, Son still believes in Neumann and considers his investment "foolish." SoftBank has a long way to go to recoup its losses.

Playing the odds

"I am responsible for his mistake, but I still love and respect him, and I believe he will return to do great things," Son stated at the DealBook Summit in 2020.

As for the loss on WeWork, Son was taking it in stride.

Fortunately, we possess additional victories, which means our overall score remains positive.

Wansley stated that the issue with the current start-up financing model is "asymmetric risk."

Wansley stated that out of the 20 companies in the portfolio, approximately 18 of them are unlikely to achieve success. Having one or two companies that become hits can make the entire portfolio successful, as the gains from those companies can offset the losses from the other failures.

Wansley suggests an alternative approach to securities laws that would allow limited trading in start-up shares and require more public disclosures, thereby exposing companies to market scrutiny.

In a recent academic paper titled "Taming Unicorns," he presented an argument.

The proposed reforms would encourage robust trading in unicorn securities among accredited investors, thereby increasing the deterrence of unicorn misconduct, while safeguarding retail investors and companies that prefer to maintain concentrated ownership.

Although Wansley recognized that his model would not eradicate misconduct, he stated that it would enhance transparency. Notably, many of the most significant corporate scandals in history have involved publicly traded companies.

Wansley's paper has received positive feedback from venture capitalists since it would allow them to cut their losses by selling their shares if an investment is going badly.

Despite some indications that a change may be imminent, there are still few signs that the current model will shift.

Nearly $330 billion in venture capital investments were made in 2021, which is almost double the previous record set in 2020.

Despite high-profile debacles like WeWork and Theranos, the investment community is not showing any pause in their numbers.

The article has been revised to confirm that WeWork did not pay for Adam Neumann's homes or private jet.

Adam Neumann, the founder of WeWork, is enjoying fame and fortune while investors remain oblivious and employees are left to bear the brunt of the consequences. Don't miss the latest episode of "American Greed," airing Wednesday, January 19, at 10 p.m. ET on CNBC.