It’s nice to be able to rest easy, knowing that founders of the firms you’ve invested in are flogging their guts out to make you rich.
With perfectly aligned interests, you’re both in it together. You succeed together, and fail together.
If only it were so simple…
Investing in unlisted companies can be a rough old game. I’ve been in the sector for around a decade now, and I’ve seen the good, the bad, and the ugly.
Sadly, founders all too often have plenty of opportunities to personally gain by fleecing investors.
I’ll give you a rundown of the most common forms of skulduggery to watch out for.
Phoenixing is a way of ripping off investors that as old as the hills. Here’s how it works: you collect investors’ cash, set up a company and start trading. Once you’ve spent their money working out how to do the job properly, you shut it down – with a total loss of investors’ cash. You then set up a new company – which you own outright. Finally, you move all your knowledge, staff and customers over – in fact, everything you developed using the investors generously apportioned cash.
How to protect yourself: guarding against this trick is difficult – particularly if you invest before a firm is well-established. Non-compete agreements have some potential – but it’s difficult to create a robust legal agreement. This is because you can’t restrict founders from making a living. In the event of a venture failing, the law tends to err on the side of allowing entrepreneurs’ economic freedom. If you must prove that somebody has phoenixed your company, expect an uphill struggle. After losing some of my best investments this way (or selling my shares for a pittance, as I suspected it was coming), I now tend to invest in companies that have already achieved steady incomes, and have honoured a previous funding round.
This is perhaps the simplest of all scams – you just raise money for a firm that you’ve no intention of setting up. Hey presto! – several hundred thousand pounds to party with. This sounds so simple that you’d expect it to happen all the time. However, outright fraudulent startups are rare – and I’ve personally not come across one in my entire time in the industry. The line between an entrepreneur with grandiose ideas and an outright fraudster can be a blurred one – but occasionally you’ll read about a conviction in the news for a scam raise of this type.
How to protect yourself: don’t bother wasting your time. If it looks like a legitimate business after your normal due diligence, it probably is. There are far more important risks to worry about.
This is a dodgy trick that’s an old favourite of venture capital firms (VCs). You know those unicorn valuations you keep seeing, where companies have hit the magic billion-dollar market capitalisation? Often this is just fakery. The companies are really valued at a far lower level, but VCs write contracts which allow them to take their own money out before other investor – often at a multiple of the valuation they’ve invested at. That means that, even if the company turns out to be grossly overvalued, the VC still gets paid. However, both early investors, and others who invest (unprotected) at the “unicorn” valuation, will effectively end up getting wiped out. But hey, what’s a few million pounds of small investors’ money, when you’re a big VC – with a big paycheque and a tiny moral compass?
How to protect yourself: read the contracts in every funding round – and be sure to check that the founders have, too.
This is a bugbear of companies large and small. Executives very often want to pay themselves handsomely, before paying back their investors. Founders often have a lot of freedom to write their own paycheques. As it’s rather hard to work out exactly what a senior manager is worth, it’s no surprise there for that these salaries can get severely bloated. For highly diluted senior managers, this ends up being a very good way of getting money out of the company, without paying dividends to investors. For early-stage firms, it’s a really good way to ensure founders profit personally from a startup that’s unproductively burning investors’ cash.
How to protect yourself: make sure that founders’ remuneration is subject to external review.
Flogging a dead horse
When the horse is dead, it’s time to get off. But what if you’re a jockey, with a salary and an ego? It’s very tempting to argue that the horse is just having a rest. You might claim that, if only you had more money for hay, the horse would probably be just fine. For a founder, it can be very hard to make the transition from Mr Very Important Entrepreneur to Mr Unemployed Failure. That leaves you with no paycheque, no clear future, and no status. Furthermore, you have to admit failure to employees, investors and customers. It’s hard – and accordingly, most founders put it off as long as possible – often burning through large wedges of investor cash as they do. Sometimes, they need a firm but friendly hand, guiding them towards an orderly shutdown – as many insolvency practitioners will attest.
Yesterday, we started a tour of the scams and tricks that executives, venture capitalist firms (VCs) and entrepreneurs use to transfer investors’ cash into their own pockets. Obviously, there was far too much to cover in one day – as they’re a wily bunch. Today we’re continuing our warning – with a whole new chapter from the rascal’s playbook. So, hang on to your wallet – and keep an eye out for these scams.
The gravy train
This technique is as old as the hills. Entrepreneurs or managers with a small stake in their companies often have difficulty getting the cash out for their own ends. If a firm is in the money, it’s really the investors who should be benefiting. But dodgy entrepreneurs don’t want to line the pockets of those who’ve helped them get where they are. Instead, they want to take the money themselves. Running up expenses is a great way to ensure that they don’t have to justify the money they’re taking out of the firm – it just disappears into hotel and bar bills, when holidays and entertainments are disguised as legitimate business expenses.
Bogus share issues
This is another scam that I’ve personally been the victim of. It’s an easy one to pull off, at an early-stage company. Because of the way UK law is set up, an entrepreneur can do pretty much what they like with the company shareholding – provided they still have a very large stake.
I’ll explain how this works – as it takes a bit to get your head round it. First, the entrepreneur raises investment, granting shares at an agreed valuation. For example, the company may raise £1m for 10% of the company – valuing that firm at £10m. Now wouldn’t it be nice if that company could be magically revalued at £20m overnight? Well, it can! All the entrepreneur has to do is grant themselves an extra slab of shares – for doing absolutely nothing. That will dilute the investors down – so the founders have the equivalent shareholding to a £20m valuation. Of course, the company wasn’t actually worth £20m when the money was raised. Sadly, investors can’t do very much about this trick, without a long court fight.
This technique doesn’t have to be done by entrepreneurs in isolation – and incoming investors may goad founders into wiping out their early backers. A new share issue is a great time to pull this scam on the existing investor base – as it’s easy for the entrepreneur to argue that they couldn’t possibly have secured the new investment, without a rationalisation of the shareholding. I got around half my stake in one of my most significant investments wiped out, using exactly this kind of skulduggery.
Jobs for the boys
This is a technique that’s as familiar to MPs as it is to entrepreneurs. By using friends and family as employees or contractors, managers can siphon money out of the company’s account. Needless to say, much of this cash often finds its way back into the managers’ own pockets. Of course, friends and family can legitimately work for companies – and that’s what makes this such a gloriously useful technique for the bent manager. It’s relatively hard to prove that a job’s been awarded improperly, meaning this can be a good way of disguising the movement of quite significant sums of cash. This is particularly the case if the relationships involved are not known to the investors – one reason why many firms insist that managers aren’t allowed to date subordinates.
Good old-fashioned bribery
This technique is as old as the hills. Managers just ensure that they get a nice fat payment, every time they award a contract. While this doesn’t work for well-vested entrepreneurs (as they’re basically spending their own money, to take a tiny proportion for themselves), the kickbacks from suppliers can make a huge difference to hired managers, and over-diluted founders. Alternatively, for entrepreneurs desperate to circumvent salary restrictions, this can be a great way of getting money out of the company – albeit at deadly cost to its long-term future.
These relatively straightforward scams can be pulled on investors by founders, managers and VCs. Some of these techniques are common (eg, phoenixing). Now, with Exponential Investor’s guide to the kind of sharp practice you can expect from founders, hopefully your investments will now be rather safer.
Do let us know in the comments below what scams you’ve suffered, in your time as an investor.