Start Ups: How is Your Financing Going (or Not)?

Every day, our company receives calls and emails from companies seeking investment.

The large ones we route to our investment banking practice and the small ones to our investment conferences in New York, where they can represent themselves to investors without an intermediary.  (Others call about our narrow angel investment criteria in telecom or board positions).

But the great majority of callers do none of the above.  Some want something for nothing.  Others are dreamers whose aspirational companies are unlikely to get off the ground, but remain the subject of loving and lengthy monologues.

It is pretty easy to separate the wheat from the chaff –
(a) those callers who understand the endurance race aspect to raising capital vs.
(b) those who think  they just have to talk someone's ear off to collect no-questions-asked checks.

The following paragraphs include snippets of  seven, initial conversations with members of the latter group (the naive idealists or what?) followed by my behind-the-scenes interpretation.  What is your first impression?  Do you think the caller will be taken seriously by a finance professional?  If not, do not be like them!

Entrepreneur 1: “I don't need to hire your investment bank or present at your conference.  I will be funded by then.”
Us:   “Then how can we help you (I'm wondering,  uh, why did you call us)?” and “Wonderful news!  Are you currently negotiating a letter of intent?  (No)  Do you have a closing date on the calender (No)."
Entrepreneur 1:  “But we have several initial meetings scheduled and they'll love us.”
Interpretation: This caller does not know that investment is often a needle – in-a-haystack search, followed by a lengthy period of due diligence, a letter of intent, negotiated terms, legal advisors, finally culminating in a well defined closing date.  In other words, it entails a protracted and wholly predictable schedule of milestones.  Therefore, this blithe comment reveals that s/he has never worked with investors before.  Some service providers may take advantage of that.  In any case, s/he has lost credibility with professionals who know what s/he does not.

Entrepreneurial Liars and Cheats

Many entrepreneurs are dismayed by the slow pace of due diligence checks by potential investors. How many interviews, how many financial documents and resumes and business plans must they submit before getting a thumbs up or down?

This process might be more understandable if entrepreneurs realize that THERE ARE SO MANY LIARS OUT THERE.

Liars will be outed

1. Consider the process of home sales. Just as in real estate, investing in a company is proceeded by a period of judicious inquiry and inspection, recognized by both parties, ending in a legally binding closing, scheduled weeks in advance. (This is why I never believe an entrepreneur who blithely reports, “I'll be funded by then” without even having a letter of interest (LOI) in hand.
2. The reason for protracted due diligence is because, sadly PEOPLE LIE. As Catholics understand, there are lies of omission and lies of commission. The former is when a home seller neglects to mention a material fact, like a rotted roof. A lie of commission is actually writing or verbalizing a falsehood, like checking the word “no” on a form that lists “do you know about this or that.” Just as a home seller may obfuscate termite or water damage, companies seeking investment may similarly “put lipstick on a pig.” Repeat investors know this, so they endeavor to separate the wheat from the chaff through careful scrutiny. As any on-line dater knows, anyone can sound good, but how do they appear up close?

A sincere and honest entrepreneur may be aided by the following short list of several entrepreneurs who have approached us recently, each with constructed stories which omitted or fabricated information. If you can appreciate how many such people approach investors (and service providers) you can understand the logic behind due diligence of your company.

Following the list are recommendations to help honest entrepreneurs make a strong, initial impression. For additional anecdotes about other bad guys (both entrepreneurs and service providers), see prior articles on this website.

High Conflict People and the Toxic Damage They Cause

Do the following statements sound like anyone who makes you cringe, at work, in your neighborhood, in your extended family?  If so, you are by no means alone.  Fortunately, there are resources available to address the damage such people do to those around them.  

• "This is all your fault. None of it was my fault.”
• "I disown you (again). You have been a terrible spouse/son/daughter/etc. How dare you contradict me.”
• "Don't talk to those neighbors; they'll screw you like they screwed me."
• "You never loaned me that money. It was a gift. Prove it.”
• "Of course, my way is right.  You can't possibly succeed doing that. How stupid.” (No, I never thought of it ).

A recognized category of extremely difficult personalities, identified as "High Conflict People," is easily recognized by a combination of unattractive traits that include:

• “My way or the highway” thinking

• Emotional over-reactions (that can include yelling, throwing things, hitting, or over-the-top messages on emails, letters, answering machines, back stabbing, starting rumors)

• Blaming others, particularly for their own problems, either defensively (“he's out to get me”) or offensively (“it is your fault now and always”)

If your business or home life has been ripped asunder by unpleasant people with such personality traits, you will be glad to learn that a number of books and articles outline how to deal with them, and in various contexts, such as business negotiations, employees/supervisors, divorce, and parenting. There is even a HighConflict Institute! The founder of that organization, Bill Eddy, was previously a therapist at a psychiatric hospital, and later a lawyer and mediator. What a great background for the topic! He has written books with such provocative titles as Its All Your Fault!: 12 Tips for Managing People Who Blame Others for Everything  and High Conflict People in Legal Disputes.

Angel Investments over the Past Decade

An excellent source of information about angel investments in the U.S. can be found at the website for University of New Hampshire's Peter T. Paul Center for Venture Research. https://paulcollege.unh.edu/research/center-venture-research
Scholars there have been tracking venture funding since the early 1980s, and the most recent ten years of annual and semi-annual reports are available for free, at the school's website. Below is a summary of highs and lows over the past decade. What questions do these statistics raise for your business funding plans?


In 2012, 21% of entrepreneurial ventures presented to individuals and angel groups (beyond a “friends and family” round) found investors willing and able to invest in their businesses. This percentage, referred to as a “yield,” is nearly as high as the peak 23% attained in 2001 and 2007, and far higher than the historic average of 10 – 15%. Interpretations for this influx of investment dollars vary greatly and sometimes combine such reasons as investor optimism, fleeing the public equity markets, and a bubble in the making.


In addition to the increased percentage of ventures funded, both the number of entrepreneurial ventures AND the number of angel investors have peaked for the past decade, at 67,030 ventures funded by 268,160 angels in 2012, and 66,230 ventures funded by a whopping 318,480 angels in 2011. These numbers far outstrip the paltry 36,000 ventures funded by 200,000 angels during the “boom years,” such as (these numbers in) 2001.


However, these investment dollars have shifted away from seed stage companies to those with more of a track record. In 2012, only 35% of angel dollars funded seed stage companies, and 33% early stage, far lower than 2005's 55% of investment for seed stage companies and 2010's 67% to early stage companies. A corollary to this shift is the nearly steady, year by year decline over the decade in the percentage of angel investment as the first investor, from a high of 70% in 2005 to 52% in 2012. In other words, although more angels invested in more companies in 2011 and 2012 than earlier, they have become more conservative, by targeting more developed companies, and preferring to follow other investors rather than lead the charge.


What about exits?
The worst year for bankruptcies was 2009, when 40% of angel funded deals went belly up. More commonly, the percentage is in the 20-27% range, highlighting the risk that angels take when they invest in young companies – a point that entrepreneurs should bear in mind when asking for other people's money. In other words, just about the same percentage of companies being funded by angels (about 1 in 5) will, once funded, fail. So entrepreneurs should expect attentive due diligence by potential investors, which may well take longer than they wish.


The most frequent positive exit by angels was in the form of mergers and acquisitions. The highest percentage was 70 in 2008. Other years, mergers and acquisitions accounted for 50 to 65% of the exits. For this reason, entrepreneurs are wise to surround themselves with industry knowledgeable management and directors, whose connections may be crucial to ensuring a profitable merger or acquisition.


IPOs don't happen for small companies anymore, and none have been recorded for the past few years.



The industry sectors most popular with angel investors remain remarkably consistent. The most frequent two sectors for the past ten years have been software and healthcare. The following industries shift back and forth for the next few places in the list: industrial, energy, retail, bio/life science, IT, and media. Financial services and telecom have both fallen out of favor in the past five years. This does not mean that entrepreneurial ventures outside these industries don't get funded, but it may suggest that other management teams need to explain their value proposition carefully to an audience that doesn't encounter as many deals in that sector.


Like any set of statistics, these data leave plenty of room for interpretation, but a few points jump out to me.

1. Entrepreneurs have a lot of competition for angel ears, as well as angel dollars. So be prepared to stand out of the crowd by being thoroughly prepared for investor scrutiny.
   
   
2. The percentage of entrepreneurial ventures successfully securing funding is close to beating the decade's high. This could mean that it is easier to get funding now than before, or it could mean that a bubble is forming and the gravy train will derail shortly. Entrepreneurs should develop contingency plans if the funding climate shifts during a protracted period of due diligence and should never, ever spend money anticipated but not yet in hand.
   
   
3. Seed funding is harder to come by. So entrepreneurs need to be able to self fund for a longer period than in the past or need to develop some revenue stream early, in order to (a) stay afloat and (b) attract investors who want to see a functioning business, not just a business plan. Besides, being able to generate some payments increases the range of potential funding sources, such as revenue based lenders (like factoring firms).
   

4. Because the majority of investor exits are through M&As, entrepreneurs need to know their competitors, suppliers, and customer base very well. Any of these could be your partners, buyers, or bosses in the future.
   
   
   To be routed to the website of the University of New Hampshire, click here.
   

Spot Liars and Frauds Before You Hire (or Date) Them

For ten years, my favorite job as Compliance Officer of an Investment Bank was spotting liars. This meant figuring out which finance professionals NOT to hire because they embellished their qualifications, which potential clients NOT to accept because they had obfuscated weaknesses in their companies, and which alleged investors NOT to believe because they would never pony up a dime. On the theory of “garbage in, garbage out,” I figured that anyone who lied to me up front about something I easily discovered was likely to lie later on about something important I might not detect. With 7 billion people on the planet, I endeavored to avoid those mendacious people and work with honest ones.


What appalls me is the frequency with which I have encountered grown-ups who lie, easily, smoothly, and frequently to get something they want, based on merits they lack. Obviously, their blarney must work on some of the people some of the time. I'm also dismayed by the number of companies and individuals who don't do background checks before they hire or recommend people, or who part with their money or let someone into their homes or lives without asking a few logical questions first. So shame on both parties!


The following article shares easy, cheap or free research that anyone can do in less than an hour and examples of falsehoods I have uncovered in the areas of education, business experience, lawsuits, and crimes.  Protect yourself with a healthy dose of skepticism, a few minutes on the Internet, and some judicious questions.

Five Questions Any Money Seeking Entrepreneur MUST Be Able to Answer Briefly and Compellingly

Every day, we talk with entrepreneurs who wish to grow or start a business, with the help of other people's money (whether the source is investors, banks, factoring firms, or grants). If you are among them, you HAVE to be able to answer the following five questions, briefly, clearly, and compellingly or you will not get past a first phone call with a legitimate source of funds and each subsequent call to someone else will be a waste of everyone's time. Too often, the entrepreneurs who call us are absolutely stymied by these questions. Don't be like them!




The Questions:

1. How do you (or how will you) make money?
   
2. How much do you wish to raise (or borrow)?
   
3. What will you do with the investment (or loan amount)?
   
4. How will you pay it back (by date) (or how and when will the investor earn a return on investment)?
   
5. What experience do you and your management team have in this industry and with prior investors' money (or loans)?
   

Why These Questions are Important:

Each question helps your potential lender or investor assess risk and potential reward. If you hem and haw on any of them, you are doomed, because it means that you don't appreciate the risk you are asking that person to take with money he/she has that you lack. A non-answer to any one of these is akin to asking someone to dive into a dark pool without being able to answer the obvious first question, “how deep is it?”




Components of Compelling Answers

1. The answer to question 1 (How do you make money?) is stronger with any of the following components:
   (a) Multiple revenue streams are better than “one trick ponies” because the variety allows the company to stay afloat even if some products or services fail or take longer to succeed or cost more to develop/deliver than anticipated;
   (b) The revenue projections are not dependent on unlikely scenarios (like huge market share grabs right away or fuel prices lower than they are today or a a shorter sales cycle than is normal for your industry);
   (c) Products and services that are correlated to a variety of economic assumptions are likely to weather the highs and lows of economic cycles better than those that depend only on a high or low. For example, a company might have some offerings attractive in periods of inflation AND recession or when client companies or target populations are growing AND maintaining, aging, and retracting.
   (d) Demonstrate profitability, even if in a small market or by another company.
   
   

2. Questions 2, 3, and 4 are related, even if they are asked separately, so construct your answers with each one in mind. This is because the amount you wish to raise should be directly related to how you plan to use it and that use should enable you to pay back your lender or investor on time and at a profit. For example, if your reason for raising money is “to rent larger office space and pay me a salary,” or “to research the market potential” such answers do not translate into repayment of the loan or investment and therefore do not encourage much confidence. These are faith based answers, like “just trust me.” Why? A compelling answer is one that directly leads to a believable profit. Good answers might sound like this: “We wish to raise $xx in order to increase our manufacturing speed to meet current demand that exceeds our capacity” or “We wish to raise $xx to buy a competitor we believe to be undervalued and that offers a complementary fit with our firm in terms of customer base, geography, and product lines.” Or “this business model has been profitably test marketed (where) and we are now ready to launch it on a larger scale, with $xx for experienced industry sales personnel in the most lucrative markets.”
   
   
3. Your answer to Question 5 indicates your ability to understand and respond to the the risks in the business you propose to run with someone else's money. Managers with a track record of relevant experience are obviously more attractive than those without. Managers who have borrowed money or taken investors' money and returned it, on time, at a profit to the lender or investor are equally appealing. If you have not done the exact thing before to great financial gain (because otherwise you wouldn't need to borrow money, would you?) you can still construct a compelling answer. For example, have a board of advisers experienced in this industry, an excellent credit rating, or prior lines of credit that were paid back on time after being used well. Have a list of pertinent referrals from professionals in your current and prior industries. If you are an expert in the pertinent field, who knows it? Have you published papers, delivered speeches? If not, write some and put them on your website or send out press releases. Neither costs much. Become an expert in your field. Research other public and private companies in this sector, join relevant professional associations, subscribe to pertinent journals.
   
   There is nothing more embarrassing than talking to an entrepreneur who knows less about his/her industry than we do, especially when we don't consider ourselves expert, but just educated business people. Compelling answers could include variants of: “I have x years of experience in this aspect of the industry, and have assembled a management team and advisory board that excels in the other areas we need to anticipate and respond to the market potential.” Or “I am a serial entrepreneur who has run xxx number of companies in other industries and sold them at a profit (or returned investors' money) in most cases and learned hard and lasting lessons when I didn't. I have succeeded by a set of priorities that has guided me in each of the prior companies and will do so in this one, too. Those priorities are xyz.” Or “I have several patented game changing innovations that will enable our targeted client companies to deliver results faster, cheaper and better than their competitors.”
   

Conclusion

If you can't answer these questions well, don't pick up the phone to ask for money. Put your time, instead, into learning more about your industry or surrounding yourself with others who know it better than you do. They can help you not only answer these questions, but build a profitable company. Who knows. You may never need to borrow a dime to make a dollar.

Why No Term Sheets... at all? or "They Just Aren't Into You"

Laura Emerson

laura@starlightcapital.com

March 24, 2013

Raising capital is hard, time consuming, expensive, and sometimes humbling. There are as many reasons that investors do not invest in companies as there are reasons why people who meet choose not to date. Sometimes “they just aren't into you.” On the other hand, if you have done your research and have found that indeed there are investors financing companies in your niche, just not you, it is WAY past time to assess whether you might be doing anything to sabotage your own game plan.

Below are five commonalities among companies that never get any term sheets at all. Do any pertain to you? Also, review the descriptions of unfunded (unfundable?) companies at the end of the article. Do any aspects sound uncomfortably familiar? If so, the most common problems are not difficult to address.

The five categories are: talking too much, talking to the wrong people, talking about the wrong things, a business plan with holes that indicate naivete or obfuscation, and inflated pre-money valuations. Do any of these sound familiar?

1. DO YOU WASTE TIME BY TALKING TOO MUCH?

Every entrepreneur I have ever met is as proud of his/her company as a new parent is of that wrinkly little baby. Both groups often make the mistake of being long winded, without first ascertaining the audience's degree of interest. Someone's polite inquiry at a networking event of “What do you do?” or “Tell me about your company” may welcome a 2 minute soundbite between drinks, not an uninterrupted oration.

No Exit

(Laura welcomes responses in the comment field beneath each blog entry).

During 2000-2008, virtually every private company’s investment oriented PowerPoint or Private Placement Memorandum  I saw (as Compliance Officer of a boutique investment bank), concluded with a “hockey stick” graph of escalating profitability, with a liquidity event in two years.   The magic number was always 2 years, regardless of likelihood, because this is what companies thought investors wanted to hear.  I cringe when I still hear that.  The liquidity event was usually posited as an IPO (initial public offering) with an occasional alternative of being bought out by a large public company.

 

To outline all the reasons I have long thought that going public early is a bad idea and an expensive mistake for small companies is another article for another day.  But here, I will outline why and how  small private companies are shut out from public capital, and what I think the liquidity options are in the near future for companies worth less than $50 mm.  

Initial Public Offerings  (IPOs)

The number of IPOs and their funding totals have declined as both the age and value of the companies has risen, raising the bars for companies considering this access to capital.  Statistics vary in frustrating ways for something that should seem so easily measurable, so consider the two following scenarios that follow the same trend line, but with different numbers. 

The first is documented in an informative RR Donnelly speech in March, 2012:  One long standing bar is that since 2003, the majority of those that launched IPOs were previously funded by more than $10 mm of venture capital. (So companies that haven’t already raised any outside capital might refocus their attention to growth first). Another is that the age of companies going public has risen from the rather ridiculous youth of 3-4 years in 2000-2002 to a more sensible 6-9 years of records, as was the norm in prior decades. The number of IPOs in each of the past three years has been about 100 – 150, raising $41-44 billion, far below the frothy years epitomized by 2000, with 446 deals raising $108 billion.  But even with this reduction in the number of deals, to companies presumably older and “field tested,” from 2004 to date, a sobering 22- 39% have not hit their offering price, despite heavy and expensive lifting by those companies’ marketing, PR, IR staffs and hired investment bankers.  They didn't mention the ones that withdrew after starting the process.
  
The second scenario, here gleaned from the excellent charts and graphs of  www.renaissancecapital.com of Greenwich CT, but that I have read elsewhere, too, shows much less volume. They count a measly 53 US IPOs in 2011, a precipitous plunge not only from 125 the prior year, but from a high of 486 in 1999. Perhaps unsurprisingly, the number of IPO withdrawals has increased in the past three years, from 48 to 52 to 67 last year.  (Did RR Donnelly use the start-out-the gate number?) The Jan-April withdrawals in 2012 are even with those in 2011.  The dollar volume raised by the IPOs differs, too.  These sources cite $97 billion in 2000 declining to $36 billion last year.  Both sources agree that the average age of companies making an initial public offering have aged, but the Renaissance numbers are MUCH OLDER than the others.  They identify the average age as 10 years in 2000, 15 last year, and 27 years old for those so far this year. 

GrowThink points out that the number of US IPOs since 2001 remain lower than the 1980s.    
The final barrier to entry is the value of the companies.  This is tough to assess, because pre-money valuations are usually described by those wanting to attract the money to prove the valuations!  Not a very virtuous circle.  But it appears that the market is not particularly interested in companies worth less than $50 mm and certainly not those less than $20 mm.  

Entrepreneurs who want to say, "we should go public" should instead do their homework to research and analyze the trend line and the differences cited here, before being swept into enthusiasm by service providers who will be paid no matter what happens once the bell rings. This summary doesn't even address the costs of going public and staying compliant, year after year, which is another topic to scrutinize carefully. 

My black and white recommendation is that if your company is pre-revenue, pre-breakeven, or even pre-$20 mm valuation, don't even think about an IPO. Doing so derails far too many companies from focusing on legitimate expenditures of time and money to grow market share, customer base, or profit margin. 

Easy, Free Due Diligence on Potential Service Providers, Clients, Employees

If you are a “glass half-full” person.  Read this carefully.  Dishonest people can be charming, or evasive, or manipulative, but all of them will waste your time or money.  “Trust but verify.”

If you are a “glass half-empty” person, you know to check out potential employees, service providers, investors, clients.  (I've even had friends who are utilizing dating websites ask me to check out people before they get too involved.)  The following list of liars and sources will save you time and reinforce what you naturally do to protect your business and wallet.    

                         

Below are two lists.  One is a list of lies learned from less than three hours due diligence of potential service providers, clients, investors and employees.  The other is a list of free or low cost public websites you can check to save you time, money, and “face.”  If you get a business card, a resume and take notes during conversations, you can ascertain a great deal in less than 3 hours of research, otherwise wasted by “big talkers.”   Some have been shameless liars who have, presumably, gotten away with this before, indicating that a lot of people DON’T do background checks. Think how much time you can save by learning this information early on. 

Preliminary due diligence is like a game.  The goal is to look for anything the person has told you (verbally or in writing, such as a resume) that is invalidated or contradicted in public sources.  If the person lied about something so easily discovered, what else might s/he lie about?  Red flag.  By asking for background information, the message you convey to the person is that it is “time to get serious.”   This can cut time wasted with big talkers.  Your time is worth money.

How Entrepreneurs Can Avoid a Financing Scam

(I originally wrote this article for Entrepreneur Magazine, several years ago)

“If it seems too good to be true…,”

“If it walks like a duck and quacks like a duck…,”

“Beware of Greeks bearing gifts” … 
Not every business scam is so obvious.  Even seasoned business people can be taken by smooth talkers, not realizing the manipulation until tens of thousands of dollars have changed hands.  Optimistic start-up entrepreneurs in need of financing are particularly vulnerable to “financial advisors” who position themselves as representing ready investors.  Without knowing the questions to ask about securities laws that protect business owners and investors, they can be suckered into typical scams.  The common theme running through all of them is “Say what the person wants to hear” and “if they don’t ask, don’t tell.” Confident entrepreneurs who dismiss nay-sayers as “not getting it” may be susceptible to smooth operators who praise their idea as the greatest thing since Microsoft, promise funding, and then slip in a creative contract. 

 Consider the following frequent scams that might be titled, rope them in; string them out”, “bait and switch,” and “now or never.” 

 SCAM:  “Rope them in; string them out”

A serial entrepreneur, Joe Knoff, 47, bootstrapped one business, Illuminating Consulting Service and Supply (ICSS), which he sold in 2002, after being diagnosed with cervical degenerative disk disease.  His entrepreneurial experience and his frustrating medical journey prompted him to found MyNaturals.com, an e-commerce solution to the $230 billion dollar healthcare-environmental consumer marketplace, known as LOHAS (lifestyles of health and sustainability).  This time, he wanted to attract investment in order to grow faster, so he posted his business summary on a website designed to bring entrepreneurs, service providers and investors together. 

Within three days of posting, MyNaturals received a letter from a firm that included the following phrases, “We love your concept and niche market,”  “capitalization is highly feasible,” “for this investor,” “we have strong interest,” and “we, in conjunction with investor, have easily pre-qualified the financing requested…” Joe was delighted but skeptical.  How could anyone pre-qualify him based on a two page business summary?  First, he called a representative of the posting website, who carefully told him that the company makes no warrants or representations about any of the entrepreneurs, investors, or service providers who register with the site.  So he checked out the investment firm.  He visited the website and was pleased to see a Better Business Bureau logo there.  Then, he interviewed one of the principals and had his accountant call, too.  In addition, he contacted a few client referrals and even checked with the state to confirm that the company was a registered corporation. 

Satisfied, he made a few adjustments to the contract and then engaged the firm.  He understood the deal as this: the firm had investor(s) ready to make either a loan or an equity investment of $650,000 if MyNaturals met certain milestones.  Both investors and MyNaturals could pull out of the deal at any time. The firm earned a non-refundable, up-front fee of $3450, as well as a percentage of funds raised, payable at closing.  This fee structure encouraged Joe to believe that the firm was financially committed to concluding the deal.  The firm also charged for various services, listed in a supporting document, but Joe was verbally assured that he probably would not need them. 

 Seven months later, he had paid $15,000 for various business preparation services and met no investors.  When the firm required yet another fee for a feasibility study, Joe balked.  On advice of his attorney, he contacted the principals and “clearly and politely” laid out his litigation strategy, their initial written assurances, and his detailed records of verbal and written communication with members of the firm.  He said that he was willing to settle out of court now or go to court later.  Eleven months later, he received a refund of 50% of the fees he had doled out, with the stipulation that he would not sue the financial firm. 

20/20 hindsight: Joe warns, “Entrepreneurs – beware.  THE FIRM IS STILL IN BUSINESS.  IT IS A MEMBER OF THE BBB.  Firms that are scamming you will never admit any guilt, even when they are made to pay up.”  Joe muses that “challenging economic times can be a breeding ground for unscrupulous groups claiming to represent capital funding sources.  I treated my search for start-up capital as meticulously as I wrote my business plan, but I did not know what I did not know - all the rules of the funding game.  There don’t seem to be well published industry guidelines, probably due to the fact that much of this industry is not well regulated.”   

 Elements of the scam:  This clever ruse encouraged the client to think the financing firm made its money on funds raised from investors (as legitimate, FINRA licensed broker-dealers do) when in fact, their revenue results from the service fees that were represented as “refundable at closing” and as “probably unnecessary.”  Charged one at a time, those costs seemed modest in comparison to the potential funding.  After all, what is a $5000 feasibility study if it yields a $650,000 investment?  A disgruntled client without the detailed notes and quotes of Joe Knoff would likely confront an uncomfortable truth – being told up front that “the investor can back out at any time” and that “the fees are refundable at closing.”  In other words, if no investor, no closing, and no refund. 

Commentary:

Steve Brewer, Managing Director of Brewer Capital in Houston, TX has heard his share of scams from vulnerable entrepreneurs.  His advice is to “Only deal with registered broker-dealers, where you have recourse to FINRA and SEC to validate people in advance and for mediation of any disputes afterward.”  In this case, one red flag was the early identification of an investor who never appeared.  “Broker-dealers can earn a commission on money raised from investors,” says Brewer.  “Therefore, we have an incentive to bring our investors and entrepreneurs together as soon as we have identified a fit. Someone who doesn’t do that may be milking a retainer.”    

SCAM:  “Bait and switch”

Kyle Holland, Managing Director of Investment Banking for Gray Capital Partners in Austin, TX, tells of a scam that happened to a client of his, who is a trial attorney.  “In early 2004, he was putting together a deal to develop a resort in Mexico.  Not every investment source is right for an international project like this, but about six months beforehand, a colleague of mine had talked with an investment firm in New Jersey that sounded likely.  My client and I talked with the principals and they said that they had all the right connections and could fund it.  We signed a reasonable term sheet, detailing costs and services, and mailed a $10,000 check to initiate the work.  To our astonishment, we subsequently received a totally new term sheet, with exorbitant terms, like a second ‘deposit’ of $100,000. We walked away.” 

Commentary: Holland shakes his head; “Of course this is illegal.  We could have sued them, but the costs of recovery with an out-of-state dispute would probably have cost more than the money we lost.  My advice is to meet investors in person, walk around their office, talk to their clients.  A $1000 plane ticket is worth the cost.”         

 SCAM:  “Now or never”

Mike Segal, of MJ Segal, Assoc. in NY has organized private equity conferences in New York for several years.  Presenting companies often mention funding horror stories to him.  In one case, an entrepreneur in NC had met, through networking in the investment community, an unlicensed “capital advisor” who appeared to have a reputation as a well-connected, hard worker.  One day, he received a breathless call from the man, saying that he had lined up $450,000 in investment for the start-up, but in order to represent him the next day in Denver, he needed a contract and an advanced fee of $22,000.  The entrepreneur had his attorney quickly draft a contract which, among other terms, solicited all written and phone records of contact with potential investors within 30 days of concluding the contract.  The advisor agreed and the money was wired.  When no proof of a meeting appeared, the entrepreneur canceled the contract, requested the records, and sent an attorney to collect a refund.  The principals of the firm refused the calls, closed the business, and are now working for other companies. 

Commentary:  A red flag here was the lack of due diligence, or company research, by the alleged investor.  As a result of corporate scandals in the public sector, the government passed the Sarbanes Oxley Act, which requires much more attention by corporate boards and the independent accounting and law firms they hire.  This requirement is impacting private companies, too. According to David Barbash, Corporate Group Partner with Nixon Peabody LLP in Boston, MA, just as entrepreneurs should take the time to investigate the professionals they intend to hire, they should expect the same evaluation themselves. "Entrepreneurs should be wary of prospective investors who do not do due diligence (on the entrepreneur and his/her company).”  “In the wake of Sarbanes-Oxley, investors are spending considerably more time in due diligence before consummating an investment.”   No reputable person would claim imminent financing by an investor who had never contacted the start-up management.   

 Overall:

Melinda LeGaye, President of MGL Consulting Corporation in The Woodlands, TX, provides FINRA required compliance auditing services for broker-dealers, and other regulated professionals.  She recommends that "entrepreneurs seeking equity capital in the form of a private placement (stock in a private company, sold to individual investors) make sure of two things.  “One, have legal counsel that is experienced with private placements, issuers, and underwriters.”  This is not the person who wrote the family will.  Securities law is an area of specialization.   “Two, utilize the services of a broker-dealer firm that is registered with the FINRA, the SEC, and with the states where the offers will be made.  Otherwise," she warns, "There are potential rescission issues (deals can be revoked) associated with sales by non-registered dealers.” 

What is the difference between a licensed/registered broker-dealer and a non-registered one?   The terms, investment banker and financial advisor, are generic.  They do not indicate academic degrees, state or federal licensing, or other special knowledge.  Therefore, you too, could set up shop with a company name like “ABC Capital Resources” or “XYZ Financial Advisors” or “Bonafide Equity Partners.”  On the other hand, FINRA and SEC DO register (license) people to perform limited functions that are subject to annual review.  Each license number, like 7 (national securities), 24 (supervision), or 63 (state only) defines the scope of their activities, and their responsibilities in raising money for entrepreneurs.

 The reason that this FINRA and SEC registration is important is that it PROTECTS ENTREPRENEURS AND INVESTORS in ways that unlicensed or unregistered “financial advisors” do not, unless you know what to demand.  Licensed broker-dealers must comply with a whole host of requirements (listed at www.finra.org) such as full disclosure in sales documents and in contracts, financial solvency, quarterly and annual audits by an outside organization, a log of client complaints that any potential client can request, and dispute mediation outside of court.  This means that entrepreneurs can validate a person’s professional good standing before hiring, ensure standards of salesmanship, fees, and contracts during engagement, and save money in case of any disputes later.  Broker Check (on the site), which the public can access for free, reveals work and disciplinary history of individuals.  Brokers who have been delisted are deleted.  Any entrepreneur considering raising money should spend several hours scanning the sections relating to private placements (sometimes referred to as reg. D).

By contrast, working with unlicensed fund raisers is a “buyer beware” proposition.  If securities law is not your area of expertise, why pay high fees to anyone who may subscribe to a “don’t ask, don’t tell” mantra of customer relations? 

 Dr. Sam Buser is a psychologist in Houston, TX who specializes in men’s issues and who works with many independent businessmen.  “There isn’t so much a psychological profile of businessmen vulnerable to scams.  It is a sociological issue.  Americans have a cultural belief that everyone can strike it rich.  We love ‘rags to riches stories.’” … “However, the person most likely to fall for a scam is one who won’t take advice from other people.”  He recommends that, “Every entrepreneur should have a mentor – someone who has succeeded at something along the line he or she is pursuing.”  Learn from what he or she did and didn’t know.

Lawyers, compliance officers, entrepreneurs and broker-dealers offer similar advice about the value of fore-knowledge.  Hire licensed broker-dealers and attorneys who specialize in private placements.  Expect detailed due diligence and do the same.  Note any differences in verbal promises and contractual language, and take great notes.  If you make a mistake, be prepared to walk away from a bad deal. Forewarned is forearmed.    

 Scam Signs:  Run, Don’t Walk  

 1)     Fund raisers who evade questions about their licenses, registration, AND amount raised for recent clients in your industry. 

----Legitimate broker-dealers comply with full disclosure requirements by FINRA in sales and contracts.  Require evidence of registration.

2)     Really wordy contracts filled with legalese that say, in essence, “we have no obligation to do anything we say,” or no contract at all.  

----Have a securities attorney write or review any contract involving investors or fund raisers.  This is an area of legal specialization.  

3)     Contracts that are clear on fees and duration but vague on deliverables.

-----It is your responsibility to define milestones and deliverables before you sign the contract.

4)     Fund raisers who won’t reveal the name of the investor/terms of investment as soon as they say they have some.  

5)     Offices with P.O. Box addresses only

6)     “Investors” calling from “boiler room” type call centers.

Sidebar 2:  How to Protect Yourself   

1)     Ask your banker, lawyer, and accountant to recommend broker-dealers. Their business with you is vulnerable if they steer you wrong.

2)     "Smart money" is worth more than "dumb money."  Hire people who specialize in (a) your industry, (b) investment in that industry, and (c) the funding range you seek.

3)     On www.finra.org, read all the requirements of FINRA registered broker-dealers that protect clients. Look up the status of the broker-dealers you are considering.

4)     Check websites for "tombstones" of funded deals and evidence of FINRA licenses.  If there are no tombstones, what services do they render?  (business consulting, business plan writing?)

5)     In interviews, ask for current registration with the FINRA, the SEC, and in each of the states in which any private placement will be offered.  If any answer is none, it is "buyer beware." 

6)     Complete background checks before you pay any money.  Visit companies like  www.ussearch.com to pay for background checks on individuals and companies.  Visit www.nasaa.org and www.finra.org for information (in English and Spanish) on broker-dealers, investment fraud alerts and other useful information.      

7)     Fees: Don’t sign an open-ended retainer. Few entrepreneurs have deals strong enough to justify a commission-only fee.  If your deal is not a slam dunk, negotiate a short term contract with monthly fees for pre-determined deliverables, like a deal critique and a pre-determined number of investment contacts.  Require updates of all communications with investors.   

8)     Set written caps and an approval process for expenses.

9)     Get everything in writing.  Don’t believe anything that is not written.        

 

Step into the Shoes of an Investor Before You Issue a Private Placement

Entrepreneurs raise money in various ways and from various sources.  One method frequently discussed is a Private Placement.  Entrepreneurs can be better prepared to embark on this expensive and time consuming step, if appropriate, or choose to delay it until success is likely, if they “put on the shoes” of the potential investor first.  What do they look for in a worthy Private Placement candidate for their dollars? What “red flags” would thwart an investment?  Are you ready?

In one paragraph, a private placement means that a company solicits investment from accredited individuals or institutions on the basis of a document called a Private Placement Memorandum (PPM).  The solicitation is private because it is narrow in scope, targeting only known potential investors.  Because it is not a broad, public solicitation, it is not bound by the same disclosure rules (and expenses) such as quarterly and annual reports and independent financial audits filed with the SEC by companies listed on the public stock exchanges.   Should a company blur the distinction between targeted approaches and public solicitations, (such as advertising on its website that it wants investors) it could lose its private placement exemption and have to pay the six figures per year charged public companies. 

The primary document used in private placements is the PPM.  It is a business plan plus other documentation on which investors should be able to make an informed decision about the merits of the management, industry, company and its prospects.  The PPM also includes pages that outline how the company plans to use the money it hopes to raise.  Often it lists the contact information for service providers, such the escrow agent at the bank or the investment bankers or attorneys involved in writing the document or the experts whose research is included.

By knowing what the investor will want to learn before investing (their due diligence), entrepreneurs can make sure that they are able to write and defend an informative and persuasive document.

Do Due Diligence on Your Company Before Someone Else Does

Savvy proprietors of businesses who have been waiting for the right time to sell, merge, or attract investors, do due diligence on their own companies before approaching anyone else.  No manager wants to look like a deer in the headlights when a potential investor asks about an employee with a criminal record, a publicly registered customer complaint, or late property tax payment.  Company leaders need to anticipate the records suitors will request, both from the company and from public sources, like the Internet, the bank, and licensing agencies.  Prepared companies scrutinize themselves, as others with checkbooks invariably will, enabling management to approach suitors with a realistic valuation and a knowledgeable evaluation of the company’s strengths and vulnerabilities.  In addition, the process can save firms tens of thousands of dollars on professional service fees.

 Internal records:

A functional due diligence file will contain about fifteen sections.  A company with few employees and assets can expect to organize about 50 documents, some of which will need to be updated quarterly or annually.  Many companies already have many of these items in separate files, such as “Employees,” “Sales,” “Taxes,” and “Legal.” Pulling them together for a purchasing or investing audience serves two useful purposes: it encourages management to review their records with the eyes of interested outsiders and it reveals gaps that may not be obvious when records are segregated. The files should encompass records of the company’s: 

q  Organization and Good Standing

q  Capitalization and Stockholders

q  Authorization of Acquisitions and the Transactions

q  Financial Statements

q  Tax Matters

q  Employees Records, Benefit Plans, Salaries, Labor Disputes.

q  Material Contracts and Commitments

q  Licenses

q  Insurance

q  Litigation, corporate and personal

q  Patents and Trademarks

q  Real Properties owned and leased

q  Inventory

q  Books and Records

q  Operating Plans

Some information will strike a potential investor differently than a potential merger partner, while other information will be equally important to both groups.  Knowing the interests of each will enable the principals of a company to assemble records that matter to that target group. 

For example:
q  Corporate structure: Is the firm a corporation or a partnership?  In what state?  The answer has implications that make your company more or less attractive to your target audience than competing firms.  Ask your attorney.

q  Stockholders: What do the bylaws say about the rights of major/minor stockholders? Who are they? How many are there? Is management invested? Stockholders, like staff, can be perceived as either an asset or a liability to a deal.  Do the shareholders bring value beyond money or do they have a history of litigiousness?

*Potential buyers will demonstrate particular interests.  One might care about owner expense add-backs or owner assets; another may be concerned about related party transactions.  Others will have strong wishes for management to leave or to stay.  A company can’t anticipate everything, but its records will be scrutinized for “deal breakers,” omissions, and evasions.  Anticipate logical questions.

q  Management: Be prepared for tough questions.  Have background checks, performance reviews, and updated resumes handy.  Explain attrition.  Know which managers wish to remain with the company after a deal is struck and who wishes to leave.  Are non-compete documents in order?

 q  Material contracts and commitments:  Have customer lists, letters of credit, installment plan purchases, and current and pending contracts.  If there are any insider contracts, be sure to show those, too.  Are there any performance guarantees?  Are any deals imperiled by a change in management?  What about agreements with dealers and distributors?

q  Cash flow:  How well does the company manage seasonal or other fluctuations in its costs and cash?  Your accountant can help you design cash flow projections to show likely future scenarios.

q  Licenses:  Technology companies often base their valuations on their intellectual property, so records can quickly inflate or deflate suitor interest. Patents “to be filed” or “pending” are a lot less attractive than patents awarded or defended.  Equally important is who owns the technology.  Is it clearly the company or could it be an employee?  Was it developed in conjunction with another firm or university?  The answers can substantially raise or lower the valuation.  Professional service firms should have current records of all licenses, compliance forms, and proof of professional good standing. 

q  Insurance:  Physical assets can be strengths or liabilities, too.   If the company owns buildings or land, have records of ecological due diligence.  A building with a demonstrated lack of mold or property with no history of chemical storage or oil spills is worth a lot more than one without such a pedigree.  How is inventory insured in case of flooding the day the contract is signed? Does the company have key man insurance?  What about Errors and Omissions?   Such evidence assures suitors that they are unlikely to suffer buyer’s remorse, and therefore, can move a deal along faster than a company that leaves such questions unanswered. 

Public records:

 In addition to organizing records for outsider scrutiny, a company’s strategy should include a survey of its electronic presence.  It is very easy to check up on other companies, so each firm should do a regular Internet search of its company name and staff.  For example, www.hcad.org indicates whether Harris County based companies (and home owners) have paid their taxes for the year, how much they are, and the appraised value of the property. Licensing agencies, like the FINRA, have websites (www.finra.org) on which the public can search for the names of broker-dealers in good standing.  A company’s own website can be very revealing.  Is it current? Clear?  If you contact the business through its website, does someone actually get back to you?  A search on www.google.com or another search engine for the company or management team names can reveal useful information – positive or negative.  For example a Google search for recent potential clients revealed: (1) a businessman who has gotten a Cease and Desist Order from California for a business he was now trying to register in Maryland (2) a CEO who lied about his education background (he made up a university) in his SEC filings and (3) a company seeking investment that hadn’t paid its property taxes for the year.  Surely none of these is the first professional impression one wants to make on the World Wide Web.  Some records can be purged by corrective action; others can be buried by generating appropriate news items, like press releases, speeches, and article bylines.

Entrepreneurs seeking funding from others must be willing to undergo scrutiny from others, so do it yourself, first.