How to Guard Against Entrepreneurs’ Dirty Tricks

05.12.2017 • United Kingdom

Andrew Lockley – Exponential Investor (United Kingdom) –

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. Today and tomorrow, I’ll give you a quick rundown of the most common forms of skulduggery to watch out for.

Phoenixing

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 some 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.

Fraudulent raising

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.

Liquidation preferences

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.

Fat salaries

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.

Tomorrow terminates the tech tykes’ toady techniques tour. Meanwhile, please let us know what you think in the comments below.

Best,

Andrew Lockley
Exponential Investor

-Read more at www.exponentialinvestor.com-

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