Andrew Lockley – Exponential Investor (United Kingdom) –
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 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.