(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.