Here’s what you can do as a founder to avoid being the victim of investor scams.
As CEO or founder, it is your responsibility to find suitable investors for your business. And just like any other group of people, there are good and bad-intentioned people, so before you sign anything, be mindful of who you are getting into business with. Unlike a civil partnership, there’s no divorcing your investor/s.
It’s always been challenging to raise funds, but as the VC market heads south, it’s getting harder to meet (and get funds from) top-name VC funds and reputable investors. And that lack of good investors gets filled by – you guessed it – rogue ones. Nothing new, they have always been lurking around the corner, but when capital was plentiful before, it was easier to avoid them.
We’ve talked about how not all investors have your best interests at heart before, so we decided to create a quick guide of things you can do (besides following your gut), so you’re not the next victim of an investor scam. Let’s dive in.
Common investor scams when raising funds for your startup
Scammers have existed for centuries so the list could be extremely long.
Loan sharks
The most commonly reported scam in the startup world nowadays is zero-equity loans.
They have incredibly onerous interest rates, short periods before the first payment, high ‘activation fees’, expensive exit premiums or penalties, and also grant themselves warrants available (at their option but not their obligation) for years. Hence, they get the right to invest in your business once and only when it’s flourishing without investing. Many also have complex convertibles, granting themselves rights without investment, bonuses down the line, or even full ratchets.
Service Providers
We also see many fundraisers acting as investors, getting your entire doc pack and confidential information with (of course) no NDA, offering to ‘invest’ a portion of the commissions or fees they charge you for arranging investor introductions. Some may also kindly blackmail you; they could take your information to direct competitors claiming they know the market so well and have “market intelligence”. There’s no cash offer, they’re just selling their fundraising services, usually at above standards and occasionally at exorbitant retainer and success fee rates.
Term Sheet sharks
Sometimes, however, you have actual investors offering you cash – but with some exotic clauses, claiming it’s “market standard nowadays”. Just so you know, there is no standard term sheet. You get the terms that you negotiate, period.
If you’re new at this and need a base template, use the British Venture Capital Association’s. It provides enough protection for investors and no nasty surprises for entrepreneurs. You can download master templates here. There are some other good ones too, in plain English, not legalese, that you get during our Bootcamp.
Examples of some nasty term sheet clauses they’ll try their luck with – there are plenty more, that’s just a few, for illustration purposes:
- (Very) short-term exercise periods. Employees only get a few weeks to convert their fully vested options into shares. The later the stage of the company, the higher the value of shares. Good luck finding several million in cash with no plan to exit or IPO. So options don’t get converted and return to the company, giving the company’s shareholders a bigger slice at no cost.
- Full ratchet anti-dilution. They invest X million into your company at a valuation of Y million. Should you raise at a lesser valuation in the next round (even by just a dime!), you hand them back the entire investment. That’s how CEOs and founders of companies going public end up with 0%. Yes, zero. Tons and tons of famous companies going public stripped the founders.
Once again, be extra careful about the term sheets that can completely destroy your business. If you want to know the other terms and tricks that can strip you out even if the company does well, I highly recommend you join a Fundraising Bootcamp – we have a whole module just for this. It will save you from disaster.
Funds…raising their own funds.
Every five years or so, funds also need to go fundraising, and they need a few good things in their marketing materials to have a chance at attracting good-name LPs. One of these must-haves is a list of hot deals, available now.
That’s you.
They’ll tell you the fund is “almost closed”, “partly closed”, “‘fully committed” and other BS. What usually happens: massive delays, especially for new or first-time fund managers. LPs aren’t backing new ones but are investing more in big-name funds and experienced managers.
There are a lot of investor scams going on right now, and it’s not pretty. Some LPs are starting to call out phoney VC claims. Don’t fall for the PR clickbait.
How to protect yourself from investor scams
Short answer: data, data, data.
Most perpetrators are very good at pitching their products and hiding the truth. Their ability to provide hard data is typically nonexistent. So check the small print: skip the general questions about their services, benefits, comparisons, or advantages, and instead ask pointed, precise, detailed questions.
Few examples:
- With a 10% inflation applied, what’s the total cost of their loan? Any admin fees or international rates/transfer charges? Account setup or termination charges? Early termination or repayment fees?
- Ask them to show you a monthly repayment graph for £X over a period of a number of months
- On a fully diluted basis, what’s the total ownership granted to you if we sign up for your service/s?
- Ask them to build and show you a cap table with their investment and ownership in it after this round, the next round and the round after that – on a fully diluted basis.
- Fake investors: ask them about the last three deals they invested in, including the name of the CEO. Call them and ask for their terms, LP names, and Fund Reg details.
- So-called “syndicates”: ask for the names of all people in it, details of the last three deals they participated in, and their LinkedIn profiles. This is how you can find and connect with the CEOs they backed and do your own due diligence.
So, what can and should you do?
1. Make a hard pass. They sometimes use your name or contacts to connect to other CEOs.
2. Disconnect them from all your social networks
3. Inform your peers and network. Founders trust other founders.
Scammers are true innovators
The short of it is, as cash gets harder to secure, the terms on offer are about to worsen. So be warned. Prepare for the extended due diligence you didn’t need to do only six months ago, and don’t despair: once you’ve done two or three, you’ll smell a rat before you even talk to them.
Remember, the above is just for illustrative purposes. Many other investor scams are going around, and scammers are great at innovating. So trust your gut, ask your founder friends, reach out to experienced advisors (hello!) or just join us at the Fundraising Bootcamp to become a pro at fundraising. You still get a gang of successful founders and advisors to get you there safely.
Whenever you’re ready to move forward with a trustworthy investor, you should also do your due diligence before signing anything. I know it sounds like a lot of steps, but it’s your job as the CEO to ensure your company’s and your team’s future. Exhaust all options and guarantee your investor wants the best for your startup.
There you go – here are some high-level insights. There’s a lot more, but that is long enough already. For more, you know where to find us.
