“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 themes 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. Don't get caught. 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. Unfortunately, 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 and firms. Brokers and firms that have been delisted are still identified for ten years. Any entrepreneur considering raising money should spend several hours scanning the sections relating to private placements (sometimes referred to as reg. D) in order to ask knowledgeable questions of potential service providers.
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 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 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. 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. 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. Fund raisers who won’t reveal the name of the investor/terms of investment as soon as they say they have some. Offices with P.O. Box addresses only, “Investors” calling from “boiler room” type call centers. Sidebar 2: How to Protect Yourself Ask your banker, lawyer, and accountant to recommend broker-dealers. Their business with you is vulnerable if they steer you wrong. "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. 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. 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?. 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." 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.
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. Set written caps and an approval process for expenses. Get everything in writing. Don’t believe anything that is not written.