Expert Tips on How to Avoid Getting Scammed by Fake Businesses While Making Equity Investments
For startups, raising funds is one of the more vital aspects of business. Equity investment is one of the more popular ways to raise these funds. For all the funding, however, there are some investments that blew up in the faces of the investors.
Flutterwave and Andela cofounder, Iyin Aboyeji for instance, narrated how he lost $40,000 to some entrepreneurs during the Initial Coin Offering. The entrepreneurs raised about $10 million in funding and afterwards took off to school.
Opinions on Twitter show that quite a number of people have experienced such scams in the course of investing. Here are some practical guidelines from other investors that could help reduce the chances of a recurrence.
Before making a decision to invest in a startup, due diligence must be thoroughly carried out qualitatively and quantitatively. The quantitative aspect has to do with every number associated with the startup or business idea. Do the numbers add up in terms of market size, financials, operational expenses, profitability forecasts and cashflow?
Abraham Durosawo, an investment banking professional, says that in addition to the qualitative due diligence, investors have to pay attention to the team. Background check on their relationships, work experience, criminal records, credit reports, etc should be carried out. If the entrepreneur has partners and investors from previous projects, they should be checked out as well.
Technical knowledge of the solution and field is not enough. Seeking out and verifying the success history and track record of the entrepreneurs is needed.
Funding structure is another important aspect. In planning out capital injection, basing the injection on milestones and making it in tranches gives the investors a better chance at recouping losses and monitoring cash use.
As much as possible, investments should be done in fields that investors are knowledgeable about. This will increase the chances of spotting any faulty business plan or forecast. Oladipo Raji, President and CEO of Focus Group, went on to say that it is good practice to ensure that a business takes off on its own before putting in funds.
One of the pitfalls to avoid as much as possible is funding operational expenses (OPEX). It is a good practice to fund the business, not the operational expenses.
In the case where an investment has been made, active participation is good for the investor and the business. Knowing what is going on in the business and keeping an eye on the money is an essential practice. It is not enough to invest money and leave until further notice.
A practice that can be put in place, according to Abraham, is for VCs to be signatories to major accounts in order to monitor what cash is being spent, on what, and when.
In some cases, VCs may want the majority share of businesses they are investing in. In Abraham’s opinion, this could shift the mindset of entrepreneurs from owners to employees. This, in turn, could make it a case of getting as much as possible out of the business for the founders as against putting their foot down to succeed.
“VCs want to take majority share in the business like 51% plus, when you do that the promoter (entrepreneur) thinks he is now working for you (VC) and his attitude changes from that of an owner to an employee. Then he tries to take as much money as possible upfront and will not care if the business fails. But where the promoter owns more than the VC, the promoter knows that if the business fails he losses more”Abraham Durosawo
In the case that an equity investment goes wrong, the investor has his share of the loss depending on the equity he owns. Barrister Akinyemi of Nlegal notes that in the case of suspected foul play or misappropriation of funds, the investor can employ the services of an auditor to check documents such as Annual Returns of the Company and Cash flow. The investor can now press charges against the startup with evidence.
“Of course, this is assuming that the investors and the startup were bound in an Investment Agreement and that the startup itself is duly registered under the Part B of the Companies and Allied Matters Act by Corporate Affairs Commission. This gives the startup a personality that can sue and be sued”Barrister Akinyemi
No matter how many cautionary steps an investor takes, the risk in investing is never totally eliminated. It is even more reason for a healthy risk assessment to be taken before a final decision is made.
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