Angel Investor FAQs: Preparation for investor meetings

Management should prepare strong, SHORT, consistent answers to the logical questions that investors are likely to ask. SHORT answers enable investors to ask revealing follow up questions. A long winded entrepreneur loses the opportunity to HEAR useful questions by informed investors. SHORT ANSWERS also allow time for SHORT QUESTIONS to weed out service providers posing as investors, and others more interested in talking than investing. Conversations between entrepreneurs and investors are inherently uneven. The investor has money. The entrepreneur wants some of it. So bear in mind that behind every stated question by an investor is the unstated question, “What’s in it for me?” Effective answers should be attentive to the investor’s interests and concerns.

Explicit questions by the investor, regarding his interests, might be worded: “How is my investment secured?” “How long before the company is in the black?” “What is your competitive advantage?” “Let me see the financial projections.” “What will you do with my money?”

Well prepared management can have 1-2 sentence answers to each of these. Implicit questions about “what’s in it for me” might be worded in a variety of ways. Some examples of questions and approaches to answers:

“Tell me about your management team.” This question is not (note underline) about biographies. What does the investor want to know: Is this team going to be effective in this endeavor? Is it going to make me rich or lose my money? Develop answers that demonstrate why this management team is the best one to preserve the investor’s money and marshal it to a lucrative end. For example, is the management team invested in this deal or looking for a salary and a nice office address? Consider the terms of the management’s compensation from the investor’s perspective. Has management successfully fielded a business in this industry before? Has it sold a prior company at a profit? Has it returned investor money at a profit?

“Who is your competition?” Never say no one. This answer implies naïve tunnel vision. Rather, identify those companies that the public might perceive to be competitors, and then briefly explain either niche differentiation or your ability to deliver faster, cheaper, better, or with an enviable barrier to entry, or a low cost/high margin solution. If an investor is interested in your industry but finds your answers weak, s/he might consider investing in your competition! Besides, “smart money,” – investors who know your industry well - are testing your knowledge when they ask this question, and comparing it to their own. Satisfied “smart money” investors do not have to do as much due diligence, and will often write a check sooner than investors outside of the industry. Know what they know, about you, your competition, the market.

“What is the structure of the deal.” The investor wonders what he’ll be left with if the company’s potential is unfulfilled and the deal fails. How attractive are the terms to the investor? For example, what is the security of the investment, the use of funds, the seniority of the debt or equity, what are the interest payment terms? Are there any tax write off advantages if he loses money? Is his investment leveraged in any way, by the state, a grant, or other means. The use of minimum/maximum funds raised will traverse what path to profitability? Will the investor’s money pay salaries, buy assets or build inventory? Does the state of incorporation protect the rights of investors?

Naturally, entrepreneurs are optimistic about their future success; otherwise they wouldn’t be pursuing it! Entrepreneurs are also ACCOUNTABLE for optimistic projections. Written and verbal answers to investors ought to be delivered as though to the investor’s attorney, CPA, or banker, because sooner or later, they will be. The bigger the deal, the longer the investor will spend on due diligence. His research should mirror your research. Verbs like, “believe, project, hope, anticipate, plan, expect” are to be expected in forecasting future business conditions. Verbs like “will, promise, guarantee, know” could be construed, in retrospect by a disgruntled investor, as fraud or misrepresentation. Also pay attention: the SEC holds entrepreneurs accountable BOTH for errors of commission (saying something that is false or misleading) and errors of omission (not mentioning something material to the investor’s decision making process). Obvious examples of omission include suits against the company or members of the management team. Less obvious examples might include “sweetheart” deals with friends and family of the management team for products and services targeted as a use of investor funds. It is more appropriate to disclose this before you take a check, rather than afterward.

By the time you are ready to approach investors, your company should have developed a due diligence file of documents about your own company that investors are likely to want to see. By developing a logical list of “who, what, when, where, why, how” questions for these files, and prepping your management team on the appropriate responses to them, your company will convey an impression of knowledge, integrity, and full disclosure.

The Emperor’s New Clothes: People Who Pose as Money Raisers and the Entrepreneurs Who Trust Them

“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.

Can You Believe They Said That?

(Comments by entrepreneurs and financial service providers who need another career.)

If there isn’t a “Darwin Award”© for entrepreneurs, there should be, for people who would benefit business most by leaving it. I’d like to nominate the speakers of the following, eye-popping quotes in response to logical, due diligence questions. The responses may elicit “you must be pulling my leg” reactions; however, they are all true or abbreviated responses by entrepreneurs or their investment bankers. A single hour’s research per company uncovered most of the underlying issues. Following the quotes are several free and useful research websites and search tools by which investors can research entrepreneurs and by which entrepreneurs can research board members and service providers. If you tend to be trusting by nature, verify, too.

· “Litigation is just a cost of doing business,” said one CEO regarding more than five current suits, judgments and settlements I found against companies in which he was listed as a director or president, including, sadly, a “charity” of his not listed with the IRS.

· “He wasn’t a very involved director,” said a company president, regarding one of his directors, who was indicted for bribery and fraud as a director of another company.

· “I don’t think the IRS tax lien will really discourage investors. People will either love or not love our business.”

· “We don’t think of it as a conflict of interest. We think it is efficient that our major suppliers are also owned by members of our management team and Board of Directors.”

· “No; we don’t want an escrow account with an independent bank and a second signature before releasing investors’ money. Yes, we are raising money to start a bank.”

· “Those two corporate bankruptcies were not my fault,” said an entrepreneur seeking investment by showcasing his financial management skills. Unfortunately, the state and county also list five recent personal liens and judgments against him by businesses and taxing authorities.

· “I learned my lesson,” shared a serial entrepreneur, questioned about evidence that he had served time as a white collar felon for duping investors. “Different investors.”

· “Yes, there is another company with the same name that owns the IP we are describing in our documents as our company. That is because we want to raise money to buy them.”

· “I know that the money we want to raise now is not enough to fund the business model I have described. Our plan is to raise enough money from individuals to buy a public shell or go public, and then raise money from stock purchases to start the real business.”

· “Oh, I didn’t realize that another company’s website says to report anyone else trying to represent the product our client wants to raise money for, but he plans to sell it in Mexico, not here.”

· “That journalist hates me,” admits a president regarding an article in his hometown business paper that cited lawyers and investors suing him for a prior business deal very similar to one that company press releases were currently touting.

· “Yeah, we’re updating those filings now,” affirmed a CEO of a pink sheet company in 2006. (The most recent filings were from 2000). The company specializes in managing other companies.

· “I haven’t done anything in real estate development before, but I ran a very successful dry-cleaning business,” said a young and enthusiastic entrepreneur.

· “I don’t know why they are suing me. It was my dad’s store,” said a man charged with 65 counts of petty theft and 27 counts of forgery, hoping to find investors for a new business venture.

These quotes prompt two questions:

1. How many knuckleheads do these entrepreneurs and investment bankers think are out there?

2. Are people really willing to write a five or six or seven digit check for a well told tale without a bit of research?

Each of these responses resulted from questions after research that took one to three hours per company, from publicly accessible documents, reading the Private Placement Memorandum (PPM), or just attending the investor presentation.

Most entrepreneurs like an audience, and if you ask the right questions, you’ll get an illuminating earful. Then hide your wallet until you hit the Internet.

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Below are extremely useful, free websites and Internet search tools that potential investors, investment bankers, and even employees can use to review a business prospect.

Useful Search tools:

Internet searches are harder for common personal names, company names with generic phrases like “Beautiful Flowers” and initials, like “ABC Corp.” Researchers would do well to try several combinations, such as name and city or name and industry.

Useful websites:

* www.sec.gov This site is for public companies. One can search for individuals who might be major stockholders or prior directors or managers, or if a company has been sanctioned, has changed names several times, or is a wholly owned subsidiary.

* www.irs.gov

www.charitynavigator.org Anyone who donates money to a charity or religious organization should see if it is listed with the IRS as a 501C3, which allows for a tax credit. If the charity is not listed, why not?

* www.finra.org This website (See Broker Check section) lists every currently licensed individual and broker-dealer in a very easy, searchable system, which includes any disciplinary disclosures and prior employers, too. It also lists people who left the industry as long as ten years ago, perhaps under a cloud of sanctions, which are also listed. The website lists the code of ethics and rules regarding most types of investment sales by which all registered people are bound. People not listed here are not registered but call themselves financial service providers.

All three of the above websites have a “wall of shame” section, too.

* www.bbb.com Visitors can search for companies and charities affiliated with the BBB and for company complaints filed with the BBB, by city. This site is less useful for financial industry firms and more useful for companies that sell some kind of inventory or other service.

* www.yahoo.com/finance A number of websites, such as Edgar and Hoovers, require log-in and membership to access information more easily available, for free, through Yahoo. A visitor can search for press releases, and access public filings and stock price histories. Anyone who has served as an officer of a public company should be searchable.

* www.google.com The most highly used search engine is very user friendly.

Searches reveal information about individuals as varied as book reviews they have written, blogs they have visited and political candidates and charities they have supported.

The websites of counties and states across the country vary widely in their web-readiness. Some have committed years and millions of dollars to filing documents electronically for the convenient access of the public. Texas and Alaska have very open records policies. California has stricter privacy policies.

a) cclerk.hctx.net/ On the Harris County Civil Court website, visitors can search for incorporated and DBA companies, for civil suit dockets according to plaintiff and defendant (and read the outcome) by company and individual names.

b) www.hcad.org On the Harris County Appraisal District website, visitors can search for property records, including ownership and tax payments. An investor might want to assess whether the entrepreneur owns property or is a flight risk if a deal goes sour. Similarly, an entrepreneur might want to determine if a potential investor owns or rents that mobile home or a mansion. In both cases, the inquirer can see if tax payments are current.

c) nasaa.org/ All states have a secretary of state website. Although the customer friendliness varies broadly, these are good sources for checking out any licensed professional, many incorporated companies, and other useful information about white collar crime prevention.

d) www.bizjournals.com This website enables visitors to search through city business journals from Albany to Wichita, which may have articles about an entrepreneur or investor active in that city.