In the new crowdfunding ecosystem, there will no doubt be wolves among us. It is up to investors to protect themselves from fraud. Here are some “red flags” to look for when investing in a company on Spring Street:
1. High Compensation with Little or No Revenue – We all need to make a living, but there is no reason why the CEO of a crowdfunded company should be making excessive compensation, particularly when the company is generating no revenue.
2. Expensive Money or Contracts – Look out for big commissions payable to management or third parties who assist the company in raising money. Be suspicious of “consultants” or “finders” who have contracts with the company entitling them to a percentage of any funds they raise. If a company is making regular cash payments to a third party for any kind of service, you should understand what the payments are for. Also, find out if there is common ownership between the company and any vendor. It is possible that management is simply funneling cash to themselves through a vendor they own.
3. Related Party Transactions – Is management involved in any contract or transaction with the company that would benefit him or her personally? Is the company buying its primary asset from the company’s CEO? If so, find out the terms of the deal and how it was or will be approved. Legitimate management will go to extraordinary lengths to mitigate conflicts of interest.
4. Accounting Issues – Has the company ever had an accountant jump ship? If so, find out why. Read all letters written by the company’s accountant in connection with the offering. They may reveal something questionable about the company or the offering.
5. Assets Unrelated to Business – Incredibly, people will invest in a company that owns assets only tangentially related to its line of business. This could be a clue that management intends to take the business in a completely different direction, after taking your money.
6. Confidential or Secret Information – Be suspicious of information provided on a confidential basis or “off the record”. Sometimes secret information is offered to give the perception of value. Other times it is offered to avoid leaving a paper trail.
7. Black Boxes – If a company claims to own proprietary technology or a trade secret that give them a marketplace advantage, demand full disclosure. A company that is not willing to share proof pursuant to a confidentiality agreement may be blowing smoke.
8. Familiar Names – You should raise an eyebrow if a company uses names similar to names of successful companies, products or people. Scour the internet for information about everyone involved (e.g., management, lawyers, accountants, consultants, vendors, and advisers). If you read something negative online, conduct more research on the matter.
9. Fast Money – Companies that use crowdfunding to raise capital are high-risk ventures. Good investments are long-term. Do not be persuaded by projections that promise high returns over a short period of time, often 6 to 24 months.
10. Guaranteed Returns – No investment can provide a guaranteed return, otherwise the owners would simply get a bank loan to capitalize the venture. Be skeptical of a company that claims that downplays the risks associated with an investment. Don’t invest in opportunities that are de-risked or enhanced by exotic financial products, complex corporate structures or insurance products. Protect yourself from the smartest guys in the room.