Fraud. It’s a subject that few of us like to talk about, and most early stage private investors prefer not to acknowledge its existence. Recently we have been hearing from industry colleagues that incidents of fraud are on the rise, so in this post we will share our perspectives on this issue and discuss some of the tools we use to prevent this from happening.
Two years ago, Sage was impacted by a fraud in one of our portfolio companies. Having spent a lot of years in finance, we’ve often heard and repeated: “if someone wants to commit fraud against you, they will, and there isn’t much that you can do about it.” True statement, but not much comfort when it actually happens to you. As investors, we generally talk to entrepreneurs with the belief that everyone is trying to do their best. Companies underperform, they don’t meet their goals, their products aren’t the hit everyone expected, but someone intentionally taking your money and running away with it – that is a shock and can shake your trust in humanity.
Fraudsters tend to strike when markets are turbulent; both in frothy markets where money is chasing everything and downturns when people are desperate. So as we enter another year of market uncertainty, private investors should continue to be on the lookout for companies and individuals who are looking to prey on their trust in order to make a quick buck. Having been burned once, at Sage we are constantly evaluating and refining our investment practices by looking back at both successes and failures to see what we can improve. Here are a couple of diligence practices that we recommend:
Find Trusted Referral Sources: By design, Sage relies heavily on trusted referral sources to send us deal flow. Our investors are our #1 source of deals, but we have cultivated relationships with service providers and entrepreneurial support organizations across the country who refer deals to us as well. We believe that knowing the person who is recommending the company allows us to better evaluate the opportunity. Preferably, the referral source is also an investor in the company.
Talk to Existing Investors: Existing investors usually are motivated to help their portfolio companies attract more money because generally that means more growth and more growth means long term success for all involved. On the surface, one might suspect existing investors would oversell their portfolio companies in order to attract those funds. It has been our experience that existing investors are generally honest about the state of the business and what they are seeing with the company and the management team, and will tell you if they suspect something is off. Again, trust is required here, but the private investing community is intimate and the majority of investors value their reputation more than artificially propping up a company that is on the ropes.
Trust Your Gut: If you feel like something is off (or a colleague indicates they feel like something is off), it generally is. We all know our gut and would benefit from trusting it more. We have also found that the way a company treats the associates at the firm versus how they treat the partners can be a very clear sign of something being amiss. Leaders at the firm should be conscious of creating an environment where the team is comfortable speaking up. It can be uncomfortable to admit to a vague feeling of uneasiness, but we have found that when one person brings it up, there are invariably others on the team who have felt misgivings as well.
Take Your Time: Although we strive to be efficient and responsive at Sage, we also make sure we don’t sacrifice thorough diligence for speed. It is important to take the time to complete diligence and rigorously follow the process to ensure nothing gets skipped along the way. Often companies will need the funds for a specific purpose and there is a tight timeline; it’s important to communicate and set expectations but not be pressured into abbreviated diligence in these situations.
Conclusion
As desperation for funding increases coupled with market uncertainty ahead, fraudsters may start being more creative with their tactics. Investors need to remain vigilant and not make hasty investment decisions without completing all diligence steps rigorously and not forgetting to trust our gut. And since we know fraudsters can read as well, this article does not contain everything we do at Sage. We hope this article provides food for thought and possibly aids other investors to avoid being taken advantage of by unscrupulous people who would prey on their trust.
About Sage Growth Capital
Sage Growth Capital makes revenue-financed investments in companies at any stage who need growth capital. It is our mission to provide a more flexible funding option to growing companies who do not fit traditional equity or lending models. To learn more about Sage Growth Capital or to apply for funding visit: www.sagegrowthcapital.com.
About Revenue-Financed Capital
Revenue-financed capital (RFC), also referred to as royalty financing, revenue share or revenue-based financing (RBF), is a non-dilutive form of growth capital where investors receive a percentage of monthly revenues until a set amount has been paid. RFC differs from equity financing as the investor does not obtain ownership of the company and it differs from debt financing as there is no collateral required and payments are variable. RFC is designed to empower entrepreneurs to grow their businesses with non-dilutive capital that aligns with their sales cycles.