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Red Flags to spot the “Decoy”-Investor

February 12th, 2008 · No Comments

One of the most tragic things I ever hear about is when young companies, who hold such strong beliefs in their own potential and want desperately to believe investors will also catch the vision they cast for their business, will get sucked into the web of deceit cast by a decoy investor.   Unfortunately, for deceitful people, the easiest thing to sell an aspiring entrepreneur is HOPE.

So here is a list of indicators that an investor may be a decoy:

1. The Decoy-Investor expresses interest, gets the documents, talks about their friends who also might like to invest, then turns around asks for a “retainer” or small fee to cover their time to talk with these investors.   No real investor or venture capital firm asks for money from the company they are intending to invest in.

NOTE:  Exception to this may be an “exec with a check” who WILL be investing and asks for additional shares to cover the time they will spend as an “executive” with the company working to build the company.  Then this is understood up front and should not be a surprise and should be a point of negotiation.   An “exec with a check” would not collect a salary (at least not initially), because their investment would just be recycled as their pay, therefore they would get additional shares for their time, experience and level of involvement.

2.  A Decoy-Investor runs a fund and promises to put in more money than is needed or requested on the condition that the company raise 10% or 20% of the total they will put in, up front.   The package often is set up with a program that the amount raised from the individual investors will be held in escrow for 90-120 days and will be paid back with interest with the larger investment.   This is a red flag because the condition of the Decoy Investment fund isn’t based off of milestones or progress made by the company in executing their business model, but rather in the fledgling company’s ability to raise funds that will be held in escrow-ed and be accessible by the Decoy-Investment fund.

NOTE:  An exception to this is when a company is in their early stage of raising capital and the fund (or super angel) wants to ensure they have the capability to raise money or the fund has a standard program to be “second” in an investment rather than the lead on the investment.   Also, this does not apply when a company is raising a “bridge” round to an institutional investment or a small cap IPO, because those bridge rounds typically will accrue interest AND converts into the same term and conditions of the institutional round.  The kind of program described in #2 is a common scheme used when the “funds” are from an unconfirmed source and is used to in effect “launder” money or because there are little recognized terms in the MOU that gives them control over exit strategies and other capital raises so that in effect they hold the company hostage when they get ready to make their large infusion and starve the company to get predatory terms or rights to the IP at a severe discount.

3.   The Decoy-Investor wants to talk or meet your other investors so they can get comfortable.   This isn’t always a red flag because it is common for some investors to want to be sure about the reasons or the knowledge level of the other investors.   But it becomes a red flag when the Decoy-Investor then tries to structure side deals with those investors under auspices of common interests or being a big roller AND asks the investor to keep it confidential from the entrepreneur.   Once an investor IS an investor, it is great for them to form bonds and positive relationships with fellow investors, as long as it DOES NOT impact your ability to raise funds from that incoming investor and WILL NOT damage the entrepreneur’s relationship with the existing investor.

4.  The Decoy-Investor represents a large off shore investor and they book a hotel room (room with beds) or conduct meetings in the lobby and have a series of companies going through to be “selected”.   They don’t have any traceable history on the web, with a website, with offices that can be verified, etc.   They don’t have a formal application process or don’t want to send you documents electronically to be completed.   They require a “small due diligence” fee that is actually $20,000 to $40,000 or more and is not based on any real work output like visiting your facility, preparing a binder that can be used with other investors, conducting real valuation work on the IP etc.   The documents they have you sign have nebulous language about investment being subject to “due diligence”.  Then the icing on the cake is that the “closing” will be in the Philippines, Brussels or some far away place.   A real fund has investor representatives on staff  that is paid by the fund to conduct due diligence.   They may occasionally ask for reimbursement of travel expenses prior to closing or say they will pay certain outsourced services, like valuation firm work, from the closing funds, but they rarely ask for “due diligence fees” up front.   If they do, they aren’t an investor, they are an intermediary and you need to make sure any compensation doesn’t violate your unregistered offering status with the SEC, and be sure you are paying for real work, not just the opportunity for them to rep you.

I welcome comments from entrepreneurs or others that have seen Decoy-Investor deals like this or other ways that an “investor” becomes a decoy.    Our goal with this Blog is to help entrepreneurs get smarter about raising capital and to be more efficient in the process of raising capital by not wasting time on Decoy-Investors or on ineffective strategies to raise capital.

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Tags: Current Financing Trends · Entrepreneurs Seeking Capital Corner

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