Several months ago, a new-ish startup founder (we’ll just call him “Chuck”) came to my law firm seeking help in reviewing and possibly negotiating the terms of a seed round with their first, outside investor. Chuck was genuinely excited because this investor had proposed (let’s just say a number between) $1-2 million for (let’s further say) 20% of Chuck’s company. A critical infusion of capital that could get the company through a few of the next developmental milestones.
However, during our first call, Chuck said something that made my lawyer antennae stand on end. While we were talking about timeframes, he said something along the lines of “yeah, [Mr. Investor] is just waiting for us to sign off on the agreement and to send in our check for due diligence.” My first thought was, “Wait, what?”
I assumed Chuck had misspoke. I asked him to repeat what he had just said, to make sure I hadn’t totally misheard. Was the investor (you know, the guy with $1-2 million to part with) was seriously waiting for Chuck to write a check to him? As in, come out of pocket in order to do this deal?
Chuck, hesitatingly confirmed that, yes, the investor was indeed waiting on Chuck’s (or rather his company’s) check for [a not insignificant amount of money that we’ll say was] several thousands of dollars for “due diligence” costs.
Besides the legal term we attorneys like to call a “NFW”, my other thought was, this investor was either a scammer or a “finder”.
Nevertheless, I told Chuck to send me the term sheet or proposal the investor had sent over to him so I could see it for myself, as well as get a handle on the main terms of the deal itself.
Although a part of me still wanted to believe that something had just been lost in translation, when I was finally able to see the “memorandum of investment” it did, in fact, not only include a $[several thousand dollar] fee for “advisory” “consulting” and “due diligence” to be paid up front by Chuck’s company.
To make matters worse, not only was this amount to come out of pocket but was not a one-off payment but rather a monthly recurring amount. But, on the plus side, the first payment was payable in installments! Oh, and it had been reduced to the $[several thousand] figure from this investor’s “normally” $20,000 per month in “advisory” fees. What a deal!
There were still more goodies in this investment “memorandum” that ultimately led me to advise the client to not sign the document and, at the very least, recommend caution in spending any further valuable time or sharing additional information with this so-called “investor”.
A Legitimate Investor Will Not Ask for Costs Up Front
…and certainly not for “due diligence”. The point is, a legitimate investor will almost never, ever ask you or your startup to come out of pocket up front for “due diligence” or “advisory” or “consulting” services. Now, if you are actually engaging this person to provide some type of advisory or consulting services, and it is clearly explained what services or deliverables this “investor” will be providing that might be one thing. But, to pay him (or her) up front for the potential of securing funding? As I said earlier, “NFW”.
Apart from being one of the reddest of red flags that your “investor” is anything but, the fact is that due diligence investigation of a company and its management team is usually done by the investor on their own dime and employing their own, trusted network of professionals. Basically, it is just understood to be a cost of doing business on the part of that investor or firm.
If the investor actually closes on the round, they typically do get reimbursed by your company (but hopefully only up to a certain, pre-negotiated “cap”) but the investor is paid back out of the proceeds of the round (in other words, with their own money.
What if the investor walks or fails to close? Again, most legit investors accept this as a cost of doing business and almost always end up eating such costs. After all, it’s better to take the hit on the due diligence costs than put in the million (or tens of millions) into something that is problematic or not pan out (or, in the case of a partner in a VC firm, get them possibly fired).
So What if This “Investor” Was a Finder. Who Cares?
Well, for one thing, your next round(s) of investors will. Secondly, the Securities and Exchange Commission (SEC) will also take an interest. Put simply, a regular person can’t just go and recruit other investors to invest in a particular company for cut of the money raised. At least not legally, anyway. This activity typically requires that the person first be properly registered as a licensed broker or dealer with the SEC.
While there is nothing inherently wrong with using a “finder”, this should be disclosed by him/her from the get-go and you need to know what your company is signing up for. It is critical that you thoroughly vet such a person and do your homework on both them and their track record. And, no, having an active or impressive LinkedIn profile is not sufficient [don’t laugh; this has been shown to me as proof of a particular investor’s bona fides].
At the end of the day, while I couldn’t say for certain that this guy was a finder, I told Chuck that if they went ahead with this “investor”, they would likely just be gambling with the $[several thousand] of due diligence fees. If Chuck went ahead with this deal as-written, he had to be prepared to never see a dime back from his up-front payment, let alone anything close to the [between $1-2 million in] investment funds from a successfully closed round.
While the prospect of your first major investor can be an exciting one, startup founders should never let the moment cloud their judgment–or dampen their instincts. Chuck even admitted that what this investor was asking for didn’t quite sound right to him either. Oftentimes, your first instinct is the correct one.
At minimum, before signing any term sheet or, as in this case, “memorandum of investment”, or the like, you should always seek the advice of a lawyer that represents your interests first not only to validate your concerns (as with Chuck) but also have a second pair of eyes to verify that what you have agreed to is actually included into the final form of the deal agreements, not to mention alerting you to what may not be in the term sheet or offer that really should be.
Photo courtesy of LinkedIn Sales Navigator via Pexels (image cropped).
Ben Bhandhusavee is the Managing Attorney for BHANDLAW, PLLC, a startup, technology, and e-commerce law practice advising founders and management teams on company startup, corporate and technology transactions, e-commerce, as well as Internet privacy concerns. The firm serves corporate and individual clients throughout Arizona, the United States, and internationally. Our offices are conveniently located along the Camelback corridor in Phoenix’s financial district. For more information about our Company Startup practice, feel free to reach out using the contact form on the right or call us at (602) 222-5542 to schedule a meeting. Connect with Ben on LinkedIn or Avvo.