Don’t Be Fooled by Investment Scams For Startups

After you have heard a few startup success stories, like Google, Facebook, and Microsoft, you may be tempted to invest some money yourself, maybe by pooling your funds with other investors who claim to have a great track record. My advice is to leave the investing in startups to the professionals (or friends and fools).

First of all, despite a few visible blowout successes, the odds of a payback from investing in startups is very low (that’s why VCs look for 10X returns to cover failures). Most investors agree the odds are better buying traditional public stocks, or even commodities. Even the hot new “crowdsourcing” companies springing up have yet to show any significant returns to investors.

Secondly, there are many scammers out there who look and act just like Bernie Madoff, even though he is safely tucked away in prison for the next 150 years. Most frauds are not on the scale set by Bernie, but even a few thousand dollars lost would hurt you and me as much as a few million did for some of his victims.

So what can you do, and what are the “red flags” to look for as you do your due diligence before pooling your money with other investors, or accepting money for your startup from investors? Here are some common sense tips:

1. Get financial statements and verify. Every reputable investment firm is registered with FINRA and files regular reports with the SEC. Look for these and investigate thoroughly to check the truth of every statement about the company. Ask for references, and call or visit previous “successes” of the company to verify experience and satisfaction.

2. Avoid “insider deals.” The Internet has just made it easier and faster for vultures to feed on entrepreneurs tempted by the possibility of an “inside deal.” Someone you don’t know promises you an “inside” deal. Why would a stranger pick you out to make rich? Does that make any sense?

3. Listen for “unnamed sources.” If all current investments are with “sensitive” clients, who are unnamed or unable to be contacted. Remember the old newspaper publishing rule of “All facts must be verified by two independent sources.” People claiming to be unbiased may actually be paid promoters, large stakeholders, or company insiders.

4. Any mention of “offshore.” Watch out if someone has a complex plan involving offshore bank financing or gemstones or oil leases in Iran to make you rich. Why get involved in a complicated scheme you don’t understand, when there are plenty of opportunities that are legal and you can understand.

5. Sounds too good to be true. The age-old wisdom here is that if it sounds too good to be true, it’s not true. I continue to be amazed at the fact that the Secret Service still gets 100 calls per day from victims of the Nigerian unclaimed cash scam alone. What are these people thinking?

Here are a few questions you should ask that might allay any remaining qualms, or convince you to run immediately:

• How much am I paying in commission or fees?
• Have you personally been involved in any arbitration cases or lawsuits?
• How do you get paid? By commission? Amount of assets you manage? Another method?
• Have you or your firm ever been disciplined by the SEC or a state regulator?

Unfortunately, in the startup and investment business, we are trained to rely on networking, connections, and professional integrity for many decisions. Remember that people who run scams may be highly polished and sophisticated, and can wrap their con games in such an air of legitimacy it may be hard to see the truth.

Don’t assume you are safe now that Bernie is out of the picture. If you have evidence of fraud, don’t be too embarrassed to contact the Securities and Exchange Commission. If others had done this sooner, his clones wouldn’t be out there today looking to help you out (of your money).

Marty Zwilling

Startups Get No Help From an Investment Bank

The name “investment bank” somehow always sounded like a place where I could somehow deposit my investments, and maybe even earn a little interest. Then I learned that these banks really negotiate investments and collect fees on the transactions, sort of like commercial banks do with loans to businesses. None normally work for or provide funds for early-stage startups.

Many investment banks even call themselves “boutiques.” As near as I can tell these are smaller ones, who don’t sell clothes, but typically sell companies and securities in a particular set of industries. All investment banks have to be staffed by licensed specialists, called broker-dealers. Very confusing.

None of these investment banks offer traditional banking services, as you would expect from one of the following:

• Retail banks
• Commercial banks
• Credit unions
• Savings and loans

As startup founders, you first need to deal with one of these banks, probably a commercial bank. Commercial banking is also known as business banking. That would be almost any bank that provides checking accounts, savings accounts, and money market accounts to businesses, and also makes loans to businesses. It may be the same physical bank that you deal with for your personal account, except in the personal context it is called a retail bank.

Most retail and commercial banks offer investment services to their customers, but these services have nothing to do with investing in your business. Typically, their service is to help you invest in stocks, bonds, or mutual funds, much like independent financial advisors.

A few, like Silicon Valley Bank (SVB), actually do provide management services to startups, invest in startups, or provide early-stage venture capital, but that is not called an investment service and is part of a function called Emerging Technologies, or sometimes Private Equity.

So unless your business is well established, and ready to sell or go public (Initial Public Offering - IPO), you should steer clear of investment banks. Officially, the investment banks mission is to raise money for companies by issuing and selling securities in the capital markets, and providing advice on transactions such as mergers and acquisitions.

Investment banks normally charge fees consisting of three components. There is an upfront or monthly retainer, and maybe a closing fee, of at least several thousand dollars. In addition, they will likely take between 3% and 10% of any capital raised. For these fees, they will develop a business plan, solicit investors, and negotiate term sheets to a closing.

Another service of investment banks is the buying and selling of “derivatives,” which many believe to be some arcane financial products to dodge government regulators, encourage foreign currency speculation by pension and mutual funds, disguise risky gambles with AAA Standard & Poor’s ratings, and avoid capital gains taxes for wealthy individuals.

After the banking fiasco surfaced a couple of years ago, resulting in the failures of Bear Stearns and Lehman Brothers, investment banks seem to most of us more like a place to avoid, rather than a place to entrust with the keys to our investment livelihood. I’m not sure whether derivatives per se were the problem, or the fact that they were often backed by worthless subprime mortgages.

Startups looking for an Angel investor, or a Venture Capital investment usually realize that neither of these sources of funds normally has any connection with a bank. Yet every business needs to have a good relationship with a bank, for day to day operations. I guess it’s no wonder that banks are struggling these days with their public image. Their message and mission is confusing, even to professionals. As your business evolves, don’t let that happen to your own message.

Marty Zwilling

2011 May be the Year of the IPO for Social Media

It has been at least a decade since going public via an Initial Public Offering (IPO) has been considered a credible exit strategy for startups. But the word is out on Reuters that LinkedIn, Twitter, and maybe even Facebook are looking hard at going public this year, so all of a sudden the IPO option is back in business plans again as an exit strategy for startups.

But before you jump on the bandwagon, you should consider the advice I saw recently from the maven of venture capital, William H. Draper III, in his new book titled “The Startup Game.” He says that you should never consider a public offering unless you are confident that the company will deliver increasing profits and revenue after the offering, so that the public buyer can anticipate a gain.

According to Draper, in addition to the above Rule Number One, there are many other questions that need to be answered before a CEO should recommend to the board that it is time for an IPO:

• Do you really need the money? If the company is growing like crazy and has only a modest income stream, the answer is probably yes. If the company is just bumping along in a quiet niche, with no bright prospects in sight, the answer is probably no. Being thinly capitalized doesn’t necessarily mean you need a big cash infusion.

• Is the money going to be enough? Usually a small company can sell about 20 percent of its stock in an IPO. Run some scenarios, including some very conservative ones, and see what going public is likely to yield. If it’s not enough, don’t do it.

• How’s the timing? The timing of an IPO is driven heavily by the state of the economy in general and the stock market in particular, in concert with your profitability. The market is moving back up, but slowly. In 1999, there were 486 IPOs nationwide; just 10 years later, in 2009, there were only 63. Is your spotlight bright enough to start a new wave?

• Do you need the IPO for your acquisitions strategy? Sometimes the best way to grow is to acquire other companies or other products, and sometimes you need a public stock in order to go that route. Of course, you’re going to have to perform well to make that stock useful in the acquisitions process.

• Do you need this for recruitment and retention? Liquidity can help attract new employees and keep current ones happy. If you have been giving stock options, employees will want you to be a public company, to exercise their rights to buy the stock and sell it at a profit.

• Do you need this for your image? Rightly or wrongly, public ownership often lends prestige and credibility to the company in its sales efforts, general public relations, and the execution of its future strategies.

• Do you have the horses? Are you ready to answer to the new public stockholders and accept responsibility for both the good and the bad as it unfolds in an uncertain future? Do you have the CFO, and the best legal and accounting help to comply with the audit requirements of the Sarbanes-Oxley Act? These can add millions to the cost of doing business.

Then there is the formidable process of taking the company public. It will take at least three months, and require endless amounts of time, money, and energy. You need to work through a team of underwriters, who administer the public issuance and distribution of securities from a corporation. False starts in this direction can be disastrous.

At any rate, it seems only appropriate that social media sites, which have dominated the Internet over the past few years, will likely lead startups back into the IPO game. Like other startups, they no doubt have private investors eager to cash out, and it certainly appears that the big three social networking firms could be well-regarded for going public. Which stock would you bet on as the leader?

Marty Zwilling

Name the Big Three Social Networks for Business

With the advent of social networking sites like LinkedIn, Twitter, and Facebook, Internet usage has totally morphed, from a serious business medium, to a social and fun medium that still means business. Regular people now build business applications with “mashup” technology, rather than hiring programmers.

I’m a technology follower from the early days of the Internet, so a couple of years ago I decided to dive into this new world and check it out (who even heard of blogging or mashups ten years ago). I realized quickly that this new world isn’t just for the social life of Gen-Y – it is a sea change for everyone in business, especially startups.

After any earthquake event, the first thing I try to do is to step back, get the lay of the land, and derive some guidelines for getting around efficiently, while avoiding personal injury (I spent some years in California). Here are the current big three in social networking for business:

1. Facebook is biggest, moving from social to business. Currently, the biggest site in numbers is Facebook with over 500 million active users. 50% of active users log on to Facebook in any given day. Their primary visitors in the past have been Gen-Y socializers, but the fastest growing segment now is business people, and discussion groups for business, like “Facebook for Business” with 56,250 members.

2. LinkedIn caters to senior business professionals. The largest site traditionally targeted at business people is LinkedIn, with current numbers exceeding 80 million members. This one is a “must” for every serious business professional and executive out there today. You can join groups with your specific interests, participate in discussions or not, and highlight your business.

3. Twitter for business and networking is ‘hot’. This site is for text-messaging on the Internet, with about 100 million unique visitors per month, and was first popular for social updates and gossip. Now it’s the source of business leads and networking for thousands of people, and the source of the breaking world news for everyone. You need to be there.

Obviously, there are many others that you should evaluation, based on your geographic location, type of business, and personal interests. Here is my perspective on a few of them:

• MySpace is for tweens, forget it. The third biggest site (just passed by Twitter) is MySpace, with about 95 million unique visitors per month. They have groups for business and entrepreneurs, but the culture is primarily teen and pre-teen. You will find business advertising there, but minimal business networking.

• It’s not all about numbers. There are many more social networks which have good traction and a more specialized focus in the business networking world. Examples include Ryze, Plaxo, Orkut, RedWire, and Ecademy. In general, their membership is focused by geography, industry, or culture, so the value can be excellent.

• Business networking today starts with social networks. Social networking sites are more effective and efficient than attending all those boring business cocktail mixers and conventions. I’ll even be so bold as to say that if you aren’t on any of these sites, you are way behind the curve in business networking today.

• Protocols for each site are different. There is a hierarchy and a culture to social networking sites on the Internet, just like there always has been with professional business organizations and clubs. There are so many sites, so you need to choose wisely, and learn the rules for each. Most are free, so you can do serious business networking around the world without signing up for any of the fee services.

Maybe because the cost of entry is low, I see a swarm of startups today busy with add-ons, and building new offerings. It’s a brave new world, for me an exciting challenge and fun to explore. But like every good explorer, I’m asking everyone I meet what’s around the next corner. Are you there today, and what do you predict for tomorrow?

Marty Zwilling

Real Entrepreneurs Avoid Multi-Level Marketing

Many self-proclaimed entrepreneurs send me invitations and accolades to join their favorite Multi-Level Marketing (MLM) or Network Marketing company, but these all sound like “get rich quick” schemes to me. For me, the essence of an entrepreneur is creating something new and innovative, whereas an MLM is a traditional formula on an existing product with a high premium on pyramiding.

I know there are a few companies, like Mary Kay and Lia Sophia, who have a generally positive image, but there are many more, often built around some investment scheme, which continue to give this sector a bad image. If you scan the Internet, you will find dozens of negative articles, like “What's Wrong With Multi-Level Marketing?”, but very few singing their praises.

Technically speaking, pyramiding is an illegal practice of a company that solicits their members to recruit more members, more than selling the product. In turn, the primary source of income for its members is the number of members they have recruited instead of the products they have sold over time. Clearly, not all MLMs are pyramid schemes, but it all seems like a matter of degree.

If you insist on trying one of these MLM offers, the least you can do is look for proper business registration with BBB, toll free number, and proper address (no Post Office box). Also, you will need lots of family and friends to make it work. As a final step, check the MLM materials for one or more of these “red flags” that are associated with the worst of the offerings:

1. Fee to "get your business started." If their business model is really from selling products, then up-front fees should be unnecessary and are inappropriate. Usually these are billed for education and training that consists of a few marketing brochures.

2. Promise big money with little work. There are of course things that you can do to make money without having to work all that hard. But, it's just not possible for everyone who joins a business to be able to make so much money without working. Making money takes work.

3. Purchases encouraged as "investment." Often times MLM companies want you to think that making purchases for products within the company will advance your status, or grow your business, more than satisfy sales.

4. High income projections. Many companies love emphasizing how much you will make, but rarely mention how you are going to make it. MLM opportunities have proven historically to be, at best, a little better than a side income for most people.

5. Money from recruiting. If they would rather have you recruit another distributor than a new customer, then their products are not what is driving the company. A company that is filled up with people but no products is still just a group of people, not a thriving company.

The Internet has made it so easy now. In the old days you had to actually visit people, or at least call them, to pitch your fabulous new opportunity. Face-to-face marketing is still practiced, but it is not so common these days. Besides, no one really loves the idea of having someone over, so they go online where everyone can be as safe as they want. They create sites with videos, testimonials, and pictures.

I will admit that I don’t like the business model of paying people to solicit other people. In fact, I’m convinced that the phrase “Multi-Level Marketing” and “Network Marketing” were invented as sanitized terms after Amway and others were charged with “pyramiding” back in the early 1970s.

Yet there must be something to the business model, since I see some big business icons like Donald Trump are joining in the MLM parade. I’ve written about these before, and I’m still looking for one that feels entrepreneurial. Who has a convincing story that will make me feel good and pure as I recommend their MLM to my best startup clients? Do you love them or hate them?

Marty Zwilling

The Renewable Energy Sector is Fundable in 2011

green and biotech investment categories, so I’ll try to do the same here for renewable energy.

Renewable energy is any source that can be produced cleanly, will not disappear like fossil fuels, and is less polluting. The Clean Technology venture capital sector, which includes alternative energy, soared 68 per cent year-on-year during the first quarter of 2010. I expect another increase this year. Here are the key components, as summarized by the New Alternatives Fund:

1. Solar power. Solar cells produce electricity from the sun. Conversion efficiency of silicon cells has increased from 4% in the early eighties to over 20% for the latest technologies. The cells create no pollution when they generate electricity. They are not yet as cost effective as coal-generated electricity, but costs keep declining and efficiency is increasing.

2. Wind power.  The latest turbine technologies have resulted in wind-produced energy becoming more cost efficient, and more widespread. New wind energy development is essentially cost-competitive with conventional energy technologies.

3. Hydropower. This technology is clean but limited by geography. This is already an important source of renewable electricity. More attention is going to low-impact and "run-of-the-river" hydropower, which does not have the ecological problems of older dams.

4. Ocean energy. Technologists predict that wave action, current, tidal movement and temperature differential will become an outstanding form of clean energy. Ocean energy has a big advantage because the timing of currents and waves are understood and reliable.

5. Geothermal energy. Geothermal energy is produced by heat from sources below the Earth's surface. Steam created by these underground heat sources is used to spin turbines for electricity generation.

6. Biomass energy. This is a broad category encompassing a variety of fuels produced from biological sources.

   • Bio-diesel can be created from used or virgin plant oil. Production and testing today center around rapeseed oil, soybeans, sunflower oil. Overall, bio-diesel works cleaner than petroleum-based diesel fuel.

   • Ethanol is derived from agricultural products, including corn, wheat, fruit, wine, and various kinds of cellulose stalks and wood chips. The techniques are steadily improving. Ethanol can be mixed with gasoline to minimize engine changes.

   • Waste gas (methane), emitted from landfills, breweries, waste water, animal sewage and coal mines, provides almost free fuel for stationary fuel cells and conventional gas generators.

   • Hydrogen is the ideal alternative fuel, since it releases no toxins into the air. It can be derived for waste gas, or mixed with natural gas in hybrid fuels. Liquid hydrogen, the preferred form of hydrogen, still requires more storage space and pressure than other fuels.

There are many other technologies which may be lumped into this category, including combustibles, municipal waste, and even nuclear energy. There is overlap between this category and the green category, as it relates to global warming and environmental impact.

Nevertheless, if you are looking for a hot sector to help you recover from tough economic times, get you tagged as a world leader, and increase your probabilities for funding support, put some energy into this one in 2011.

Marty Zwilling