Signed into law earlier this month, the Jumpstart Our Business Startups Act makes it easier for the general public to invest in startups by removing rules that previously allowed only wealthy investors to buy stakes in young companies. Under the new law, effective early 2013, a startup can raise up to $1 million in small increments from large groups of everyday people.
According to Ken Springer, a Certified Fraud Examiner and former FBI agent whose company, Corporate Resolutions, works with individuals and institutions to uncover securities scams, people tend to spend only 0.1 percent of their investments on services that sniff out fraud.
"If you're investing $10 million in a startup, you may pay $10,000 for in-depth background checks on the company and its founders," Springer says. "But if you're only investing $10,000 -- and we expect an up-tick in these small investments in light of the new law -- then you're better off just doing the background research on your own."
What are some red flags ordinary investors can look for when considering an investment in a startup?
Signs that should raise red flags are certain lawsuits, frequent re-locations or the founders frequently changing the name of the corporate entity. Other red flags include the company's founders offering only a limited number of references, founders name-dropping too much in their pitch and founders who employ only family members. Finally, can you freely talk to employees or does the business owner shelter the employees? We recently investigated a startup company that hired 30 temporary employees before its investors visited their factory, and ensured that none of the employees spoke English, so the investors couldn't communicate with them.
What are some free or cheap resources that regular investors can use to track down that information?
The best free resource are public court records. Use them to find out if an entrepreneur has ever been sued by other investors. Search under both the entrepreneur's name and the name of their company. Also seek out answers to other questions like, did he or she really start the company when they say they did? Are they still licensed? Verify their college degree online. Also, track down and contact someone who knows them via a social network, such as a former colleague on LinkedIn.
What about the actual company documents that the entrepreneur releases?
It won't be entirely clear what documents startups are required to release to potential investors until the SEC issues its new rules in the next 270 days. But here's an easy way to do some digging. If someone says their company's revenue was $500,000 and they netted 10 percent, you should ask to see their tax returns. Then, to check for erroneous tax return information, ask for their permission to submit the return to the IRS via Form 4506, which will tell you whether that specific return was actually filed.
What about face to face meetings? Are they necessary before investing, and if so, what are some tell-tale signs you may be dealing with a scam artist?
You can't rely solely on face to face meetings, but I do suggest that investors meet with an entrepreneur in person before investing. See if the entrepreneur tells you the whole story or if they just give yes or no answers. Do they avoid looking you in the eye? Are they tapping their hands or feet?
When you're investing, you're really buying the management, and that's what people should focus on in their hunt for information. And remember, as the old saying goes: If something sounds too good to be true, it probably is.