3 way investors can cheat you

By John Paul
On one hand, they are excited that they have found an investor who is willing to bring in money.

On the other hand, they are anxious (and sometimes afraid) of getting a bad deal and being cheated.

And in today’s email, I want to talk about ‘getting cheated.’

Government giving mining jobs to youth

I have seen a good number of promising businesses fail because the entrepreneur was naïve and didn’t understand the implications of the deal he/she got from the investor.

Not finding an investor to invest in your business is sad.

But finding an investor and getting a bad deal is far worse.

If you get a bad deal, you could end up in a very bitter dispute that could cost you all the sweat, energy, and money you sacrificed for your business.
Why do investors ask about this?

But before I go ahead with this lesson, here’s an excerpt of the email that inspired today’s message.

It’s from Temitope who’s from Nigeria:

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Good day John-Paul,

I am into the post-production of paddy rice.
I meet a billionaire and he thought me 3 lesson I have found an investor who is interested in contributing capital to my existing business, but I don't know how to go about the legal frame work that should define the deal with this investor, including the profit sharing formula.

Kindly give me a guideline that will prevent me from being cheated.

Thank you.

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First off, thank you for sharing this learning opportunity with me. A lot of people are going to learn from the advice.

Also, there’s something I need to mention before I get into the details of my advice:

Most investors have no intention to cheat you. Their natural goal is to get a good deal for themselves.

However, when an investor gets a good deal, that doesn’t always guarantee that the entrepreneur gets a good deal.

That’s why you, the entrepreneur, need to look out for yourself.

There are 3 factors that make a good deal with an investor.

When it comes to deals between investors and entrepreneurs, templates don’t work.

Every deal is different, and every situation is different.

But if you understand the 3 factors I’m about to discuss, you will instantly know when you’re getting a good or bad deal.

It doesn’t matter what type of business you’re in, what country you are, or what language you speak. These 3 factors are universal.

And if an investor is going to ‘cheat’ you in a deal, he/she is likely going to be doing it by leveraging one or more of these three factors.

The first factor is risk

Essentially, who will lose more, or suffer more, if the business does not succeed?

Investors love to make a great return on investment, but they also pay a lot of attention to the downside.

Naturally, investors will want to transfer as much risk as they can to the entrepreneur. That way, if your business does not succeed as they expected, the investors won’t lose all, or most, of their investment.

And investors can transfer the risk of failure in a variety of interesting ways.

Equity investors, like venture capital and private equity investors, can build in legal devices and clauses into the deal like liquidation rights, participation rights, conversion rights, anti-dilution rights, and co-sale rights.

I explain each of these devices in detail inside my private Roadmap program, but it would be impractical to go into each of these in this email.

Debt investors, like banks, use collateral, guarantees, and court-ordered administration to protect their investment in the event that your business fails.

Depending on how eager the investor is to invest in your business, you can use that position to negotiate a deal that limits how much risk they can transfer to you.

But if the investor has the upper hand, and you’re the one almost ‘begging’ for a deal to happen, investors are likely to use that leverage to transfer as much risk as they can over to you.

The second factor is reward and ownership.

Essentially, who gets a bigger share of the reward if your business succeeds?

The typical investor will want a low risk for a high reward. Investors will want to maximise their upside (reward) and reduce the downside (risk).

One way equity investors do this is to ask for a bigger share of your business in exchange for their capital.

If an investor can get 60% (rather than 30%) of your business by investing $100,000, they’ll go for it.

By asking for more equity, an investor can get a bigger chunk of your business with the same amount of money ($100,000).

But if the entrepreneur knows how much their business is worth, and is not under pressure to raise funding, he/she can push down the investor’s demand to a fairer percentage.

Business valuation is a complex issue that I addressed in one of my earlier emails, and inside the private program. I hope to revisit the issue sometime in the future so we can learn from it.

The reality is, if you don’t know how much your business is worth, a savvy investor can get away with a bigger chunk of your business.

And a few years down the road, after your business has become very successful, it's the investor who will earn a big chunk of the profits even though he/she didn’t take as much risk as you did.

The third factor is control.

Make no mistake, the relationship between investors and entrepreneurs is as much an economic relationship as it is a political one.

Unless you’re dealing with a passive investor, your relationship with active investors is likely to be a struggle for power.

Essentially, it’s all about control. It’s about who can make or influence the major decisions of the business.

In my experience, this is the most sensitive issue for entrepreneurs. But most entrepreneurs usually don’t know it until they’re close to a political crisis.

Have you ever heard of founders who were kicked out of their business?

One famous example is Steve Jobs who was kicked out of Apple, a company he co-founded.

A recent example is Travis Kalanik, the co-founder of Uber, who was kicked out of the CEO position by his investors.

Equity investors, like venture capital and private equity investors, can use devices and clauses in the deal such as use of preference shares, board representation, voting rights, and right of first refusal to grab more power and control of the business.

Debt providers, like banks, can use loan covenants to exercise their power by restricting certain actions the entrepreneur could take.

Here’s what I suggest:

Your email is not clear about what you intend to use the invested funds for.

If the funds will be used for long-term needs, such as leasing land or purchasing equipment, you should propose an equity investment. That way, the capital can be patient and stay in your business long enough for the investment in the lease and equipment to pay off.

But if the funds will be used for short-term needs, such as purchase of raw materials or use as working capital to support or expand your existing operations, you should be asking for a loan or debt instrument.

Whichever you ask for, you need to make sure you set the right expectations. Don’t promise high profits just because you want to impress or convince the investor to give you money. That could backfire.

And for the sharing formula, here’s what I have to say:

Only you know what is fair.

Don’t settle for a deal that will make you feel like a slave or labourer in your own business.

Insist on a profit share that reflects the risks and effort you’re putting into the business. Anything less will make you feel cheated.

Makes sense?

To recap…

Every deal with an investor depends on 3 critical factors:

1) How much risk each party is exposed to

2) How much reward and ownership each party gets; and

3) Who has more power and control?

Whatever deal, agreement, contract, or covenant you get will reflect each of these factors.

And if you lose out on these factors, you’re more likely to feel cheated by the investor.