Apply now to be an Entrepreneur 360™ company. Let us tell the world your success story. Get Started »
To hear Don Spencer tell the story, he and his business "got screwed."
Spencer is no stranger to starting and running businesses. Between 1987 and 1993, the nationally certified training coach ran a gymnastics complex in CaÃ±on City, Colorado, which cleared approximately $200,000 a year. The business eventually expanded to a satellite operation in Pueblo.
Colorado proved too small for Spencer's ambitions, however, and, after doing a great deal of study, he left in January 1994, determined to build a bigger and better operation in Las Vegas. "I researched the entire United States," he recalls, "and every time I looked at Las Vegas, I was just amazed."
The bright lights of that city's gargantuan casinos may have blinded Spencer temporarily. How else to explain why he put up a $10,000 retainer, plus several thousand dollars in upfront fees, for a Nevada broker-dealer to raise money on a "best efforts" basis?
What Spencer was trying to do was raise capital for his company, Go for It Inc., through a Small Corporate Offering Registration (SCOR), a 50-question form used to register public offerings in 43 states without going through the time and expense of filing a registration with the Securities and Exchange Commission (SEC). Trouble is, SCOR laws vary among states, and in Nevada, brokers are not allowed to solicit indications of interest from potential investors until after the SCOR offering is approved by the state securities commission.
Bob Tretiak, president of Retirement Financial Centers of America Inc., which tried to raise money for Spencer, says lawmakers and brokers alike are working to overturn that law. "We busted our hump on it," Tretiak says of his company's efforts to raise money for Go for It. Sadly, he adds, few of Spencer's vendors or clients seemed inclined to invest.
All Don Spencer knows is that "[Tretiak] said in front of many witnesses that he could raise $500,000 in 60 days and $1 million in 100 days. One year later, he had raised $4,000."
Spencer might have been more careful, knowing after all that Retirement Financial was only working on a best-efforts basis and had no obligation to deliver on what it had proposed.
"We believe an issuer, like Mr. Spencer, when he says people are coming out of the woodwork wanting to buy his stock," Tretiak says. Enthusiasm, however, is no substitute for a realistic view of the possible financial pitfalls involved in raising capital. "I would caution every small company [that] desires to go public to realize that there are unreimbursable risks and costs attendant to such an effort," Tretiak adds.
That advice means little to Spencer, who came out of the deal a little wiser and a lot more bitter. All he knows about the transaction is this: He lost his cash. And now he has turned to another investor to do a private placement for the firm. Could he be tempting fate once again?
For entrepreneurs seeking expansion capital, danger lurks at every turn. With any viable method of acquiring additional funds comes a warning, a caution, a potential scam. Because small business is on the rise nationwide, more would-be plunderers are picking inexperienced business owners as possible targets.
Securities enforcement officials across the country report a variety of tricks, from dishonest brokers taking a wide array of unreturnable upfront fees to market manipulators who merge a relatively small but expanding firm with a dormant "shell" company. With the Internet taking on increased importance, the possibility for electronic chicanery is on the rise as well.
What makes matters worse in some cases is that most of the losses could have been avoided with a little common sense and greater attention to sound business practices. Risk-taking comes naturally to many entrepreneurs, some of whom readily fall victim to a combination of their own greed and foolishness. Getting money isn't easy, but in the quest for expansion capital, overeager entrepreneurs often miss some obvious, telltale warning signs. In the process, they can lose their companies, most of their money or both.
"As a result of our activities with capital-raising individuals, we have an iron-clad rule in the company that we simply don't pay upfront fees," says Joseph Meshi, a principal with Genovation Inc., an electronics product development company in Irvine, California. "Hundreds of people come here [offering to raise money for us]. As soon as we say 'No. Go ahead and perform, and we'll really fatten your wallet in the tail end,' they disappear, in which case we know [they were unscrupulous]." Other small-business owners report a similar plague of dubious brokers descending upon them. Placing an ad in a newspaper seeking capital can be tantamount to putting out honey for a swarm of flies.
Perhaps that's because small businesses represent a sector of the nation's economy that is doing so well. The number of new small businesses opening in the United States has increased steadily since 1991, according to the U.S. Small Business Administration (SBA). That number reached approximately 810,000 in 1995. Corporate downsizing, the declining price of office technology, and a new emphasis by banks on lending to small businesses are all contributing factors to the phenomenon, says Bruce D. Phillips, a director of economic research for the SBA.
Those particularly at risk in expansion debacles are businesses trying to raise between $500,000 and $5 million, says Neal Sullivan, executive director of the North American Securities Administrators Association (NASAA). "You have a lot of people out there holding themselves out as either matching services or other services entrepreneurs need to get desperately needed capital," Sullivan says. "Through 'angels' and family connections, [entrepreneurs] can usually raise a [limited amount]. Above $5 million, they're usually sophisticated enough to get public capital through more ready means. But between half a million and $5 million, that's where the real problem seems to be taking place. It's an area of the market completely off the [radar] screen for the SEC. It's too small."
One of the most common and most successful scams comes in a variety of forms. Unscrupulous brokers, investors and venture capitalists offer to find investors for a small business, or offer guidance and direction toward an Initial Public Offering or SCOR, only to charge thousands of dollars in upfront fees. When the money doesn't roll in as promised, whatever funds have been raised generally fall out of escrow and are returned to the investors. The only party sustaining any serious loss is the business owner.
What many entrepreneurs fail to realize, says David Newton, an economics and business professor specializing in entrepreneurship at Westmont College in Santa Barbara, California, is that many of the underwriters approaching them agree to work only on a "best efforts" basis. In other words, they are under no obligation to produce any investors or capital in return for the fees they charge. They simply promise to make a stab at doing so.
"It's almost like having your stock out there on consignment," Newton says. "The big question comes down to what constitutes a best effort. Most of the [unscrupulous investment firms who use this practice as a con game] probably don't have any intention or ability to sell an entire inventory of stock, but they collect management fees or other fees on a best-efforts offer." Legal fees and document processing fees are among the types of charges billed.
The best way to avoid such losses is to thoroughly check any unknown party offering such services, usually through your state's securities oversight authority. "You're giving them your hard-earned capital, which is at a premium," says Philip Rutledge, deputy chief counsel for the Pennsylvania Securities Commission. "Before you part with it, you want to see them do somersaults." Be warned: Some con artists are already prepared for such a background check, Rutledge says, providing phony public relations companies that will give you fraudulent letters of reference. Protecting yourself against such a practice is difficult, hence his advice: Use only agents who are known to you through others.
Another common scam involves stock manipulation and can wind up causing more headaches than a small-business owner ever imagined. Some brokers merge an entrepreneur's firm into a dormant shell company, one that's already traded on the public market but is firmly under someone else's control. "It's hard to understand how you make money that way," says Mark Griffin, Utah's security administrator.
It works like this: A broker approaches a small business, offering an alternative to going public for capital. In this scheme, the offer entails becoming part of a company that has already gone public but isn't currently active. Sounds appealing, but it's also very dangerous, says Tom Stewart-Gordon, who publishes the newsletter SCOR Report. "The entrepreneur doesn't ask the appropriate questions-'Who's [tracking the performance of] this company?' and 'What is the trade volume on this company?' Basically, the shells are dead, like seashells. They just lie there," says Stewart-Gordon. If you don't investigate before getting involved, your company could end up dead, too.
While some shell mergers are legitimate (see next month's "Raising Money" column for more on the subject), Griffin warns that getting involved with an empty shell company is exceedingly dangerous, and he recommends asking a great many questions before entering into such an arrangement. First and foremost is finding out exactly who controls the company, although this can be difficult. "A certificate of stock has a name on it, but once that name is endorsed on the back of that stock certificate, it can travel from hand to hand," says Griffin. "It can wind up in somebody's safe or shoebox." Take as long as you must to investigate thoroughly before buying into the deal.
If you make the wrong decision about merging with a shell, Griffin says, you may find yourself answering to a host of angry investors. Once your name is on the public record of an empty shell, you're an easy and likely target for shareholder angst. "You wake up in the morning, and you're answering telephone calls from angry investors complaining about the stock price," he says.
Even more heartbreaking, Griffin says, some scam artists manage to find defunct public shell companies that have been dissolved. They resurrect them as private companies but tell the entrepreneur the company is public. The business owner opts to merge, only to discover, tragically, that he or she is no longer in control of his or her company after building it from the ground up.
Griffin's advice boils down to common sense: When it comes to raising money, haste can land you in a lot of hot water. If something seems too good to be true, it probably is. "[Entrepreneurs] don't realize there is a certain maturation process that has to take place," he says. "Growing overnight can lead to significant pain and discomfort."
Caught In The 'Net
Technological advances have given rise to new kinds of scams. The Internet, while providing all sorts of legitimate business opportunities, has also become a breeding ground for charlatans looking for easy money. Maintaining a Web page is a flashy and impressive way to separate an entrepreneur from his or her closely guarded cash.
A fancy-looking Web page makes any promoter, well-intentioned or not, that much more attractive, according to Ben Lewis, an investigator with North Carolina's securities division. "You can [claim a top] magazine has chosen you as the number-one fund for entrepreneurs and let it stay up [on your site] until someone questions it," he says. "It gives credibility and reliability." Pages with eye-pleasing graphics, bold headlines and other electronic bells and whistles dazzle entrepreneurs. One page Lewis has seen offers users a choice of three languages: "You think, 'Someone who's going to this much trouble must be legitimate.' "
Lewis cautions entrepreneurs to go "beyond the screen" and verify the organization's or individual's true identity. Legitimate brokers are always registered with the state's securities division or the National Association of Securities Dealers, he says, "and they jump through the more traditional hoops, crossing the T's and dotting the I's."
Scam artists lurking behind the screen use the quick-fix nature of such technology to get your money without allowing much time for thought. Real brokers don't promise instant money online; they go through the traditional steps of meeting face to face, mapping out a financing plan and taking the time and thought necessary to make it work.
Lewis' advice is simple, direct and common sense. It also begs the ques tion: Why are so many entrepreneurs plagued by scams that seem to have an obvious escape hatch? If a small-business owner seeking capital would only stop and think before making a move and spending unnecessary cash, shouldn't the aforementioned cons be easily avoided?
You might think so, several securities administrators and financing experts say, but eager entrepreneurs are often blinded by their own business vision.
"The biggest problem is entrepreneurs don't understand how brokers work and what they can expect from their brokers," says Stewart-Gordon. "They think of it as being a turnkey service: 'I'll give you X amount of dollars, and you'll give me a finished product.' It doesn't work that way. I'm opposed to giving a broker an advance fee. If he doesn't think he can sell it [and profit that way], there's no reason to do business with him."
Others believe entrepreneurs focus their minds and energies too much on their products or services. They've already come up with what they believe is a wonderful idea; shouldn't everything else flow naturally from that? But people who develop good products and ideas aren't necessarily the most savvy businesspeople, remarks Utah's Griffin. "Entrepreneurs tend to want to believe in good things happening-especially when they're under pressure to get financing for their company," he says.
Dave Barrie learned that hard fact more than a decade ago. Back in 1985, the Dallas entrepreneur was running a $5 million software and services company and needed to raise $500,000 to create another division. A pair of venture capitalists promised him the money within 90 days. All it would cost him was $50,000 in various fees. A month later, the two would-be saviors found a more lucrative project . . . and walked off with Barrie's money.
Barrie has bounced back and in fact now lectures on how to obtain capital without taking unnecessary risks. He also guides others through the SCOR process with his business, Small Corporate Offering Co. Although he asks a $3,000 fee in advance, he subtracts that from the money he takes after completing the deal. Despite his experience, Barrie understands what leads inexperienced entrepreneurs to hand over their savings to a seeming financial angel.
"They seemed to have good credentials. They had good references," Barrie recalls of the venture capitalists he dealt with. "I just didn't get into checking out what they were going to do for me and asking 'Well, if it doesn't work, what happens? What's the down side?' I didn't have the experience. Now I do-and I ask all kinds of questions."
Brian Steinberg, a writer in Washington, DC, has contributed to The New York Times, The Washington Post and Entertainment Weekly.
Genovation Inc., 17741 Mitchell N., Irvine, CA 92714, (714) 833-3355;
Go for It Inc., 4860-A W. Lone Mountain Rd., Las Vegas, NV 89130, (702) 656-8333;
North American Securities Administrators Association, 1 Massachusetts Ave., Washington, DC 20001, (202) 737-0900;
North Carolina Department of Secretary of State, Securities Division, 300 N. Salisbury St., Raleigh, NC 27603-5909;
Pennsylvania Securities Commission, Eastgate Office Bldg., 2nd Fl., 1010 N. Seventh St., Harrisburg, PA 17102-1410, (717) 783-5130;
Retirement Financial Centers of America Inc., 8518 W. Lake Mead Blvd., Las Vegas, NV 89128, (702) 254-1336;
SCOR Report, P.O. Box 781992, Dallas, TX 75378;
Small Corporate Offering Co., 3508 Greenville Rd., #9, Dallas, TX 75206;
Utah Division of Securities, 160 E. 300 S., P.O. Box 45808, Salt Lake City, UT 84145-0808.