Investing in a startup: risks and tips

Investing in a startup: risks and tips
Investing in a growing business is always risky. In the future, a startup may become one of the market leaders or go bankrupt because the audience did not like the idea. An investor may also encounter scammers. They will lie about the success of the idea, persuade you to invest money in their project, but spend the money for personal purposes. How to safely choose a startup to invest money in. Experts advise asking startups for technical materials about the product and including in the deal ways for the investor to exit the business.
A startup is a business whose team develops a new product and raises funds for its implementation. Investments in startups are called venture investments - these are investments in a business with a high degree of risk. According to Forbes, 80% of companies in which venture investors have invested, as a rule, are expected to fail. Investing in such a business can be done by a private individual—in the market they are called business angels—and by venture funds—companies that specialize in supporting risky projects. Their capital is created from the funds of investors, which are then used to develop innovative projects.

If you invest money in the development of an understandable business, for example, opening a cafe, building an office center, launching a production line, then you can check business plans, financial models, and analyze the market. Then evaluate how the business is going: whether the promised equipment was purchased, whether the outlets were opened on time, what are the purchase prices, what are the sales markets. Such projects can receive financing from a bank. Startups that attract investment through venture funds cannot clearly describe their business.
In relation to a startup, all the usual categories are greatly blurred: a business plan is a vision of an idea. Implementation is a founder's skill. Risk assessment is a belief in the genius and profitability of the idea.
The product may simply not appeal to the audience. But another risk for an investor is to run into scammers and therefore lose their investment. At the end of last year, JPMorgan Chase filed a lawsuit against the founder of the fintech startup Frank, Charlie Javis, writes Forbes. In 2021, Javis convinced a bank to buy her business for $175 million. The essence of Frank's idea: young Americans in need of financial help are offered a program that makes it easier to apply for education loans. According to the publication, in order for the bank to invest in her business, Javis lied to JPMorgan that 4 million users used the service. When the company was conducting a financial and legal review, the entrepreneur created a database of fake clients with fictitious data. Having received a list of supposedly Frank clients, the bank began sending them test advertising letters to promote its services. As a result, only about a quarter of the messages reached their recipients, and only 1% read them. Javis filed a counter-complaint, where she indicated that during inspections, the bank presented her with false accusations of improper performance of duties. The Federal District Court of Delaware will hear the JPMorgan lawsuit.
In another case, the founder of the medical startup Theranos, Elizabeth Holmes, was convicted of defrauding investors and fraud. The company developed equipment for instant clinical blood tests. In 2015, the organization was accused of using other people's technologies. And in 2018, the US Securities and Exchange Commission indicated that the entrepreneur, together with the ex-president of the company, exaggerated the success of the business to investors and the media in order to attract more money. Hearings in the case were postponed several times due to the pandemic and Holmes' pregnancy. As a result, in November last year she was sentenced to almost 11 years in prison.

In the United States, the market for venture capital investments, that is, risky investments in potentially promising young businesses, is an already established industry.
How to safely invest in startups
In practice, negotiations with a startup team begin with the receipt of some prepared material - a presentation, a booklet. They can be prepared either by the creator himself or by external consultants and intermediaries. It is important to carefully analyze these materials. This will help you understand what the company is and whether it has permits for the desired type of activity, evaluate its financial statements, and learn about possible legal disputes and their causes. You can also search for information about the company in open sources. We advise you to pay attention to the availability of contact information. If an organization's email does not use a corporate domain, but uses free email clients like Yahoo and Gmail, this may be a sign that the startup is not serious.
There are other aspects that investors should pay attention to to avoid being deceived.
I recommend being more careful when making investment decisions if:

❌ No investment presentation, clear business plan, strategy, budget.

❌ There is no website with a description of the project or information about the company.

❌ The startup has an incomprehensible, irrelevant or copied product or solution from competitors.

❌ The startup is not ready to legally formalize the relationship and sign documents.

❌ The company is not registered as a legal entity, it does not have a license or permit if the activity is subject to regulation.

❌ The business does not have a team of specialists in the field where the startup operates.

❌ The startup is not ready to cooperate and provide information and documents to verify the business.

❌ There are no fixed assets or minimum investments of the founders themselves in the authorized capital.

❌ The founders and CEO of the startup have a dubious reputation.

❌ Business has signs of a financial pyramid. For example, they promise a guaranteed high return on investment.

❌ They offer to invest in cash in a startup.

❌ The founders do not have relevant experience.

❌ There are no specialists who accompany investment transactions.

❌ There are legal disputes, including labor disputes or the payment of wages, conflicts with contractors regarding the payment of remuneration.

❌ There is a debt to the tax authorities.

❌ Founders, director or board members participated in startups that left the market.
In practice, startups borrow a letter of intent form known as a term sheet. They often indicate that it has no legal force, but is needed only to record the results of negotiations. In this case, this document does not bind the signatories with any obligations. Therefore, I do not recommend investing on the basis of a term sheet without concluded contracts and proper verification of the startup.
What to do if you invested in a scam startup
The issue of deceiving venture investors who have invested in a startup is a very delicate matter. The basis of such investments is the increased risk of losing investments, this is their essence. “I believed in the idea, it took off, the investments, as a rule, paid off many times over. If it didn’t fire, the investor lost money.”
You cannot expect success from every startup. And often unprofessional venture investors, especially government agencies and sovereign funds, approach risky investments as if they were a bank deposit. They want to see guaranteed profitability and a whole range of protections that are not typical for venture capital.
It’s one thing when startups openly deceive their investors and invent non-existent technology or falsify scientific and technical information about the product. Another thing is when the investor himself finds himself captive of inflated expectations. The first is a crime, and the second is an unfortunate combination of circumstances and a distorted understanding of the essence of venture.

If an investor has already invested in a startup, but realized that he was deceived, there are several mechanisms to protect himself and try to get the money back. First of all, you can submit an application to law enforcement agencies. If cases are brought, then, as a rule, they are about fraud. In such cases, it is necessary to prove not only the loss of money, but also that the person initially did not intend to run a business, and after collecting funds, disposed of them for personal interests.
In addition to criminal legal protection, in order to return at least part of the investment, you can initiate bankruptcy proceedings for a startup and challenge transactions for the withdrawal of assets, bringing management to subsidiary liability. In addition, if there are many investors, a class action lawsuit can be filed. This will attract the attention of the media and society to the situation around the startup. In this situation, perhaps the defendants will be more willing to enter into a settlement agreement.

I recommend presenting evidence in court about what financial indicators the startup promised and for what purposes it was going to spend the investments. Correspondence in instant messengers and by mail, information from the website and social networks of the startup, any documents signed by the parties, materials and presentations of the startup’s product that were sent to potential investors to attract attention, audio and video recordings from negotiations may be suitable for this.