You’re at lunch with an old friend when he brings up the subject of some cutting-edge technology he’s been working on that’s going to change the world.
He’s animated as he describes the problems this technology will solve. “Imagine a portable 3-D body scanner that attaches to your phone that you can use to scan your body and upload your body profile to Amazon for perfect sizing for clothes, hats, shoes, the whole nine yards.
Can you imagine what Amazon would pay for that technology? Can you imagine how much money Amazon and customers will save from not having to return clothes that don’t fit?
You find yourself nodding your head a lot. The technology sounds great. You only wished you had thought of it first. It’ll transform online shopping. It’s a multibillion-dollar tech you tell yourself.
YOU’RE IN!
You’ve got it made. You’re in on the ground floor of the next Apple you tell yourself. You can’t keep this to yourself so you decide to share it with family and friends. FANTASTIC!
You can’t wait to see a prototype. Six months go by . . . nothing. Soon, it’s a year since you bought-in. Still no prototype. Your friend assures you that they’re close. They just need a little more capital to get over the hump.
Of course, nobody wants to see their investments go down the drain, but you think it’s kind of odd that your friend is driving a new Rolls Royce while he complains about not having enough capital to continue. Everyone ponies up more money to “get over the hump.”
Another six months go by . . . still nothing. After two years, you finally get to see a prototype. Honestly, when you first see it, it looks like one of those Square credit card readers you connect to your iPhone, but you’re holding out hope.
Your friend uses you as the test subject. After what seems like your friend illuminating a flashlight on you for two minutes, the resulting 3-D image on the phone looks like a 500-pound pile of clay. You know you’ve gained a few pounds, BUT NOT 300 pounds you think to yourself. “I don’t think they make shirts in XXXXL,” you jokingly tell your friend.
Your friend assures you that it’s just a few bugs. It’ll all get worked out and we’ll all be on Easy Street. After three years, you, your family, and friends realize that you’ve been had.
You find out your friend’s been living by a common self-motivation mantra popular in Silicon Valley . . . Fake It Till You Make It.
The idea behind “fake it till you make it” is that you shouldn’t let your shortcomings prevent you from achieving your goals. Never be afraid to jump on an opportunity or take a position you may not be entirely qualified for.
Fake yourself into believing you’re qualified for the job or the opportunity and eventually you’ll grow into it and figure things out. In the meantime, put on a happy face and work through the challenges.
The problem with “fake it till you make it” is that some entrepreneurs have taken this mantra to mean fake it to others till you make it. Instead of a self-motivation tool, the saying has been hijacked by con artists to justify self-serving. Elizabeth Holmes of Theranos infamy is the perfect example of “fake it till you make it” going off the rails.
At 19, Elizabeth Holmes, dropped out of Stanford to launch Theranos, a blood-testing company that vowed to revolutionize the industry with breakthrough technology.
In less than a decade, she had become the youngest self-made woman billionaire drumming up investment from the likes of Oracle CEO Larry Ellison and attracting no less than former Secretary of State George Shultz, retired military commander General James Mattis, and former CEO of Wells Fargo Richard Kovacevich to her board.
Holmes touted Theranos’ cutting edge technology that would revolutionize blood testing by requiring a single pinprick of blood instead of the vials and vials of blood required using current technology. This magical box was dubbed the Edison.
It turns out, the technology never got close. In 2012 Theranos released Edisons to some stores, but they failed miserably – even falsely claiming a woman had cancer, among many problems.
Despite the problems, Holmes exuded charisma and had a gift for lying and leading investors on and convinced her subordinates to keep the problems under wraps. She was able to drag it out for a total of 15 years before one of the grandchildren of a Boardmember finally blew the whistle and went to the SEC. The SEC raided the headquarters and exposed the scam.
Holmes will be on trial next March and faces a likely 20 years in prison for lying to investors and for releasing defective and potentially dangerous products to the medical industry. Theranos is worthless, Holmes has lost her wealth.
Investors like Larry Ellison and other Silicon Valley bigwigs were duped out of tens of millions of dollars because of Holmes’ charisma.
Hindsight is 20/20 and looking back, all the warning signs were there:
- Holmes had no track record in business.
- No background in medicine.
- The extent of her science background was taking a few classes in Chemical Engineering.
The problem with Holmes was that she wasn’t faking it to herself until she became competent. No amount of faking was going to compensate for her lack of background. She took “fake it till you make it” to mean lie and deceive investors, regulators, employees, staff, and so on as long as you could until the technology magically appeared.
When you’re weighing an investment opportunity, you have to ask yourself if the promoter asking for your money is living by “fake it till you make it” or if they’ve already made it. The difference can be losing everything or receiving a healthy return on investment.
How do you weed the Elizabeth Holmes out of your investing universe? How do you invest with the right partner?
ASK THE RIGHT QUESTIONS…
Finding the right partner to invest with requires asking the right questions like the following:
What is the experience and track record of management?
Because private investments are passive and investors will have no hand in management, the most vital step in the whole process is scrutinizing the managers, their experience, and track record.
Do they have the requisite experience and knowledge in the industry, geographic market, and asset class of the central business that they’re raising money for, or is this their first rodeo for everything?
In other words, is the particular business in the manager’s “wheelhouse”? Be leery of managers undertaking a business they don’t have any experience with.
What’s the Expected Rate of Return?
Investors are in the game to make money. Analyzing the potential return on investment (ROI) is essential to understanding the capital commitment and opportunity cost against the potential benefits.
When estimating returns, be mindful of any fees or costs associated with the investment as any management fees or business expenses may diminish any expected returns.
Is there a defined exit strategy?
An open-ended investment is a sign of a lack of vision and a plan for executing that vision on behalf of the fund’s managers. Having a clear exit strategy is essential for investors to know when they can expect a withdrawal of their initial investment, along with any associated profits.
Are there adequate disclosures in the offering documents?
You’d be surprised at how many promoters there are out there soliciting capital without a formal offering document like a private placement memorandum (PPM).
The SEC says the lack of a PPM is one of the top 10 red flags that you’re being scammed. First of all, are the documents competently written? Does it have typos? Does it have false information? Is it coherent?
If the documents don’t even pass this initial smell test, it’s time to move to the next opportunity.
If they pass the smell test:
- Do the offering documents provide adequate disclosures for you to gain a sense of the company’s strategy, business plan, and likelihood of success?
- Is there enough information about the company’s proposed business and adequate discussion about the industry and market trends to indicate management’s competency?
- In other words, do they know what they’re talking about?
- Is there enough information to be able to see through the smoke and mirrors and weigh the facts presented objectively?
Do the Financials Make Sense?
The Projected Use of Funds and Financial Statements section of the PPM outlines in a spreadsheet or table format the company’s projected sources and uses of funds.
In terms of sources:
- Is the company relying on other funding sources like debt for its acquisitions?
- Are the projected sources and uses detailed and outlined or are they vague?
- What is management compensation like? Is it excessive?
Included with most PPMs are pro forma financial statements showing the fund’s projected income for at least 3-5 years and sometimes longer. The failure by a fund to provide financial statements or coherent ones should be a red flag.
When evaluating these pro forma statements, make sure the revenue projections are realistic and not overinflated and that the expense projections are not overly conservative.
If there’s a leap in projected net income from one year to another, are these projections based on sound economic principles, or are they based on speculative factors?
Beware of overpromising by the manager.
What are the risks?
Nobody wants to think about their investment tanking but it’s better to know the risks beforehand than to lose all your money.
What are the market risks? Industry risks? Company risks? Management risks? Legal risks? Regulatory risks?
Does management have any processes or steps for mitigating these risks? What is the worst-case scenario? Do the investors have any security or priority to funds in a liquidation?
DUE DILIGENCE…
Meeting management and receiving the PPM isn’t the end of the road. Don’t turn over your money just yet. Now, you have to do the homework.
The due diligence phase is the opportunity for a prospective investor to analyze the deal with a fine-tooth comb, run the numbers, scrutinize management, and to ask any relevant questions.
Most managers are accessible and are happy to answer questions about the offering, company, and management themselves during this phase.
To avoid bad deals, overlook the promoter’s charisma and personality. Don’t be afraid to ask the right questions and do your due diligence.
The more you do it the better you’ll get at analyzing deals and recognizing red flags. All of this preparation and diligence will help you avoid bad investments.
