Don’t Back a Broke (Dishonest) Founder

Written by: Haseeb H. Shaikh

I realize the title of this piece may be a slight generalization – not all broke founders are dishonest. However, I can wager money that all dishonest founders are broke!

This is a selection of lessons learned over the years backing entrepreneurs in startups, both as an institutional investor and while making my own personal investments. And my list of mitigating steps in order to protect your investment and yourself from such scam artists.

The most obvious and least painful approach would be to identify a founder with dishonest traits and show them the door, castigate them with a few choice words of warning and foresight if needed. But it’s never as simple – the dishonest ones are ingenious and crafty, they have a way with words, glossing over details, conjuring up grand visions, creating fantasies, and ever so slightly exaggerating the truths, boldly lying in reality.

There are tell-tale signs to look for as you’re building up the investment case and as any savvy investor will tell you, in a startup you are investing in the founder. It’s his or her commitment, integrity, work ethic, and ability to execute all the hype and glory that ends up on paper in the form of a business plan. A monkey can draw up a business plan. But only a competent and honest founder can execute it successfully.

Conduct due diligence on the founder

Investigate and conduct thorough due diligence on the founder. Engage a professional firm to do a background check; trust me it’s worth it to incur an expense of a few thousand dollars when your equity check will be in the tens of thousands or in six figures. Consider sharing the cost with another investor or investors, if cost prohibitive. There are many companies, the likes of Kroll, that can offer this service in a completely discreet manner.

Dig up his past, obtain reference checks from past employers or partners, and investigate any history of legal action, whether civil or criminal. Treat the founder as you would an employee or even a spouse! Except in this marriage, you are not equal in the relationship. You are trusting the founder to spend your capital judiciously and efficiently, while you sit on the sideline and anxiously await results.

Founder’s financial standing

Ask for the founder’s net worth statement with disclosures about any indebtedness and any past history of insolvency. A credit report would do the job nicely. The objective is to assess the founder’s financial position, her creditworthiness, and whether she is in financial distress; it is absolutely not intended to harm a financially disadvantaged founder.

From the moment she accepts an investment, our founder becomes bound by a fiduciary obligation to her investors. The capital provided to her is given under this duty of care, first and foremost, to the investors. Herein lies the biggest potential pitfall – if the founder is in financial distress and sees your funding as a piggy bank to sustain herself, whether to enrich an already comfortable lifestyle or to pull herself out of a broke rut.

A financially troubled founder may be more susceptible to breaching her fiduciary duty to your investment. The moment she sees and takes the opportunity to benefit herself, however insignificant the amount may be, over the duty of care she has to you, the trust is broken.

Insist on founder equity

This is a major red flag. A founder pitching to investors with grandiose visions of success and promising substantial profits in the future, but unwilling to put his own money into the same venture is unjustifiable.

By not putting equity, he has little ‘skin in the game’ and, while more than likely drawing a salary from the venture, there is little sharing of risk in such a scenario. Indeed, there is a value to time and effort being expended by the founder for which compensation is a fair ask.

But that could be achieved through recruiting an expert professional for the executive role that the founder intends to take. He must be able to commit equity to the venture, whether from his own funds or from family, friends, or lenders. And unless he does, he will never feel the same level of obligation and duty of care towards the company’s funds.

Clear roles and remuneration for the founder

Clearly define the roles required to build a professional and competent executive team. Objectively assess the founder’s capabilities and her competence for a position on the executive team. There is absolutely no shame to call out the founder and inform her that she is not the best candidate for a particular position. Allow her to define a role that is more befitting of her experience and expertise and consider constructing such a role in the executive team. But never force fit a founder into an executive position as a presumed birthright.

Post-formation of the legal entity, the company should immediately seek to execute employment contracts with the founder. This is crucial as both the founder and the company must be able to separate the role of the executive from her role as a shareholder. Define the remuneration structure, clearly state any benefits or perks she may be entitled to, introduce goals and KPIs for her position, and link incentive compensation to the achievement of such KPIs.

Governance. Governance. Governance

There is no substitute for nor a shortcut to good corporate governance. No matter how small or how young the company may be, robust governance is a failsafe mechanism that protects you, the company, its employees, its shareholders, and its assets.

Corporate governance is a set of structures and processes for the direction and control of a company that facilitates a set of relationships between the company shareholders, Boards of Directors, and management. The Board is the primary governing body of a company and is responsible for acting on behalf of the shareholders to set the strategic direction and for the provision of guidance and oversight to its executive management. The Board’s key purpose is to ensure the company’s prosperity by collectively directing the company’s affairs, whilst meeting the appropriate interests of its shareholders and stakeholders.

The Board typically has approval and delegation authority and may delegate some powers to sub-committees and to executive management. However, certain powers are often reserved specifically for the Board. The general objectives and regulations governing the Board should be clearly stated in the company’s constitutional documents such as its Articles of Association.

The right Board composition is unequivocally the number one priority for the success of any company. For you, as an investor, negotiating a Board seat can be your key to success. Aim for an observer role, at minimum, if your stake is small. Collude, band together, with a group of investing peers to control a larger stake and the ability to demand a Board seat. Inviting an independent sector expert to join the Board will add tremendous objective and non-conflicted value.

Focus on the below, at minimum, as guardrails to have in place when seeking to implement robust governance:

  1. Comprehensive Articles or Memorandum of Association with clear rules of engagement and specified authorities for how the company will be governed.
  2. Board charter that spells out how the Board will conduct its activities.
  3. Board mandate to establish core Board sub-Committees such as Risk & Compliance Committee, Audit Committee, and a Remuneration Committee, the composition of these committees and their charters.
  4. A clear and concise Delegation of Authority matrix for all actions, transactions, engagements, and functions when the company goes live. This matrix should dictate how the company’s banking mandates are operated.
  5. Policies, procedures, and operating manuals for the main functional areas of the business such as finance, risk, human capital, operations, procurement, etc.
  6. Identify and eliminate, or at minimum mitigate, conflicts of interest and governance loopholes. A husband and wife as co-founders must not have joint control over the company’s decisions or finances. Others may be less obvious but always fail the smell test.

Never fall for the argument that the company is too young or too small to have governance in place. These governance principles are the forces that direct good business practices guarded by controls and checks and balances.

The right organizational structure

Determine, in consultation with the founder and other investors, what the optimal organizational structure should look like. Assess the positions necessary in the executive team and any management-level positions in addition to the timeline appropriate for such hires. Reporting lines should aim to follow best practices for the company keeping in mind the sector in which it operates. Having the CFO report to the Board is not only good practice but also keeps a firm check on how frugally and judiciously the company incurs expenses, ensuring prudence in how your capital is utilized.

Active monitoring

Construct and implement a robust reporting framework. It is imperative to keep tabs not only on progress but also on how your capital is being put to use. Insist on monthly updates, or quarterly at minimum, with a comprehensive review of all activity. These updates should include:

  1. P&L snapshot with details of expenses incurred.
  2. Balance sheet snapshot with details for movements in balances.
  3. Historical cash flow statement and forecast on a rolling 3-month basis.
  4.  Use of funds detailed by month, by category.
  5. Progress in the ramp-up of business activity.
  6. Buildup of the organization structure and hiring plan.
  7. Governance plan progress.
  8. Forward-looking business plan for 3 months, 6 months and 12 months,

I started writing this post intending it to be a short, bullet-point summary of lessons learned and tips. As I progressed, it grew into a fairly long hypothesis, and I stayed on course regarding my objective – use foresight and caution to avoid future losses. Avoid making mistakes that may end up being costly.

I have not spent any time talking about the documentation and agreements that govern the investment. I might follow up in a later post or a few posts to delve into these!

Haseeb H. Shaikh holds a Master’s degree in Business Administration from the University of Notre Dame in the USA and an undergraduate degree in accounting. He is a Certified Public Accountant and a CFA Charterholder and has 25 years of expertise in investment management.

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