Feature: Venture Capital Firms Hedge Exposure To Fraud –

Who says you can?t buy the Brooklyn Bridge?

The FBI?s chief of economic crimes, Joe Ford, says the bureau recently caught a group duping investors with a scheme reporting to privatize the old bridge. The group sold shares in the bridge for between $125 and $1,000, and people actually bought it.

Let?s hope a venture capitalist would not fall for that scam, but VCs face a world full of hidden schemes. A private equity firm investigated an executive from a company shopped by an investment bank and found that 18 years ago, he had been a major drug dealer with a supply connection in South America.

In another case, a company had raised $192 million in venture financing, had attracted two major customers and was cash-flow positive. It seemed too good to be true. When the company?s venture backers sent in a third party to verify its claims, all the books and records turned up missing.

As the examples demonstrate, the high stakes of venture capital attract folks with suspect intentions and backgrounds. Although an increasing number of VC firms hedge their risk by using professional firms to investigate entrepreneurs before they lay out any capital, some continue to rely on an old-boy network to source deals and contact entrepreneurs ? a network that keeps outsiders (for better or worse) out.

But, as the venture market scaled up and grew internationally over the last several years ? even with many deals coming through referrals and many firms limiting their investments by region ? it?s hard to know everything about everybody in the market.

?Anybody in the investment business long enough has their own war story,? says Jerry Oldham, investigator and chairman of 1stWest Financial Corp.

In the heyday of the telecom boom, a management team of eight people shopped their company to a private equity firm. Before committing capital to the deal, the investors called Robert Strang, executive vice-president of Decision Strategies. Strang found that one of the entrepreneurs had been indicted for fraud and the other seven were unindicted coconspirators in the same scheme. Six months later, without the indicted member of the team, seven of them showed up at a different equity firm looking for cash.

Many VCs interviewed don?t yet use outside investigators, but doing the legwork up front can prevent severe consequences down the road ? consequences that can kill a company.

?Sometimes, it scares the shit out of folks when they find out what we do,? says a source at a Chicago buyout firm who always investigates entrepreneurs and wished to remain unnamed, because he was afraid of scaring away potential deals. ?You never know. You just never know. It doesn?t matter how clean a resume looks.?

The standard background check offered by most corporate investigation firms covers a search of public records available in databases and local courthouses to verify claims and uncover hidden liabilities. The standard check runs about $1,000 to $2,000.

Beyond that search some companies offer a deep search during which they will interview everyone that ever knew the person or ever dealt with the company. VCs who have used this service say the people these interviewers turn up amaze them.

?They will find this guy?s worst enemy and interview him,? says a VC. Kroll pioneered this service and remains the brand-name search firm in the industry. These deep searches generally start around $6,000 and increase significantly.

?In deals where you?re buying companies for upwards of $50 million, spending $15,000 on security is a no-brainer,? a VC says. While those metrics make sense, investigators say they have many clients involved in deals down to the $5 million range.

VCs and turnaround specialists also hire investigators to perform asset searches and forensic accounting functions when an investment turns sour or if they feel that something isn?t right in the situation.

?If you?re at the point where you need an asset search it means you?ve lost all your money,? says Dan Karson, executive managing director of Kroll Associates.

Unfortunately, VCs occasionally lose all their money on the most well-intentioned portfolio companies. In the past 18 months, companies have failed due to unfortunate decisions ? rather than fraud.

?Most of the money that got spent was spent honestly, but it was just spent misguidedly,? says John Halvey, partner at Milbank, Tweed, Hadley & McCloy LLP.

Skeletons in the closet

Repeatedly, VCs say the most important factor in their decision to invest in a company is the management team, and some VCs want to know everything about the people they back. Ultimately, a VC wants to know: Are they reputable? And, are they competent?

?The types of fraud are as limited as your imagination,? Ford says. ?If you have a very vivid imagination, you can commit many kinds of fraud.?

The investigators say the skeletons they find would shock anybody. For example, they estimate that anywhere from 25% to 50% of the resumes they see include misrepresentations ? often fabricated academic degrees. One executive candidate claimed a degree from USC ? San Diego, which doesn?t exist. Another candidate for a high-level, science-related position claimed a PhD in Chemistry, but the candidate really had none of the degrees he claimed.

And yet, poor academic credentials haven?t stopped the likes of Michael Dell and Bill Gates. By the point in their careers when these nominally-educated entrepreneurs approach the VCs, their business experience may outweigh the importance of the degree.

For example, Karson tells of a case of a doctor running oncology centers in Pennsylvania raising money to expand the network of clinics. At some point in the past, the doctor gave himself an MBA from Wharton, and the VCs backed away from the deal when they uncovered the lie. Unfortunately, the doctor?s practical business experience may have been enough to get backing.

?Somewhere along the line, they get into the mode that to get to the next level they need to have better educational backgrounds,? says Larry Scherzer, president of investigation firm Scherzer & Co. ?They can?t change the story later on, because they?ve left too many records.?

Even if the searches don?t reveal fraudulent tendencies, they may show evidence of character flaws that could jeopardize the venture down the road. A CEO candidate for a women?s products company had been sued three times for sexual harassment. A VC asked about a technology entrepreneur who had been in the real estate business 10 years previous and found he left real estate because his reputation was so bad.

Sometimes investigators find a situation that is presently harmful to the company, such as a turnaround specialist who found out that a sales representative had three jobs, because the sales rep. never returned his calls and his company voicemail only listed his name.

In other situations, the investigators find surprising character traits, like the CEO who was a cross-dresser and the entrepreneur who had killed an endangered animal in a public park.

And, if any of this information saves the VCs from a disaster, they?ve gotten value from their homework.

?People will get found out,? says Claire Irving, principal of Investigative Consultants International LLC. ?I don?t know why they keep doing it [lying about their backgrounds], but it?s good for our business.?

Other common blemishes investigators find include unreported citations from regulatory agencies, liens and pending litigation. If the VCs had not found the liens until after the deal had closed, they could have ended up with a group like the state taxing authority as a partner, according to Scherzer. Other litigation can also target the company?s coffers if it involves a director.

Investigators also find felony convictions and arrests. A group of VCs who ran a news search on a group they were about to meet found reports that the group had formerly headed a brokerage that had been raided by the FBI for suspicion of both securities fraud and drug dealing.

Drunken driving arrests also commonly pop up. Some VCs walk away from these deals saying drunken driving is often a symptom of a drinking problem or just poor judgment. VCs also worry the entrepreneur will kill somebody next time he goes on a bender and jeopardize the company.

VCs who do their own due diligence say they can find this stuff on their own, but the investigators say their professional examination provides a much more thorough search. They say that having a paralegal check Nexus and call a handful of references is not enough to catch people that don?t want to be caught.

?People who are really good at fraud never get arrested,? says Strang, who also recently became the co-chairman of the New York State Terrorist Task Force.

What To Do

In 1995, Chris Bagdasarian took an asset management company public in a Salomon Brothers-led IPO for $260 million based on reported assets of $750 million. Fortune magazine even called him the young Warren Buffet, but it was all a hoax. He never had anything he claimed. The most he ever managed was maybe $50 million.

?The greatest temptation as a banker or a VC when faced with a great deal is the allure of a pay-out,? Karson says.

The crooks know this, and they tend to gravitate to industries that are moving quickly, which is common to VC. The crooks also find most success in times when due diligence and investing cycles are shortened.

?One of the effects of the boom years is that the due diligence cycle got compressed,? says Tom Blaisdell, partner at DCM ? Doll Capital Management. ?Some folks just didn?t spend as much time as they previously had.?

Board members have learned to question every transaction. In one case, an executive said he was going to invest money in the company, but he later said he would substitute property at cost instead. The VC found out he had bought the property from his father-in-law.

While good times may attract people with the worst intentions, tough times may also lead some well-intentioned entrepreneurs and companies to stretch the truth about a contract that hasn?t quite closed, a customer or something in their past.

?People are going to stretch,? Irving says. ?Some may panic. We are going to see bad behavior.?

When the investigators turn up a skeleton in the closet, it doesn?t always kill the deal. If the deal is good enough, the VCs may be able to restructure the situation to get it through.

?If we find someone in the deal with sticky fingers, we can help put gloves on them,? Irving says. For example, when another investigator discovered that a CEO in which VCs were about to invest faced several state tax liens, the VCs had the liens settled before closing the deal.

When the investigators find information about an entrepreneur that kills the deal, some of the underhanded entrepreneurs try to continue the con and convince the VCs to invest anyway, but no investigators reported ever being sued or challenged by someone whose falsifications they exposed.

?They don?t want a record showing they were turned down,? Strang says. ?They just want to quietly move forward and find another equity group that doesn?t do as good of a due diligence process. They just want to close the deal.?

Contact Charles Fellers at: