Business Kiting
Most people are aware of the concept of check kiting. A person uses a number of banks or other institutions to in effect give himself a loan. He rights a check on bank one and then deposits a check into his account at bank one drawn on bank two. He then deposits a check in his account at bank two drawn on bank three. If you can find institutions that are sufficiently slow at presenting the checks, you can give yourself a loan for several days until you get money to cover the checks. You can also get yourself a criminal record, as check kiting is illegal.
The word kiting is also used to refer to domainers who use the five day trial period to acquire and use domain names. Someone with good software can repeatedly register domain names without ever having to pay for them. The domain names are referred to add farms and hopefully make the domainer $20-50 per year in add revenue. It does not sound like much until you see that some domainers are grabbing thousands of domain names per day.
This brings me to what I call business kiting. In business kiting a purported "investor" gets to try out a business without really investing in it. For example, an investor shows interest in a company and enters into a contract to invest in the company. In exchange, the investor gets an equity stake. The only problem is that the investor never really makes the investment. The company, thinking that it now has funding, moves ahead with expansion, acquisition or other expenses. It is often several months before the company's founders realize that the investor (who often offers to handle the finances) has not actually invested the money. Bills go past due and into delinquency. If the business does not look promising after a few months, the investor simply walks away and allows the business to go bankrupt. The investor is out little, if any, money.
So where is the upside? It is all owned by the investor. The investor will often get a substantial stake in the business for his or her investment. If the business does well, the investor may claim that the remainder of the investment was not needed - but will still retain their full ownership. In the best case scenario, the investor will invest the promised money once it is sure that the business is going to take off (drastically changing the risk/reward calculation to the investor's advantage). If other investors appear, the purported investor will often insist on taking a piece of the action or on selling out the equity stake that he should not have received in the first place. The founders have little choice but to buy him out, as litigation with the investor will send other funding sources running.
Regardless of the scenario, the founders of the business do not get what they have bargained for and the phony investor gets a windfall. The phony investor shifts the risk to everyone else, but is front and center for the reward.
One key to avoiding business kiting is to make sure your agreements are reviewed by an attorney. Yes, attorneys are expensive, but a thousand dollars today can save hundreds of thousands spent on buying out the phony investor. One provision that should be seriously considered is a provision that clearly sets forth that receipt of the funding is a condition precedent to the investor receiving equity. This may be staged if necessary (i.e. 3% ownership for each $10,000 received up to X percent). This way the investor cannot lay claim to equity that he or she does not deserve.
Another possible provision is to cap the equity interest of the investor based on funds received prior to receipt of further funding commitments or other bench marks. For example, if the investor was to invest $100,000 within six weeks for a 40 percent equity share and has only invested $20,000 by the end of the period, the founders can freeze the investor's interest at 8 percent. This prevents an investor from watching to see if the company lands an important contract or otherwise shows signs of growth prior to investing the rest of the money.
Most of the "angels" in Utah are honest and will make the experience a win-win. However, there are a few who want to "invest" without putting their money at risk. Founders beware.
The word kiting is also used to refer to domainers who use the five day trial period to acquire and use domain names. Someone with good software can repeatedly register domain names without ever having to pay for them. The domain names are referred to add farms and hopefully make the domainer $20-50 per year in add revenue. It does not sound like much until you see that some domainers are grabbing thousands of domain names per day.
This brings me to what I call business kiting. In business kiting a purported "investor" gets to try out a business without really investing in it. For example, an investor shows interest in a company and enters into a contract to invest in the company. In exchange, the investor gets an equity stake. The only problem is that the investor never really makes the investment. The company, thinking that it now has funding, moves ahead with expansion, acquisition or other expenses. It is often several months before the company's founders realize that the investor (who often offers to handle the finances) has not actually invested the money. Bills go past due and into delinquency. If the business does not look promising after a few months, the investor simply walks away and allows the business to go bankrupt. The investor is out little, if any, money.
So where is the upside? It is all owned by the investor. The investor will often get a substantial stake in the business for his or her investment. If the business does well, the investor may claim that the remainder of the investment was not needed - but will still retain their full ownership. In the best case scenario, the investor will invest the promised money once it is sure that the business is going to take off (drastically changing the risk/reward calculation to the investor's advantage). If other investors appear, the purported investor will often insist on taking a piece of the action or on selling out the equity stake that he should not have received in the first place. The founders have little choice but to buy him out, as litigation with the investor will send other funding sources running.
Regardless of the scenario, the founders of the business do not get what they have bargained for and the phony investor gets a windfall. The phony investor shifts the risk to everyone else, but is front and center for the reward.
One key to avoiding business kiting is to make sure your agreements are reviewed by an attorney. Yes, attorneys are expensive, but a thousand dollars today can save hundreds of thousands spent on buying out the phony investor. One provision that should be seriously considered is a provision that clearly sets forth that receipt of the funding is a condition precedent to the investor receiving equity. This may be staged if necessary (i.e. 3% ownership for each $10,000 received up to X percent). This way the investor cannot lay claim to equity that he or she does not deserve.
Another possible provision is to cap the equity interest of the investor based on funds received prior to receipt of further funding commitments or other bench marks. For example, if the investor was to invest $100,000 within six weeks for a 40 percent equity share and has only invested $20,000 by the end of the period, the founders can freeze the investor's interest at 8 percent. This prevents an investor from watching to see if the company lands an important contract or otherwise shows signs of growth prior to investing the rest of the money.
Most of the "angels" in Utah are honest and will make the experience a win-win. However, there are a few who want to "invest" without putting their money at risk. Founders beware.
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