How To

May 7, 2020

How to avoid cowboy investors

Investor due diligence cuts both ways; here’s how to ensure you don’t take money you’ll later regret.

Maya Braine

6 min read

It will not have escaped anyone’s notice that these are troubling times for companies seeking funding. Investment in the fintech sector is at a three-year low, with early-stage companies across all sectors witnessing a collapse of investment interest amid fears the Covid-19 pandemic will lead to a recession. 

In this environment, it is hardly surprising that many companies looking for capital will feel they have to seize any potential investment they are offered. However, accepting the wrong funding can come with a cost, and even in these difficult times, startups should be prepared to ask questions about where their money is coming from.

Earlier this year, UK peer-to-peer lender Zopa found itself in trouble when board member Kapil Wadhawan was arrested in India over money laundering allegations. Wadhawan, the chairman of Wadhawan Global Capital and the owner of a large Indian property finance group, had co-led a £32m investment in Zopa which secured him a seat on the company’s board. He was arrested in late January in connection with a money laundering probe, and subsequently had to resign his position at Zopa.

...companies mustn't be afraid of asking questions.

This incident highlights the importance of knowing who you’re doing business with. In the thrill of securing financing, it can be tempting not to scrutinise your potential backers too closely, especially now when the Covid-19 pandemic means funding sources are drying up. However, as the Zopa case shows, this is a potentially risky area and companies mustn’t be afraid of asking questions. 

'Investor due diligence' should cut both ways, and target companies should be prepared to conduct 'know your investor' research. Investors with poor reputations can have a knock-on effect on portfolio companies’ credibility and their ability to raise capital in the future. And in a worst case scenario, target companies could even find their investors or directors are involved in criminal proceedings, or discover that the investment consisted of illicit funds.  

Doing your homework: Reputational and integrity due diligence

So what does this mean in practice — what do target companies need to know and how can they find it out? It can be relatively straightforward to ascertain the track record and reputation of well-established investors, but how do you tackle more niche players, new entrants to the market or those based overseas?  

1) General online research

An easy starting point is online research — sources like the investor’s own website, news reports and Google searches. Depending on the size of their public profile, this can help you find out if investors are well-established figures with a good track record and a logical interest in investing in the company in question. How long has the fund been incorporated? Has it made successful investments in the past and does it have discernible experience in the sector? Is it the subject of any negative media coverage? 

If your company uses regtech tools for KYC (know your customer) checks, you can repurpose these to look at your investors.

2) Specialist research

It may be worth delving into specialised online resources if you identify red flags or high-risk factors like the investor’s main country of operations. This could include media databases, foreign language news reports, litigation and corporate records, regulatory watch lists and cached online material. If your company already uses regtech tools for KYC (know your customer) checks — e.g. screening adverse media or regulatory watchlists — you can repurpose these to look at your investors.  

You could also consider subscribing to (or trialling) products like Dow Jones’ Factiva or LexisNexis, which enable you to search media and litigation archives. Google Translate can help you locate negative news, although it leaves a lot to be desired in many language combinations and you may need to find a helpful bilingual colleague or friend (a useful search function on LinkedIn lets you identify contacts who speak the major European languages). 

There is no one-size-fits-all approach here, as media sources vary and different official records are publicly available in each jurisdiction — but Google search may at least help you determine what is available and where to try looking.  

Specialist compliance or intelligence companies may also be able to help.

3) Making enquiries

Speaking to peers in the marketplace will help you go beyond online information and provide a better sense of the investor’s track record, modus operandi and general reputation. This can include other investees, or other sources in the relevant sector and country. Are they in a good financial standing? Are they known to practice dubious or aggressive business practices? Have they been involved in any previous scandals or legal or regulatory issues? Have any previous investment relationships gone sour? 

This approach is particularly useful in countries with undeveloped media landscapes, poor press freedom or limited public records. Investors from countries with lower standards of transparency and higher levels of financial crime pose additional concerns — for instance, how did they initially make their money and what is their political standing in their home country?

...human sources will normally be far more revealing than published information."

Use LinkedIn to identify helpful people in your extended network, and don’t be afraid of leveraging second-degree contacts who you don’t know personally — the majority of people are likely to be happy to help. It’s important to consider the impartiality of whoever you speak to and how discreet you need to be, but if you bear this in mind, human sources will normally be far more revealing than published information.  


4) Contextualisation

Analysing information on overseas investors may require an understanding of their home country; for example, investors who established their fortune in Russia and the former USSR in the privatisation programmes of the 1990s. In many countries, it will be important to understand political patronage — whether your investors have political influence or connections, whether this could have helped them make money illegally or unethically or to avoid legal actions and whether their position may be threatened by changes to the current political regime. Consider speaking to people in your network who may be able to provide these contextual insights.

We recently saw the value of sound investor due diligence in the case of a Russian venture capitalist looking to invest in a UK fintech. Research using the steps outlined above uncovered concerns about their source of wealth and modus operandi: they had political connections to the Kremlin, held business interests in opaque jurisdictions through apparent shell companies and held UK corporate interests which raised questions. These concerns ultimately led to the fintech rejecting the investment — a disappointment in the short term, but likely a prudent decision in the long run.

Just as all compliance processes vary based on a company’s profile, business model and risk appetite, different companies will apply different standards of due diligence when considering potential investors. But the important message for all startups right now is to do your homework, and don’t panic and get into bed with someone you’re not comfortable with. It is still possible to fundraise successfully (see Lunar and Yapily’s successful funding rounds earlier this month) and the current situation will eventually pass. But on top of all the other problems the Covid-19 crisis is causing, you do not need a dodgy investor to add a ticking time bomb.