If you live long enough, you will be defrauded. And the longer you live, the more times it will happen to you.

The question is: How do you manage risk to reasonably control the frauds and their effects on you as an investor?

Please note that people running and working in companies are also hurt by frauds within their companies (unless they are the fraudsters, and many of them end up in jail, so they get hurt too).

Some examples of recent frauds

I would not want to name names because I would not want to be sued for defamation. So if you sue me over what I am about to say, you are only revealing the information yourself.

Word on the street

We talk to investors we work with, and we have come to believe, as have many of then, that the investment instrument is particularly important in terms of detecting and mitigating frauds. The big problem seems to be debt instruments and various sorts of notes.

I am not a fan of SAFE notes in particular, because they are not in fact very safe as they are usually used. In most cases, they start with the original SAFE note and then add terms and conditions that make it highly favorable to the company and unfavorable to the investors. But even a straight SAFE note, as almost all other notes, mean that the investor is not a shareholder. Shareholders have rights, in most cases, that note holders do not. In particular, rights to information, which are key in detecting frauds. In the real estate example above, I asked about investing in the company rather than in a portfolio of properties. Their response was ~"perhaps in a few years", and my response was ~"no sale".

Certain types of debt come earlier in line for recovery of funds in case of failure. Banks and other such institutions are generally fist in line, then other debt holders, then equity holders. Of course, companies that fail, typically do so with few if any residual assets that are recoverable. But for things like real estate with actual physical and potentially valuable assets, assuming the deeds are good and the leverage (loans taken out based on the investment and property value) is not excessive, there's a very good change of recovery. Except of course fraudsters tend to over-leverage, over-spend, over-value, and under-report. So when that happens, all the work to check it out falls apart, unless you check it out a bit more.

Risk management

So sometimes I lose, and sometimes I win. It's a statistical game we play with investment. And that means that coming to believe in an investment is usually the fastest path to your demise. I am a skeptical optimist by nature. I want good things for the world, and I believe the world can get way better very soon. But I also know that things fall apart (title by Chinua Achebe), and I try to work to help them not do so when it effects me (and those in the larger circle around me, starting with my family, friends, business associates, and ultimately, the rest of the world).

The statistical game, in the context of most early stage companies, relies on diversity and risk disaggregation. Here are a few pointers from my approach:

A few questions

An interesting question is how many investments are needed to get the average return. Of course the more you invest the same amount in, the more you are likely to get the average return. Of course the average return in a vertical may not be good enough for you, in which case you should not invest there... unless you are trying to disrupt. The numbers from studies of early stage companies getting angel investment from angel groups doing significant due diligence and helping the companies over time are, according to Wiltbank, 70% do not return the invested capital after 10 years, 22% return between 1x and 10x the investment, 4% return between 10x and 30x, and 4% return more than 30x. By my not really precise analysis, this means that 92% ([70*0+22*5]/92=1.2) end up at just over break even over 10 years. The average time to exit in these studies has been about 5 years. So if we invest $1 in each of 100 of these companies and everything goes exactly as predicted (which it never does), that comes to $100 invested, and returns of something like 22*5=110 + 4*20=80 +4*50=200 == $330, or a multiple of 3.3 over 5 years, or about 11x over 10 years. One better or worse at the high end can make a lot of difference here (one more out of each 100 with a 50x return instead of 0 makes the 10 year return 14x, and one less turns it into 8x).

Another interesting question is whether to follow your own investments with more in as companies succeed. Of course the companies that fail are not likely to be good ones to put more money into. So companies that seem likely to fail should probably not be "saved" for another period of time by adding to your sunk cost. But companies meeting plans and growing and who have anticipated more funds in a next round of funding may be a better place to invest more. Many investors who put in substantial amounts do so in tranches with performance requirements for each subsequent tranche. But in order for this to be sensible, each investment should be as good a return as the average, which means that the expected increase in value for each tranch should be 3.3x over 5 years, or the same investment would be better put into diversification. A good rule of thumb for the angel level is that valuation should increase by a factor of 2 every year, and of course re-investing if there is really a doubling of value in a year and expectations of the going forward seems like a pretty good move. Few companies actually achieve this of course, and this also brings up the question of valuation. This for another day.

Too good to be true

Usually, too good to be true is the result of a lie. Year after year 18% returns on real estate investments in a market getting 8% on average would lead to skepticism. Unless there is some really good reason for this to be true (and a good story is not a good reason), I probably would not (and did not) invest, and certainly would not follow my own investment. Yes you could win big, but you could also lose big.

Similarly, a company that will become profitable as soon as they reach 1 billion customers, and that will get there in 3 years from a standing start by the magic of viral marketing over the Internet is one I would walk away from (and did). On the other hand, a 3x growth rate over 5 years getting to $1B in revenue in a large enough market and the details to support the claims is probably feasible, even if a high risk investment. Even better, if they only get 1.5x/year and still generate a profit, and only get to a few hundred million in 5 years, it may still end up being a good investment.

A call to action

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In summary

Frauds are just another way companies fail. Diversify your investment portfolio, be diligent, don't follow your own investments too far, measure carefully, and get great returns regardless.

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