An integral feature of sustainable entrepreneurship and corporate social responsibility is ensuring that the resources required to establish and operate the business are sourced in a responsible manner that does not impair the integrity and reputation of the company. While transparency regarding sources of funding is relatively robust among public companies, which are subject to extensive reporting requirements imposed by governments and securities exchanges, the same is far from true in the startup world and the risks for sustainable entrepreneurs are increasing as rogue investors dangle capital in front of them at the same time as employees, customers and other stakeholders demand that founders be able to explain how their businesses are funded. As explained below, founders need to understand the techniques they can use to conduct due diligence on prospective investors and ask questions to prospective business partners to determine how they are funded and the pressures they may be under from their own investors.
The robust economic conditions during the mid-2010s have encouraged many fledgling venture capitalists to hit the road to attract capital for their initial funds and, as recently reported in The New York Times, they have often been advised to go after so-called “easy money”: billions of dollars available from sovereign wealth funds managed by Middle Eastern countries such as Saudi Arabia and Abu Dhabi looking to become major players in Silicon Valley and other innovation clusters around the US and in Europe. The strategy seemed to make sense and, in fact, appeared to have been endorsed by major investment players such as SoftBank, an investor in Uber and other high profile Silicon Valley companies that had accepted a commitment of $45 billion from Saudi Arabia’s Public Investment Fund. However, even before news of additional repressive political tactics in those countries came to light in 2018, fund managers, increasingly sensitive to calls for responsible investment, were hesitant about taking money tied to those countries and were instead focusing their fundraising on wealthy individuals, nonprofit organizations, universities and pension funds committed to conforming to international standards for investing in an environmentally and socially responsible manner.
More and more investors must now contend with questions from founders and executives of their existing portfolio companies, as well as questions during the courting process with prospective funding targets, about where the money they are investing came from. In particular, founders are asking investors whether they have received money from sources that are connected to foreign governments with poor human rights records or from foreign investors looking to effectively “launder” profits from illegal and unethical business activities in their home countries. Another concern is funding from government-supported sources in countries such as China and Russia where there are significant risks that one of the purposes of the investment is to gain access to proprietary technology and strategic business information. Venture capital firms have traditionally been less than forthcoming about their own investors (they are under no legal obligation to disclose the information, often keep it secret for competitive reasons and may actually refuse funding from public pension funds that publish the results of their investments); however, it is becoming clear they may often not have a clear idea about where the money is coming from because they have failed to ask the right questions themselves and/or investors employ sophisticated schemes such as shell companies to mask where the funds are actually controlled.
Some founders, with the support of their investors, have extended their concerns about financial and business support from repressive regimes beyond investors to include partnerships with customers, distributors and suppliers, announcing that they would not do business with companies that have taken money from such regimes and/or conduct significant amounts of business with affiliates of such regimes. Companies are also concerned about doing business with firms that have board members designated by “questionable” investors since sensitive details of transactions are often distributed and discussed at directors’ meetings. In addition, lack of clarity about ownership and control of investment vehicles means that a founder may discover that one of its investors has also provide capital to competitors through affiliates as part of a broader scheme to gain access to the details of all proprietary technology relevant to a particularly promising sector regardless of which companies own that technology or whether any specific company will be most successful.
Investors have always conducted extensive due diligence on the founders of prospective portfolio companies and their proposed business models, seeking information on the company’s governance, management and finances and often meeting with customers, distributions, suppliers and other business partners; however, the founders themselves have rarely asked too many questions about potential investors, perhaps fearing that aggressive “reverse due diligence” would cause investors to back away. However, experts caution founders about being too timid, noting that the relationship with an equity investor is akin to a marriage that cannot easily be undone and thus must be entered into only if and when there is trust on both sides. Recommendations for reverse due diligence provide by one experienced adviser to founders include getting a perspective from peer investors; personally visiting another startup funded by the investor; doing research on investor visibility via Google and social media; inviting the investor to dinner or a fun-related activity; and conducting a routine credit and background check. In addition, founders need to be direct and clear about asking investors to explain the source of the funds that are to be invested and not be satisfied with vague and elusive answers.