One of my hobbies at work is collecting outrageous stories about the greed, crookedness and sleaze of some financial advisors working in China. Sadly, there are too many bad stories â€“ and bad advisors â€“ to keep an accurate, up-to-date accounting.Â
Over 600 Chinese companies, of all different stripes,Â are listed on the unregulated American OTCBB. The one linking factor here is that most were both badly served and robbed blind by advisors.
Many other Chinese companies pursued reverse mergers in the US and Hong Kong.Some of these deals succeeded, in the sense of a Chinese company gaining a backdoor listing this way. But, all such deals, those both consummated or contemplated, are pursued by advisors to put significant sums of cash into their own pockets.Â
Talking to a friend recently in Shanghai, I heard about one such advisor that has set a new standard for unrestrained greed. This friend works at a very good PE firm, and was referred a deal by this particular advisor. Iâ€™ve grown pretty familiar with some of the usual ploys used to fleece Chinese entrepreneurs during the process of â€œfund-raisingâ€. Usual methods include billing tens of thousands of dollars for all kinds of â€œdue diligence feesâ€, phony â€œregulatory approvalsâ€ and unneeded legal work carried out by firms affiliated with the advisor.Â Â
But, in this one deal my Shanghai friend saw, the advisor not only gorged on all these more commonplace squeezes, as well as taking a 7% fee of all cash raised, but added one that may be rather unique in both its brazenness and financial lunacy. The advisor had negotiated with the client as part of its payment that it would receive 10% of the companyâ€™s equity, after completing capital-raising.Â
Letâ€™s just contemplate the financial illiteracy at work here.Â No PE investor would ever accept this, that for example, their 20% ownership immediately becomes 18% because of a highly dilutive grant to the advisor. Itâ€™s such a large disincentive to invest that the advisor might as well ask the PE firm to surrender half its future profits on the deal to put the advisorâ€™s kids through college.
The advisor clearly was a lot more skillful at scamming the entrepreneur than in understanding how actually to raise PE money.Â The advisorâ€™s total take on this deal would be at least 17% of the investorâ€™s money, factoring in fees and value of dilutive share grant.Â
By getting the entrepreneur to agree to pay him 10% of the companyâ€™s equity, along with everything else, the advisor raises the companyâ€™s pre-money valuation by an amount large enough to frighten off any decent PE investor. Result: the advisor will not succeed raising money, the entrepreneur wastes time and money, along with losing any real hope of every raising capital in the future. What PE firm would ever want to invest with an entrepreneur who was foolish enough to sign this sort of agreement with an advisor?Â
This is perhaps the most malignant effect of the â€œworkâ€ done by these kinds of financial advisors. They create deal structures primarily to enrich themselves, at the expense of their client. By doing so, they make it difficult even for good Chinese companies to raise equity capital, now and in the future.Â Â
Iâ€™m sure, based on experience, that some people reading this will place blame more on the entrepreneur, for freely signing contracts that pick their own pockets. No surprise, this view is held particularly strongly by people who make a living as financial advisors doing OTCBB and reverse merger deals in China.Â This view is wrong, professionally and morally.Â
In most aspects of business life, I put great stock in the notion of â€œcaveat emptorâ€. But, this is an exception. The advisors exploit the credulity and financial naivete of Chinese entrepreneurs, using deception and half-truths to promote transactions that they know will almost certainly harm the entrepreneurâ€™s company, but deliver a fat ill-gotten windfall to themselves.Â
Entrepreneurs are the lifeblood of every economy, creating jobs, wealth and enhancing choice and economic freedom. This is nowhere more true than in China. Defraud an entrepreneur and, in many cases,Â you defraud society as a whole.Â