Startup Founder Fraud: the Misuse of Early Stage Funding

Startups often start in a garage or spare room funded by personal funds, credit, and loans or investments from family and friends. As a startup grows, the founders seek funding beyond their intimate circle, seeking more prominent angel investors and venture capital. Along the way, especially in the early stages, it is easy for startup founders to mishandle finances leaving behind a trail of broken friendships, angry family members, and distrust from investors. To help startup founders and newbie angel investors to understand how startup finances can be used, we interviewed Venture Capital Lawyer Honghui Yu from Olshan Frome Wolosky. Honghui represents emerging companies in forming, funding, and operating an early stage startup.

Spending years in Silicon Valley, working with startups in various stages, and running VC-List there are definitely some entrepreneurs who are financially unorganized and some bad entrepreneurs doing outright fraud. We have all heard the famous cases of Ponzi schemes, vaporware, and startups skirting regulations, but let’s talk about the very early stages of startups, where it is easy for startup founders to attract naive investors whose funds can be miss handled if they get into the wrong hands.

Question: If a startup founder works from their home, can they use investors money to pay their rent or mortgage? No, they should not. As corporate lawyers, we frequently counsel clients on best practices to avoid “piercing the corporate veil”, which is a legal concept that refers to when a court can disregard a business entity’s corporate form and impose personal liability on the shareholders of the entity (i.e., the founders). For example, we advise businesses that they should maintain separate books and records and bank accounts from the business owners and that they should avoid any commingling of funds between the business and the business owner. Even if a startup founder works from their home, their rent and mortgage are personal expenses and it’s not a good idea to use business funds to pay for those personal expenses.

Question: How can angel investors make sure funds are not being used to pay personal property? Many investment agreements have a use of proceeds provision, which says that the proceeds from the investment can only be used for certain specified purposes.

Question: Can a startup founder take a personal loan from funds that they received? For example, the startup has $1 Million in the bank from angel investors. Can the startup founder use it to pay off personal debt or make a personal purchase with an understanding they will pay back the funds they borrowed? No – again, this touches on the corporate veil piercing concept I mentioned earlier. Personal debt and liabilities should be kept separate from the business’s accounts.

Question: How can angel investor see what loans have been granted from the startup funds? Personal or not personal? To the extent the startup produces financial statements (even if they’re very simple financial statement generated by accounting software), the loans should be reflected on those statements, and we always advise investor clients that, as part of the due diligence process, they should ask to see those financials if they exist. Also, post-investment, it’s important that investors have some ongoing visibility into the business’s financials so we counsel our investor clients that they should push for information or inspection rights when negotiating the investment agreements.

Question: If a startup has a credit card that has a rewards program who is entitled to the rewards? Can the startup founder use them for personal use? If the credit card is a business credit card that is associated with the startup’s business bank account, any rewards belong to the business and should not be used for purely personal use.

Question: How can angel investors make sure funds are not getting used for personal items such as cars, vacations, and home improvements projects. A use of proceeds provision is critical here. Admittedly, enforcement can be difficult if the investor doesn’t have visibility into the startup’s books and records so it’s important that investors ask for information or inspection rights, which means that the investors will receive periodic information from the company (typically annual, quarterly and/or monthly financial statements, depending on how mature the business is) and have a right to inspect the business’s books and records and speak with management to get business updates.

Question: Can a startup founder use investors money to pay for their immigration issues, using investors money for immigration lawyers? If the immigration issues go to the founders’ ability to work for the startup in the U.S., that’s generally considered a business expense and so long as the investment documents permit it, the funds can be used to deal with those immigration issues (including engaging immigration lawyers to assist with those issues). We frequently see use of proceeds provisions referring to the use of funds for “general corporate purposes”. Hiring an immigration attorney to assist obtaining work visas so that an employee can work for the startup would typically be considered a general corporate purpose.

Question: What legal fees can be covered and not covered by a startup for the founders? Generally speaking, when the business is first formed, the founders are covering all legal expenses for the business (including expenses incurred to form the business). However, one of the first things a business should do once it is formed is obtain an employer identification number (EIN) with the IRS so that it can open its own bank account. Then, on a going forward basis, all expenses, including legal fees, should be paid only from funds in the business bank account. Of course, initially those funds will be capitalized by the founders, but it is still important to maintain the separateness of the business’s bank account from the founders’ personal accounts.

I would like to thank Lawyer Honghui Yu from Olshan Frome Wolosky for the detailed answers on misuse of early stage startup funds by founders.