Profiting from Failing Businesses

by Mr. Cheap

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This post is part of our scam category. With scams the best defense is often to discuss them and let people who haven’t run into them know how they work. Unfortunately, talking about scams can seem like a “how to” for scam artists, which IS NOT my intention here. I always love reading about scams and cons, in part to protect myself, and in part out of amazement at how devious people can be when they’re trying to part us from our cash.

I’ve often wondered if there’s a way to profit from a business destined for failure.  While I haven’t come up with any legitimate way to do so, there are well explored way to do so if you’re willing to defraud investors.  I’ve heard about this in fictional settings, but have never personally encountered it in the real world.

The core idea is you set up a business destine for failure (guaranteed to lose money), but in some way sounds good.  You go around looking for investors, the same way you usually do, but instead of selling some portion of the business to one person, you massively oversell it.  For example, you could started up a restaurants, and sell 49% repeatedly to 10 people (so, collectively, they’d own 490% of the restaurant).  You don’t tell any of the investors about the others (you pretend it’s just the two of you), and you show them the books every month as you lose “their” money.  In reality, you’re only losing a portion of the money you raised (when the restaurant goes bankrupt, you lose 100% of the value of the restaurant, and keep the remaining 390%).

For example: Say I’m opening a restaurant with $100,000 of seed money.  I collect $49,000 from you and 9 other people.  Each month we lose money (which I show to each investor), and once $100,000 is lost I shut the place down.  Since I raised $490,000, losing $100,000 leaves me with $390,000.

It’s obviously key that each of the investors not find out about the others.  Forged paperwork probably won’t be looked at too closely (since people are more eager to assert ownership over something of value, not a bankrupt company).  The biggest weakness would probably be taxes (if all the investors claimed a lose on the same venture it might raise red flags at the CRA).  The investors would have to be kept quiet, perhaps with some story why it’s important that you present yourself as the full owner of the restaurant.  The worst case would be if two investors got talking to each other and both bragged about being half owners!

This was the scam at the heart of “The Producers“.  Basically a terrible Broadway producer (who made one flop after another) and an accountant cook up this scheme and it blows up in their face when the production is a surprise hit.  This was also a small side-plot in Ayn Rand’s “The Fountainhead“:  a group of investors hire Howard Roark to design a resort, Monadnock Valley, when they think his idea sounds crazy, but it also blows up in their face when it turns out to be a good design.  Some real world variants on this are detailed at Crimes of Persuasion.

Part of the beauty of this scam is that the perpetrator doesn’t even have to leave town.  Investors may be upset with him, but if they accept that business entails risk, they might even be willing to invest in future projects.  A truly morally-bankrupt promoter could offer a number of investment opportunities, some profitable, some deliberately sabotaged and perhaps stay a respected member of the community while repeatedly defrauding investors.

If the scammer is prepared to leave town…

If you’re not worried about keeping your good name, it’s even easier to execute this sort of scam.  It’s possible to sell investments in a business that doesn’t, or won’t, exist.

When I taught English in Taiwan a man I met claimed that many locals started up computer companies, sucked up a bunch of investments by making the company look like it was doing well, then drained the company bank accounts and fled the country.

Even promoters selling rotten investment “opportunities” like timeshares or condo hotels could be considered performing a variant on this.

Protecting Yourself

This is a high pay off type of scam targeting wealthy individuals, so avoiding it is very different from some of the small scale scams we’ve posted about.  First and foremost, this will target people with money, so being poor (and not able to invest) is the easiest defense.  Being cautious around any investment that requires secrecy is probably another good policy.  I’d avoid these generally, unless there is a VERY good reason for the secrecy.  I talked to a man once about doing a rent-to-own deal with him on my condo, and he told me about 5 times that he didn’t trust lawyers and wanted to work the agreement out between the two of us without involving one.  Definitely creeped me out and I’m sure he was up to something (obviously I didn’t do business with him).

By the time the venture has failed, I’m not sure how much good it would be digging into the paperwork and finding out you’d be scammed.  It would be worthwhile to try to prove the scammer’s wrongdoing, but the chances of recovering money at that point would probably be pretty slim…

Have you heard of anyone being taken in by a scam like this (local investors, friends or family)? Do you think this is happening often in the real world, or is this a scam that sounds better on paper rather than something that would be common?

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{ 5 comments… read them below or add one }

1 Rachelle

Junior miners who don’t mine comes to mind. My brother in law is a diamond driller and there are companies who don’t really prospect.

I was going to buy some shares in a junior mining company once and I googled the CEO’s name and he had already been at the helm of three companies that had been mentioned as doing this.

Bottom line is you’re not going to find any mineralisation if a significant portion of your budget is not drilling in your claims. It is very rare to find any gold while driving around in your company pickup downtown Toronto while collecting your bloated CEO salary.

2 Potato

Biotechs that don’t research is another similar one. Big IPO, raise millions, then cancel the trials in the early stages because the data isn’t promising enough, but while there are still millions in cash left. Then spend years collecting full salary while “evaluating options for returning shareholder value”.

3 jesse

You mention Taiwan. While I don’t think corrupt scams are necessarily more prevalent in Asia than Vancouver, businesses are much more aligned on family ties, not contracts. It seems like a logical conclusion to an environment rife with confidence scams.

Agree with @Rachelle that looking at the reputation of the people involved is imperative. That they themselves are successful is not really what you should be looking for.

4 James

Best article I’ve seen in a while — though I’ve been lucky to have only been (knowingly) scammed for a few hundred in my lifetime, it taught me a valuable lesson. The thread (and the comments here) are all eye-openers. Big thanks to all for sharing their stories!

5 Financial Uproar

I enjoyed the Ayn Rand reference.

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