The Internet has made many people rich, but these investors lost millions.

Sometimes business ventures don't work out as planned. This mini case study from Margolis & Co. highlights of one of those situations, with an emphasis on what went wrong and how it could have been prevented. Margolis & Co. is dedicated to the success of new business ventures, and to the fair resolution of those that do not work out.

The Deal

Michael Stevens, Ph.D, IVS ’ founder and CEO, was a bright and energetic engineer developed an innovative idea to streamline video transmission over the Internet. He moved quickly to bring his idea to market, simultaneously forming a company to manufacture and sell the new technology, and recruiting investors with startup funding. A group of seven investors recognized the opportunity at hand and contributed $8 million. However within two years, the money had disappeared.

What Went Wrong

Our investigation of this deal gone bad found that Stevens had created a web of arrangements that allowed the diversion of funds from many different parts of the business. Fraud was embedded in routine operations, loans, a line of credit and provisions for the distribution of stock.

Many of the funds from Stevens’ initial loan to IVS and from the line of credit were distributed right back to Stevens or entities he controlled by means, including fees, interest, royalties, and other types of payments. Our analysis revealed that this exceeded $2 million over 2 years. In many cases Stevens had received cash while the liability for loans and payables remained on the books. Stevens enriched himself from the outset.

• Stevens said that he had invested substantial sums of his own money in IVS, but in reality the funds were a poorly documented loan of $1.l million. Then, he converted the loan to 3.9 million shares of common stock.

• Stevens established a line of credit for IVS with funds from a trust (for which he was the trustee) at the inflated interest rate of 1% per month. He drew on the line from time to time to cover unusual expenses. With each draw however, the note required IVS to grant warrants to Stevens to acquire thousands of shares of stock.

• Stevens acquired office space for IVS through a sublease from a company he owned. He rented approximately 4,000 square feet at $9 per square foot and subleased most of it to IVS at $11 per square foot. He retained a small portion of the space for his other business interests. In addition, under the sublease IVS was responsible for all of the utilities. The sublease was signed before the investors came on board, but this related party transaction was not disclosed in the due diligence investigation or in the stock offering.

• Stevens also enriched himself through a royalty agreement covering the video communications technology. As the owner of the technology and the CEO of IVS, Stevens executed both sides of a licensing agreement that provided IVS with a worldwide perpetual license to use the technology. In exchange, the agreement required IVS to pay Stevens a royalty in the amount of 0.9% of the net revenues from the sale of products, applications or services. The minimum payment under the licensing agreement was $2,000 per month. The minimum payment was equivalent to royalty payments on approximately $222,000 in monthly sales. Based upon the licensing agreement and the timeline of IVS' start up, the royalty agreement provided payments to Stevens on the equivalent of $2.6 million in sales that had not occurred.

• Stevens had a management agreement with IVS that paid him a management fee of $15,000 per month. Our work indicated that his time was spent primarily on IVS' business and indicated that the management fee should have been handled as wages with the appropriate payment of payroll taxes. The management agreement created a potential liability for IVS for additional payroll taxes, based upon IRS definitions of employment.

• In the area of general expenses, Stevens used business credit and debit cards for over $200,000 in personal, household and mortgage expenses.

Lessons learned

In this installment of our newsletter we would like to highlight the following point which would have helped to prevent the loss of investors' funds.

Due Diligence: Before putting in their money, the investors should have conducted a more thorough due diligence investigation. Good due diligence starts with a standard list of items to review to ensure completeness, but, more importantly, due diligence is a process that goes beyond a checklist to asking questions aimed at identifying hidden problems. In this case a due diligence checklist would have detected that Stevens had not filed state or federal taxes for his existing business or himself personally. That would have led to additional questions about Stevens’ integrity.

Due diligence by knowledgeable accountants would have led to the identification and examination of all related party transactions, such as the sublease for space and the royalty agreement. In new business ventures, due diligence should include verifying that business entities exist, ensuring all related parties are disclosed by researching state filings, and ensuring that patent counsel or technology experts review the issues underlying the critical processes or intellectual property.

Thorough due diligence would have also investigated the basis for the $1.1 million loan from Stevens and the amount of capital that Stevens provided to IVS.

Margolis & Co.

The course of events with IVS highlights the fact that prevention is the best cure. Margolis & Co. has worked with attorneys, bankers, investors and entrepreneurs in creating successful new businesses in many industries. Our staff is skilled at applying traditional, proven methods and new innovative approaches to ensure the success of new businesses, and in protecting the participants in new ventures. Likewise, we have a long history of assisting attorneys, bankers and investors in resolving situations that have not been successful.

David H. Glusman, CPA, DABFA, Cr.FA, CFS is Chair of our Forensic and Litigation Services Group and has over thirty-three years of experience. Contact David at dglusman@marg.com.