Can a $310M startup avoid due diligence?
How Merits.com took advantage of easy money to raise $50M last month
These days, if investors think a company might have a path to a $3B, $30B, or $300B exit, they can stomach terms like $50M at $310M post. But an unwanted side effect of these high valuations is that investors become vulnerable targets for a type of founder who perpetually spins up new companies, takes cash off the table, enjoys a good lifestyle, keeps raising larger and larger rounds, all the while hoping the pieces fall into place for his latest business idea, but not really minding if they don’t.
Let’s take a deeper dive into Merits.com, a.k.a. Merit, a startup that just raised $50M. The founder and CEO is Tomer Kagan, a serial entrepreneur whose last startup, Quixey, raised $170M ($650M valuation) and then shut down, laying off all its employees, leaving observers scratching their heads about where all the money went, since the company never built and released a product.
What does Merit do? The company’s homepage says Merit “brings visibility and liquidity to all digital credentials, memberships, opportunities, and more, from trusted organizations.”
You might compare Merit to Credly, a ten-year-old company that was just acquired by Pearson for $200M. According to Pearson’s press release, “Credly offers an easy-to-use platform for organizations, companies and educational institutions to award employees and workers trusted digital credentials that verify their skills and help connect them with the right opportunities” and “more than 2,000 organizations use Credly… making it the world’s largest professional credentialing marketplace”.
According to documents obtained by SV Gossip, Merit has made claims to investors of having over 1,500 organizations issuing “merits” on their platform. This would imply that Merit’s business is a close second to Credly’s. Is this claim factually true? One way to try to find out is using the search feature at lookup.merits.com. Here are the results for a popular last name, Zachary:
The only results are a handful of recipients of certifications issued not by 1,500+ organizations, but by a single organization: BARBICIDE, a manufacturer of disinfectant solutions that also certifies salon and barbershop staff in knowledge of disinfection procedures. Try poking around and see for yourself that the set of certifying organizations appears much sparser than what would be expected from the company’s claims.
What else has Merit done that might account for its $310M valuation? Here’s the company’s own list of memorable moments of 2021, touting a few one-off contract projects for a small scattering of state and local government organizations such as building an online vaccination registry system for the city of Marco Island, Florida. The contract for this project is publicly available here, so you can see that the total revenue generated for Merit by the partnership is $10,000 per month and not to exceed a total of $49,000.
Who looked at all this and decided to invest a big check? That would be Rose Park Advisors, the family office of the late Clayton Christensen, whose son Matthew Christensen is the primary decision maker. Andreessen Horowitz, who led Merit’s $4.35M seed round back in 2016, declined to lead this round. But a16z is typically known for breaking out the checkbook for follow-on funding the instant their investments are showing signs of success. What happened here?
Besides Andreessen Horowitz, Merit has built up a roster of respectable names who have provided the company with funding at various stages over the last six years:
While the investors listed above can take care of themselves, unfortunately, invitations to invest were also extended to small-time individual angel investors. Thousands of AngelList members were invited to invest personal checks ranging from $2,000 to $20,000+ via the mailing lists of multiple syndicates. These individual investors were not provided with any kind of due diligence report about what business activities the company is really engaged in, how many organizations are really actively using the company’s products and services, and what kinds of spending have historically been paid for using investment capital. They were shown the positive spin coming from the company, as well as social proof in the form of names of other investors.
Sadly, this is how investing in AngelList syndicates works. The small-time angels in a syndicate put their trust in their syndicate lead, who often delegates that trust to the lead investor in a deal. The belief that others have done due diligence is typically what makes individual syndicate members feel comfortable investing based on the limited information they receive. Unfortunately, the system of trust fails if the lead investor is susceptible enough to a founder’s salesmanship or assumes proper diligence has been done by other investors even further upstream. This is usually a reasonable assumption, but in a frothy market, we are seeing signs of this system breaking.
Insiders familiar with Kagan tell SV Gossip that he’s preternaturally talented at pitching, blessed with a version of the famous Steve Jobs reality distortion field that lets him work investors into a frenzy while somehow not having checked off any of the milestones, metrics or other objective criteria they typically look for.
When you’re the founder of a startup that takes in a $50M investment like this, you’re all set to live off the money however you want. You can pay yourself a “market salary” of $500,000/yr+. You can use the money as a piggy bank for flights, hotels, Uber Black, and other travel expenses. You can hire your friends and give them similarly large salaries and expense accounts. You can do what’s known in the Silicon Valley jargon as “taking money off the table”, giving up a couple percentage points of your personal stock shares in exchange for transferring $5M+ from the investor’s bank account into your own personal bank account.
Hustles like this are becoming increasingly common in the world of Silicon Valley startups. The integrity of the founders who run them varies from having a real vision of a lucrative business, to deluding themselves, to deluding themselves and others, to just deluding others. Besides a few high-profile scandals like WeWork and Theranos, and besides the much-discussed explosion of token and NFT scams, many of today’s biggest startup disasters are unfolding under the radar. Being entrusted with tens of $millions isn’t enough to make them newsworthy.
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