Sometimes a business is so exciting that an inexperienced investor can talk themselves into a situation they should have walked away from. Unhelpfully, there is a mindboggling lack of standardisation in the presentation of early-stage investment deals. The information offered, and at what points, varies from deal to deal and from network to network. This lack of standardisations increases the risks for investors.
The onus is on the investor to know what to ask, and that can be hard for those new to investing, so here are a few questions to include in your due diligence:
Does the Intellectual Property (IP) belong to the company you are investing in?
The question of ownership is a vital one. It should be owned by the business, not a director, and definitely not a third-party. Do not be shy about pointing out any issues, paying particular attention to ownership structures where you are dealing with group companies. What looks like a solid opportunity quickly unravels when you learn that the company offering you equity for your hard-earned cash does not own the IP. Sometimes it is a topco (which you are not investing into), sometimes it is another company all together.
Who is working for the business and why?
Make sure all directors have the right skill set for their role and that their salary is in line with market norms for the sector and business stage. If you find a case where there is a really good reason to have a husband and wife founding team, make sure there is a chair or independent non-exec on board to act as arbitrator should issues ever arise.
Ensure there are solid contracts of employment for key personnel with sufficient non-compete and good/bad leaver clauses. This minor detail is an important one as you want to ensure a co-founder does not slink away and re-emerge as the founder of a very similar business.
If that all looks good, make sure that no director has any conflict of interest with any supplier or customer. You want to ensure they do not also own a company which happens to be a vendor to the business.
Are there any disputes and/or lawsuits you should be aware of?
The last thing you want is to get blindsided by a dispute with a vendor, employee, customer or, more frighteningly, HMRC that means the company runs out of cash. So, you need to ask about open disputes. Check there are no significant outstanding invoices or purchase disputes that might put the cash flow situation at risk.
Who is keeping an eye on cash flow?
Few relish the idea of investing into a business that needs a cash injection to sustain itself as opposed to driving growth. But many companies fundraise for this reason and so make sure you really understand the motivation behind the raise. Scrutinise the balance sheet and ensure there will be enough cash in the bank to keep going – before the investment comes in and after.
A central part of this process involves giving yourself confidence in their accounting by making sure they have a qualified accountant. Sure, we can all work a spreadsheet, but it does not mean we should.
Has the necessary paperwork been completed by an appropriate professional?
Fundraising in the UK involves many complicated processes – from applying to the Seed/Enterprise Investment Scheme (S/EIS) to preparing the investment agreement. While there are tools on the market to help with things like legals and EIS application, be wary of inexperienced founders who have done a DIY job and not worked with a professional. You want to ensure that the company has dotted all the i’s and crossed all the t’s before you commit.
Finally, do make sure the pre-money valuation reflects a realistic assessment of the risk of the company not meeting its forecasts. If you think it is too high, ask the company to justify it. If they can’t, be prepared to walk away. You also want to ensure that the business will exit. Make sure there is a long-term plan for exit and that the founders have the appetite and determination to get you a return.
So, when it comes to early-stage investing, the devil really is in the detail. And if you are not working with an experienced and regulated network you need to make extra effort with due diligence to ensure you do not get burned.
ABOUT THE AUTHOR
Chantelle Arneaud is from Envestors.Envestors’ digital investment platform brings together entrepreneurs and investors across geographies, communities and sectors – creating the single marketplace for early-stage investment in the UK.
Envestors is authorised and regulated by the Financial Conduct Authority.
Web: https://www.envestors.co.uk/
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