By Chantelle Arneaud, Envestors
Most start-ups, while full of passion and vigour, are not experts in fundraising. When they do not include an important detail in their fundraising pack, it is usually out of naivety: they don’t know what they don’t know. Of course, good intentions never equate to a return on investment. So, the onus is on the investor to know what to ask. And that can be hard for those new to investing.
All of Envestors’ companies go through the same readiness process. Not only does this alert the entrepreneur to any potential investor red flags prior to going to market, but it helps them to ensure their deal and all the associated documentation are presented in a clear and accessible way. In turn, investors get standardised information supplemented with due diligence flags that indicate areas for further exploration as part of any investment decision. This process, of course, does not take away risk, but it goes a very long way towards minimising it.
Despite being a regulated activity, 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. This lack of standardisations increases the risks for investors.
Here are five things you must include in your due diligence:
- Intellectual Property (IP) Ownership
The question of ownership is a vital one. Assume nothing. Start by checking what IP there is and who owns it. It should be the business, not a director, and definitely not a third-party.
Sometimes, founders, let us suppose innocently, put IP in the name of directors and not the business. This is bad news for investors. If this is the case, do not be shy to point out the issue and ask the director if they are willing to change this. It does not need to be a deal breaker when it is an innocent mistake. But if they are not willing to do this, think very, very carefully about handing over your money.
Another detail to explore is 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?
There are a few things to look at here. Some investors raise an eyebrow when they learn that a family member is working for the business. There could be a good reason for this, but sometimes there just is not. 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. And 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.
Next you want to check that the founders actually work for the business. This involves ensuring 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.
- Disputes & lawsuits
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.
- 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.
- The fine print
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.
You want to ensure that the business will exit. You do not want to be in a situation where your once ambitious CEO has become a little too fond of flying first class to meetings and conferences and shows no sign of driving for exit and return. Make sure there is a long-term plan for exit and that the founders have the appetite and determination to get you a return.
Additionally, make sure the pre-money valuation reflects a realistic assessment of the risk of the company not meeting its forecasts. Sometimes a business is so exciting that you can talk yourself into what you know in your heart is an inflated valuation. Be prepared to walk away.
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 partners with accelerators, incubators and angel networks to provide a white-label platform empowering them to promote deals, engage investors and connect to other networks.
Founded in 2004, Envestors has helped more than 200 high growth businesses raise more than £100m through its own private investment club.
Envestors is authorised and regulated by the Financial Conduct Authority.