Early-stage investment opportunities are unique, inherently difficult to assess and impossible to compare. The decision for an angel to put £10k+ into a company is always complicated.
This challenge is exacerbated by the way investment opportunities are typically presented. Despite being regulated, there is a mindboggling lack of standardisation in the presentation of early-stage investment deals. This increases the risks for investors.
Most start-ups are not experts in fundraising and may fail to include important details in their fundraising pack. The onus is on the investor to know what to ask, which can be hard for new investors.
Envestors was founded to address this problem. All of Envestors’ companies are put through the same readiness process, but we recognise that many deals on the market haven’t experienced such a rigorous process. The lack of rigour leaves investors at risk. Therefore, we’ve summarised our top tips on due diligence to help investors ask the right questions.
Ownership of Intellectual Property (IP)
The question of ownership is vital. Make no assumptions. First check what IP there is and who owns it. The owner should be the business, not a director ‘ and definitely not a third-party.
Then check the ownership structures where you’re dealing with group companies. What looks like a solid opportunity quickly unravels when you find out that the company offering you equity doesn’t own the IP. Sometimes it’s a topco, sometimes it’s another company altogether.
Who is working for the business?
Some investors look askance when family members work for the business. Make sure all directors have the right skill set for their roles and that salaries are in line with the sector’s market norms and business stage.
If you find a case where there is a really good reason to have a husband and wife founding team, ensure there is a chair or independent non-exec on board to act as arbitrator if issues arise.
Establish that the founders actually work for the business. There should be solid contracts of employment for key personnel with sufficient non-compete and good/bad leaver clauses.
Finally make sure that no director has any conflict of interest with any supplier or customer. You want to establish that they don’t also own a company which is a vendor to the business.
Disputes & lawsuits
You don’t want to get blindsided by a dispute with a vendor, employee, customer or, more alarmingly, HMRC that means the company runs out of cash. You’ll need to enquire about open disputes. Check there are no significant outstanding invoices or purchase disputes that might put cash flow at risk.
Cash flow
Few relish the idea of investing in a business that needs a cash injection to sustain itself, rather than driving growth. However, many companies fundraise for this reason, so make sure you understand the motivation behind the raise. Scrutinise the balance sheet carefully and ensure there will be enough cash to keep going ‘ before the investment comes in and afterwards.
Give yourself confidence in their accounting by making sure they have a qualified accountant.
The fine print
In the UK fundraising involves numerous 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 e.g., legals and EIS application, be wary of inexperienced founders who have not worked with a professional. Complications occur and you want the company to have dotted all the i’s and crossed all the t’s before you commit.
Your return
Sometimes a business is so exciting that you can talk yourself into investing despite a gut feeling that it has an inflated valuation.
Does the pre-money valuation reflect a realistic assessment of the risk of the company not meeting its forecasts? If you think it’s too high, ask for a justification. Most won’t change their valuation once its set, so if you’re not convinced of the value be willing to walk away.
Experienced angels will tell you about the company in their portfolio with the once ambitious CEO, who now relishes flying around first class to conferences and meetings. Make sure there is a long-term plan for exit and that the founders have the appetite and determination to get you a return.
When it comes to early-stage investing the detail is vital. If you’re not working with an experienced and regulated network you’ll need to double-down on due diligence to avoid getting burned.
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