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Alternative Finance blog


due diligence for start-ups

2 years ago


FINANCIALS
RISK
OPERATIONS
MANAGEMENT
SALES


Like a business plan dissected, the due diligence process – whether for an investment through equity crowdfunding or the old-fashioned way – is about evaluating risk. You need to check that the entrepreneurs behind any start-up have done enough to minimise their own risk because, if they haven’t, then a proportion of that risk will automatically become yours.
This is hugely important because, as every schoolboy knows, the majority of new businesses end up in failure. My own personal approach to assessing risk can be encapsulated in the acronym FROMS – so-called because it derives from the five key elements in due diligence: Financials, Risk, Operations, Management and Sales.
Whilst it is true that the majority of crowdfunding platforms conduct their own due diligence before presenting any company’s proposal on their site, it would be my firm recommendation that anyone considering such an investment conduct their own research. It is always worth taking a little extra time and trouble to look carefully at the information being provided – whether in the company’s presentation video, business plan, cash flow forecast or cost projections.
The other ‘golden rule’, of course, is never to speculate in an equity start-up if you can’t afford to lose all the money.

Financials
Under-funding is one of the most common causes of business failure so you need to test the financial details to satisfy yourself that the proprietors of the business have properly considered funding for the future and not just for the here and now – where do they believe the money is going to come from and how are they going to manage that process?
If they expect to raise it from a bank, they may be disappointed given the scarcity of institutional money for start-ups or young businesses. If not a bank, where else – another equity round? If the latter, you need to appreciate that your shareholding could be diluted. This may not necessarily matter providing that the overall value of the company increases – you may simply own a smaller percentage of a much larger cake.
With that possibility in mind, make sure that you study the Shareholders’ Agreement carefully; all equity crowdfunding sites display their standard terms and conditions for investors and impose standard Shareholders’ Agreements on the companies they feature. Read it thoroughly and, if in doubt, ask your solicitor to take a look on your behalf – especially if you are considering investing a substantial sum. Don’t be afraid to raise the issues that concern you and, if needs be, enquire as to whether you can add a small clause to the Agreement to allay your fears. It is no use complaining later.
You can also try to find out a little more about the people behind the company. If you have access to a computer, it is what the internet is for – to provide information, allowing you to check, research, compare and to analyse.
However, the central issue is to satisfy yourself that the valuation of the company is realistic and based on sensible calculations and assumptions. As before, if you are unhappy, consult an experienced professional to gain a second, independent opinion.

Risk
No one has a crystal ball. The paramount consideration and one which I cannot over-emphasise is NEVER INVEST WHAT YOU CAN’T AFFORD TO LOSE.
Having considered your own capacity for risk, look very closely at the tolerance to risk of the company in which you are considering making an investment. Examine its competitive analysis – have they really got a grasp of what form their competition takes? For example, the competition for a pub is not necessarily confined to other local pubs, or even other hospitality businesses – it could include the local cinema, sports fixtures, live music events, even the church. You need to spread the search to include anything that presents an attractive alternative to the business in question.
Look, too, at the rules and regulations surrounding the industry or activity and any likely changes on the horizon. To use the pub analogy again, consider the impact of the 2007 smoking ban on the licensed trade. Even the subsequent boom in electronic cigarettes in now threatened by even newer regulations. So, the advice is to look beyond the sales pitch which is bound to concentrate on the positives and play down the negatives.
Tax can be another factor. As an individual you may be eligible for tax reliefs under the Government’s EIS or SEIS schemes, which may have a major bearing on your decisions.Tax reliefs can not be guaranteed, will depend on your personal circumstances and may even be subject to imminent change – but check it out with an independent tax expert.
Operations
By this I mean the product or service that the company offers, the supply chain, logistics and so on. Above all, you need to establish that the company’s claims stack up and that they can deliver whatever it is they are producing to their customers at a profit. So buy and test the product for yourself, or ask for a sample – better still, speak to some existing customers and ask them about their experience or for their opinion.
It is equally important to check that, in costing the product, the entrepreneur has built in the price of delivery. It is not unheard of for some companies to be making a loss on every sale because they have overlooked some of the associated delivery costs.

Management
This is where instinct or personal judgement really comes to the fore. In essence, by investing in a company you are really buying into the people who run it. Consider them in the same light as people you might be hiring to take on a key role in your own business.
So, who are these people? Where do they come from – where have they been before? What qualities do they bring to the company? Does the company have the required strength in all the key roles in the business (e.g., finance, sales and marketing)? It is not always easy to establish the full facts, but conduct your own research.
Also, having established that they are vital to the business, are these people covered by key man insurance? It would be a cruel twist of fate if, for whatever reason, the driving force of the business was to disappear immediately the ink was dry on your signature. You must ensure that commercial life can carry on in such unfortunate circumstances. After all, it’s your money that’s at stake.

Sales
Last, but by no means least, comes Sales and Marketing. Many companies fail because it is quite possible to be too product-orientated. Entrepreneurs can sometimes be so enamoured with their product or service that they are blind to the possibility that there may not actually be a market for it. Even more likely, they have totally failed to develop an effective marketing strategy to make their creation viable.
Look at the marketing plan – and look who’s in charge of delivering it; is it in-house or is it contracted out? Either way, it is a vital ingredient in the mix. And bear in mind, it is not unheard of for marketing to account for 90 per cent of the retail price. Ignore it at your peril.

So, there you have it. Get your FROMS analysis right and you can commit your start-up investment with a little more confidence. Even so, investing in early stage businesses, bonds, loans, debentures and other investments through crowd platforms remains high risk and should only be considered as part of a diversified portfolio. This is just an overview of the key topics I believe prospective investors should consider when conducting due diligence on potential investments. And don’t forget: never invest more than you can afford to lose.

Sacha Bright
CEO, Business Agent


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