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Here's What You Need To Know About Due Diligence

Posted 4 years ago

Here's What You Need To Know About Due Diligence
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Like dissecting a business plan, the process of due diligence - whether it be for an investment through equity crowdfunding, or more traditional methods - is about evaluating the level of risk. As an investor, you need to check that the entrepreneurs behind a start-up have done enough to minimise the risk of failure. If they haven’t, then a proportion of that risk will fall on your shoulders. This is vital, because the majority of new businesses fail in the first two years. . 

Whilst it is true that the majority of crowdfunding platforms conduct their own due diligence before presenting any company’s proposal on their site, we recommend that anyone considering such an investment conduct their own research. It is always worth taking a little extra time to look carefully at the information being provided – whether in the company’s presentation video, business plan, cash flow forecast or cost projections. You should also never speculate in an equity start-up if you can’t afford to lose all the money.

In this piece, CEO of Nextfin, Sacha Bright gives his tips on assessing risk through the acronym ‘FROMS’: Financials, Risk, Operations, Management and Sales. The five elements comprise each step in the due diligence process. 

1. 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; most but not 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. This can be difficult to impose if you are not a major shareholder, but if you don’t ask you don’t get - and it is not always practical, especially on an equity crowdfunding round. 

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.

Here are some further tips from a blog I wrote earlier. 

2. Risk

No one has a crystal ball. The paramount consideration and one which I cannot over-emphasise is never invest what you cannot 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 is 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.

Cashflow and capital are a major factor in why businesses fail. Check to see that they have professional systems and processes to ensure the collection of money, and that the business has enough capital to cover its cost for at least six months. The one thing you can guarantee are the predicted costs. 

3. 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 production, selling the product, delivery and ancillaries such as: administrative costs, tax, import and export duties, exchange rates, licensing etc. 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. 

4. Management

This is where a combination of fact-checking experience/qualifications and an 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 part of the investment. Without the people there is no business, so it is essential they are the right people and the key people are locked in and incentivised to stay. 

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.

5. 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 size of the market, competition and their 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.

Authors: Oliver Murphy & Sacha Bright

Disclaimer

To the best of our knowledge, the information we have provided is correct at the time of publishing. Sacha Bright is not a solicitor or accountant and we recommend that you seek professional advice on any topic discussed.



Tagged: sme business risk startup finance equity crowdfunding alternative finance



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