Avoiding the pitfalls of early-stage investing

Chantelle-Arneau of Envestors

By Chantelle Arneaud

Early-stage investments are one-offs which often makes them difficult to assess.  

This is not helped by the lack of standardisation in the way that investment opportunities are presented, despite the fact that this is a regulated activity.  

The essential information that an investor needs may well be there – but buried deep in the documentation. Particularly with start-up owners who are fundraising for the first time it’s possible that vital details may not have been included.  

This problem is the reason Envestors was founded. When CEO, Oliver Woolley got started in angel investing, he didn’t ask all the right questions and learned a few very hard lessons as a result.

“One of my earliest investments was into a trivia app. What I failed to uncover in my due diligence process was the ownership of the Intellectual Property (IP). It turned out that the CEO, not the business, owned the company’s IP and so when it fell on hard times, the CEO walked away.

“To add fuel to the fire, I later learned the EIS paperwork had not been properly submitted and I wasn’t even able to get the tax relief.”

Looking back, Oliver has a clear idea about what questions to ask to when assessing early-stage investments. Here are the key ones:

Intellectual Property

As Oliver’s example illustrates, the question of ownership is a vital one. Don’t make any assumptions. Start by checking what IP exists and who it is owned by. It should be the business and not a director, or a third-party.

Sometimes, founders, often innocently, put IP in the directors’ name and not the business’. This is bad news for investors. If this is the case, point out the issue and ask the director if they are willing to change this. It doesn’t need to be a deal breaker when it’s a silly mistake. But if they aren’t willing to do this, think very, very carefully about handing over your money.

Another detail to explore is ownership structures where you’re dealing with group companies. What looks like a solid opportunity quickly unravels when you learn that the company offering you equity doesn’t own the IP. Sometimes it’s a topco, sometimes it’s another company all together.

Key personnel

There are a few things to look at here. Do 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?

Some investors are sceptical when they see a family member is working for the business. There could be a good reason for this – but sometimes there just isn’t. If 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 occur.

Check 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. You want to ensure a co-founder can’t slink away and re-emerge as the founder of a very similar enterprise.

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 don’t also own a company which happens to be a vendor to the business.

Potentially damaging disputes

The last thing you want is to get blindsided by a dispute with a customer, vendor, employee, or, more frighteningly, HMRC, which means the company’s cash runs out. So, you need to ask about open disputes. Check there are no significant outstanding invoices or purchase disputes that might put the cash flow at risk.

Reason for the fundraise

It is unfortunately the case that many companies fundraise for a cash injection to sustain themselves as opposed to driving growth. So, you need to understand the motivation behind the raise. Scrutinise the balance sheet and ensure there will be enough cash in the bank to keep going, both before and after the investment comes in.

A central part of this process involves giving yourself confidence in their accounting e.g., by making sure they have a qualified accountant.

Handling the complex processes

Fundraising in the UK involves many complicated processes – from applying to the Seed/Enterprise Investment Scheme (S/EIS) to preparing the investment agreement. Who is putting this together?

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 rather than working with a professional. As Oliver detailed above complications do occur and you want to ensure that the company has completed everything correctly before you commit.

Getting a return

Will you make a return? You may find yourself so excited by an opportunity that you can talk yourself into what you know in your heart is an over-inflated valuation.

Make sure the pre-money valuation reflects a realistic assessment of the risk of the company not meeting its forecasts. If you think it’s too high, ask the company to justify it. If you’re not convinced of the value be prepared turn down the investment opportunity.

You also want to ensure there is a long-term plan for exit and that the founders are fully committed to getting you a return.

For early-stage investing’ drilling down into the detail is essential. And if you’re working with a regulated, experienced network – great. If not, your accounting skills and business experience will be put to good use in your due diligence.

Chantelle Arneaud is Strategic Director at Envestors.