Due diligence is a critical aspect for any investor to consider when investing in an early-stage company. Due diligence provides reassurance that the investment’s potential upside outweighs its associated financial risk.
Ensuring that you have asked the right questions and received the right answers to those questions is the sensible way to begin your journey as a SEIS/EIS investor. You may wish to invest in companies directly or through an investment fund that pools the capital of individual investors and does much of the due diligence on target companies on your behalf.
Due diligence entails evaluating the management team’s credibility and ability to execute the business strategy, which will determine whether or not the investment is successful. It also allows prospective investors to look for information to confirm that both the business and business potential are being represented accurately. It also brings to light any previously overlooked issues.
Usually, the amount of time spent on due diligence is proportional to the size of the investment and the financial risk that comes with it. Listed below are some of the important areas to pay special attention to:
Heads of terms
Heads of terms, also referred to as ‘terms sheets’ usually list the general terms on which the company is willing to accept investment. Thereafter, the terms will be formally documented in the investment agreement and the company’s articles of association.
Unless there is particular language stating otherwise, the heads of terms are not legally binding. They do, however, provide a solid foundation that could clear up any misunderstandings or unforeseen issues and constitute an “agreement in principle” that will guide the remainder of the transaction. Due diligence can start as soon as the heads of terms are agreed on.
Track record: Fund Manager
If you are investing through an investment fund, background checks on the fund manager need to be actioned to confirm that the necessary approvals are in place. Do your background checks on the fund manager, confirm that the necessary approvals are in place, and don’t rely on the company’s size to determine the accreditation status of a fund manager.
When choosing a SEIS/EIS fund to invest in, the experience and credentials of the fund manager will undoubtedly be the most important aspect of “due diligence”. The manager must have the necessary degree of FCA approval, and this is something that should be verified first. The FCA thematic review[1] came to the conclusion that the best advisers are those whose companies have a “culture of challenge” at their foundation. Additionally, it was determined from the research that an advisory company’s size is neither a hindrance nor a criterion for determining if they are best equipped to manage the fund.
Track Record: Company & Leadership Team
If you are investing directly, investigating the company’s capacity to forge a solid competitive position in a lucrative market is necessary. A product or service that will be challenging for competitors to replicate, a genuine “first mover” advantage, or the ability to “fly under the radar” of more established competitors might all be contributing factors.
Investigating specific companies requires understanding the context in which they operate, including regulatory and competitive forces that affect them. Having specific industry knowledge and awareness of the competitive landscape as well as having a knack for numbers and finance are prerequisites for performing meaningful and valuable due diligence.
Still, according to the most successful angel investors, the most determinative factor in a company’s success or failure is not its competitive or financial position, its products, or services, nor the competitive landscape. Data mining studies conducted by one EIS fund on Companies House records that revealed the identities of the most successful angel investors in UK companies by a track record of returns showed that these investors consistently looked to the composition of the leadership team for clues about whether the company would be more likely than not to succeed.
Contrary to what most believe, good ideas are not as important as execution[2]. Therefore, beyond the market studies, business plans and financial projections, an investor should take a close look at the leadership team and its members. As the successful investors interviewed by one EIS fund noted, talking and getting to know the team personally matters and also offers greater clues than simply looking at their CVs.
What these investors have found through trial and error, is that teams that work well together and whose members are able to execute their parts of the strategy in a timely way and demonstrate flexibility by pivoting according to market demands are more likely than not to result in a successful exit for their investors.
Accuracy of valuation
The valuation of a company should be aligned with its track record as well as future prospects.
The necessity to decide how much money to invest and “what’s in it” for investors necessitates the importance of valuation.
When deciding how much equity to contribute to the initial round of funding, businesses often follow certain guidelines. It usually falls between 10% and 30% for the initial round of “risk finance” (SEIS/EIS). Notably, no single EIS investor may control more than 30% of the business.
To check the accuracy of valuation, the following questions need to be addressed, for example:
- What will this do for the company?
- What additional equity will have to be given if additional rounds are required?
- How much equity should be offered to external investors?
- What is the amount of equity that the founders are to hold on exit?
Business plans / Business model
Business plans should be requested and reviewed with care to determine how the SEIS/EIS funds will be used and when the enterprises are expected to start generating income. This involves analysing the financial projections (usually income statements for the ensuing 3 years) but more importantly the assumptions underlying the projections. These assumptions are not usually spelt out in the business plan in detail, making a deep analysis difficult.
Financial projections are more likely to be reliable if they are prepared by an experienced CFO embedded within the leadership team who understands the business. However for investors what is most important is that the financial projections are vetted either by their financial advisor or the management or advisors of the fund in which they are investing. According to one EIS fund manager that we interviewed who has done extensive data-driven analysis that identified angel investors who consistently beat the rest in terms of generating outsized returns on investment, fully one-third of the most successful investors have a strong background in accounting and finance.
Being presented with all the ins and outs of the business and having a good understanding of how the business intends to make money, is imperative for investors. Knowing that the business operates on a sustainable model will paint a fairly good picture of its potential. Here again, the track record of the leadership team (especially the CEO, CFO, COO) are an important part of the likelihood of future success and therefore whether an investment is likely to pay off.
The trading start date
Investors should be able to request tax relief, six months after the trading start date of the investee company.
The trading start date is important since businesses may only apply to HMRC for EIS 1 certificates – the documents necessary for the issuing of EIS 3 forms – after they have been in operation for at least four months. In addition, it takes HMRC an additional six to eight weeks to process an EIS 1 application and provide EIS 3 forms. Because of this, investors can anticipate being able to claim their tax relief six months following the investee company’s market debut.
Moreover, investors should be mindful that the tax relief available to them is limited to the amount of tax payable to HMRC in the year of the investment and the previous tax year. The upper limit of relief available under the EIS and SEIS schemes to a single investor in any single tax year is £300,000 and £50,000 respectively but the relief will only be applied to the extent of the aggregate tax payable to HMRC in the current and prior year of the investment with any excess investment receiving no relief. Therefore, it is important that investors consult their accountant or otherwise work out the limits of tax relief they are entitled to given their individual tax positions.
Warranties from management
The use of warranties helps management ensure that they are providing total transparency.
As written declarations, warranties serve as the foundation for legal action in the event that material facts turn out to be untrue, or are misrepresented or purposefully omitted, and they also serve as confirmation that the management team has carefully reviewed all assertions made in connection with the investment.
Networking with other Investors
Becoming a member of an association of like-minded investors or networking informally with other investors is a way to share acquired knowledge and due diligence information as well as become acquainted with investible target companies with investment rounds open in real-time.
Whether you have specific industry experience or knowledge, a financial background or a knack for investing, putting your skillset to work alongside others is a good way to improve your chances of investment success in a world where successful early-stage investments are few and far between and generating high returns is the purview of the very few who bring passion and skill to this area of endeavour.
Conclusion
Investments in the early stages of a company carry a significant risk. However, investing a small sum in eligible businesses can be profitable both financially and in terms of the impact that the underlying portfolio companies have on the world.
The main driver of early-stage investing is speed. Companies looking for capital are generally not willing to wait for months to have their businesses evaluated and investments completed. Although the availability of investment capital varies from time to time with the broader economic climate and macro-economic and political events, it is always available for the most promising companies and there are usually investors willing to respond to their funding requirements. Therefore, being prepared and able to make decisions quickly when a potential investing round opens is key to success.
Becoming a successful investor involves a combination of industry knowledge, financial skills, decisiveness, hard work and passion.
With the guidance of a professional, appropriate due diligence will provide you with a good sense of a company’s true state and on the viability of completing a proposed investment.
Written by George Marques, Head of Corporate
Email: gmarques@redfernlegal.com
[1] [Carson, Vasiliki. “How to Select an EIS Fund to Invest In.” How to Select an EIS Fund to Invest In, 19 Apr. 2016, info.sapphirecapitalpartners.co.uk/blog/what-due-diligence-is-needed-when-investing-in-eis-funds.
[2] Jeff Bezos, former CEO of Amazon, has made this point in more than one interview.
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