Startup due diligence: how to spot red flags - part 2

March 10th 2017 | via:

Rutger Kemper from Leapfunder shares his second batch of tips in finding red flags. The first post was about the startup’s legacy, funding history and funding options. In this part, he shares more tips that will help startups learn not to make mistakes in their investment proposition. And of course, it will help investors to identify potential flaws.

Read part 1 here

8. Do the investors understand all risks?

Investors often only want to take risks they understand. If it is a market or product risk, they usually understand the dynamics. If a product is great but the market isn’t quite ready to adopt it, and so the startup fails, fine. They invested, took the risk, and lost. That’s how it works.

But there are also risks associated with startup investing which are much more difficult to assess. For example, legal risks or risks endured because of regulation can be more complicated. For somebody who is not well-versed in the judicial system and government regulation, it is difficult to assess certain risks. In many cases, problems arise when there is no transparency in the situation.

A quick example: say the product is great and there is a demand for it in the market, but then a new regulation is put in place. As a result, the company fails, and of course the hangover is much worse, because the risk came out of nowhere.

It is always important for startup founders to identify and assess every potential risk, and communicate the risks clearly to the investors. That way, you minimize surprises if the venture takes a turn for the worse.

Investors who have invested in a startup and enjoy working with them can deal with a startup failure due to an unforeseen risks. If the collaboration is positively reviewed and the investor has confidence in the founders, there is a better chance of them wanting to invest in the next business proposition, even if the last one failed. But if investors are burnt once by a lack of communication or transparency, they will likely never want to dedicate capital to those founders again.

In general there is no such thing as being too professional when it comes to making sure that investors know what they are getting into, and being clear about how things are going, even when they are not necessarily going the way you want.

9. What is the startup’s roadmap?

Startup founders should always be very clear on what they will do with the investment amount they ask for. What amount do I need? What will I use it for? For how long can I sustain my burn rate? What milestones will I achieve?

Investors should always ask these questions and startup founders should have very clear and straightforward answers for them. If startup founders are prepared and able to give immediate and concise answers, then the investors will gain confidence in them and in the startup. In case you work for a startup and you do not know the answer, don’t make up stories. Rather, go back and prepare correctly. Transparency and communication are critical to success.

It is important not to get too focused on the specific financials. I have seen many startup forecasts that cover up to 10 years in advance in great detail, even though they have only been operational for less than a year. Every projection you make will be flawed since no one can predict the future of a company, especially one that has been around for less than a year.

Of course, you do need to be able to project your financial forecast, but make sure not to get stuck too much on detail. Startup founders and investors with financial backgrounds can lose sight of the business proposition by spending too much time on analyzing the financials. It is understandable because people like to focus on what they know, but remember that finance should be used as a support tool to show what the intention of the startup is and, further, what the potential can be. So it’s a means to that end. The spreadsheet is not primary product of your business.

10. Who is member of the Non-Executive Board?

The non-executive board is an official part of the company. It should not be confused with the advisory board. An advisory board has no official status to the company; it is just a group of individuals who mentor and advise you. In contrast, the non-executive board has a formal role in serving the interests of the shareholders and works as a controlling function to management. The non-executive board can decide on sensitive issues such as a salary increase of management and other issues that may arise. They can also properly monitor management functions, advise on company policies, and serve as public relations agents.

Usually appointed by the shareholders, the non-executive board is considered a group of knowledgeable and independent professionals with a network and experience. Since the impact of a non-executive board can be large, it is important to a) choose them wisely and b) for the investor to review them carefully.

For early stage startups, we usually see the first larger investor (business angels) take up a non-executive board seat. During the later funding rounds, VCs may take up more non-executive board seats.

11. Where are the crown jewels?

It is very important to know where the most important assets, the crown jewels, of the company are located. For example, intellectual property (IP) or the source code should normally be located in the entity which does the funding round, meaning the top holding or the top operational holding. It can be extremely dangerous if the IP is possessed by an affiliated company or third party rather than by the legal entity which conducts the funding round.

Let’s look at an example: One of the founders owns the IP in his personal holding, and he has two operational holdings below that. Both entities license the IP of the product of the holding of the founder, so they offer the same product. The difference is that they distribute the product in different markets: A and B. The investors invest in the operational holding A. What if operational holding B does really well and A is lagging behind? It could mean that startup founder will choose not to spend any more time on making market A work, or even give it up. Why continue with market A if market B is much better off? However, this means that the investors who have put in capital into market A lose all their money. The investors would have been much better off investing in the top holding of the founder. From that holding the would share in all the proceeds from the IP, and their interests and the interests of the founder would have been aligned.

12. What financial instrument is used?

It is very important to realize which financial instrument is being used for the funding round: shares, debt, convertibles; they all work very differently. Since I predominantly cover early stage startup funding, I will focus on convertibles.

A red flag bottleneck that is sometimes found in convertibles is about what happens during conversion. Some convertibles have an option built in which allows investors and/or the startup to decide what will happen to the investment at the qualifying event. Early stage investors investing via convertibles usually hope to get shares eventually.

If the startup has the option to repay in cash, investors will not get the shares they’re after. Instead, they get their initial invested amount plus accrued interest in cash. That could be a serious disappointment for investors that endured the high risk of investing in a startup but are merely compensated by a return which could have simply been achieved by investing in a loan. This is not how the risk/return mechanism should work.

Even more worrisome, in the case an investor has the option to be repaid in cash, then the startup may get into serious trouble. In general, startups do not have a lot of cash on hand. Investors opting for cash repayment may well be a cause for an increased debt burden for the startup. This direct burn rate increase can be dangerous for the startup and for existing shareholders and investors that opt to convert into shares. The startup would then need to start paying back the investors as soon as possible, depending what is written in the contract. This could mean a default or even bankruptcy of the startup.

The fairest and clear cut way is to make it mandatory to convert into shares during either a qualifying event or at maturity. The only way of opting out should be when both startup and investor mutually agree on not converting and paying back the investor plus interest. But remember, you should always treat your investors equally, so if you offer one investor the option of opting out, then you should offer it to all investors.

Keep it simple

The above-mentioned practices in due diligence of startups can be quite complex to investors who are new to the startup funding scene. And these are just a few common examples of red flags that appear in the due diligence process. Since there are so many examples, the main message for both startups and investors is to always keep the deal as simple as possible. Finally, make sure to get well informed by fellow investors, or perhaps an experienced professional, when you decide to invest a large amount.

Rutger Kemper is co-founder of Leapfunder, the largest online angel investment platform of the Netherlands, which facilitates funding for startups. The original post appeared on the Leapfunder blog first.

Main image: Pixabay

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