At The Armchair Trader we usually write about listed companies or markets traders can access through OTC derivatives like CFDs, but it is obvious that many investors are becoming increasingly interested in the opportunities offered by unquoted companies. Crowdfunding and business angel investing have become popular routes to fund fast growth companies at a very early stage in their development.
There are substantial differences between being a business angel (investing £10,000 or more) and a crowdfunder (where you can start with as little as £10). Business angels platform Envestors estimates that around 12% of investments made into companies it showcases had an IRR of 30%+, with another 67% returning middling rates of between 0-29% (excluding tax relief). A further 24% were failures. Compare this to the market average of 56% of start ups failing and the importance of due diligence becomes obvious.
Much of the success of early stage investing is based on thorough due diligence on a company. While crowdfunders can make a decision to invest in less than a day, seasoned business angels will typically take up to five days poring over a company.
Here are some of our top tips for business angel success, although there are many more:
Check the balance sheet: This applies to listed companies too, but investors should expect to see an up-to-date balance sheet that has been produced by the accountant or a finance director and that has been signed off by the management team as accurate. This should not be misleading, and should include all actual and contingent liabilities. Investors should expect to see any outstanding payments to creditors, including the HMRC. Ideally, companies should not have any outstanding loans, and if they do, investors should make sure all repayment provisions are fully disclosed.
Invest in what you know: We all like taking a punt from time to time, but Envestors encourages business angels to make sure that someone in their syndicate knows enough to have insight into the market the prospective company is operating in. Envestors also observes that “most business angels invest within 50 miles or two hours drive of where they live or work so they can attend shareholder meetings.
Check the exit: This makes sense in life as well as investing! Is there a realistic and credible exit plan as well as a genuine desire on the part of management to exit? Too many business angels end up with their funds tied up in projects they cannot realise.
Pay close attention to the financials: Cash flow can be an important indicator of risk, so make sure you can ‘smell the revenue’; discount low probability revenue streams, and watch out for financial models that include multiple non-core revenue streams which are unlikely to come to fruition. Make sure the model still makes sense without these. There should be a cash flow prediction for the next 12 months. Is there enough headroom, and is the company sufficiently capitalised? If not, you could see the company involved in further fund raisings when targets are not met.
Allow for follow-on funding: Having said this, there are some companies that are pre-revenue and will require additional funding to achieve a cashflow break even. Experienced investors will take this into account, but will want to make sure they can participate in further rounds in order to avoid dilution. Envestors says that typically investors allow for follow-on funding of up to 50% of their initial investment in order to “save them having to tear up their ticket.” Follow on funding can also be needed when sales exceed forecasts and investment is required to fuel growth.
Check the people: Most seasoned business angels ‘bet on the jockey and not the horse’; they place considerable importance on the perceived strength and trustworthiness of the core members of the team. Directors of companies need to be responsive to their investors and should have some significant ‘skin in the game’ which prevents them from simply walking away from the company at the first sign of trouble. Investors should also try to get clear understanding of any potential conflicts of interest – do any of the directors have interests or shareholdings in any related ventures – e.g. a supplier to the company?
Keep salaries under control: This goes for spending too, to be honest. Directors should be earning enough to provide a basic standard of living, but substantially less than they could command if they chose employment in the workplace. Typically, founders will take a low salary, if anything, from the first 12 months of launch, following which salaries tend to be in the region of £45,000 to £60,000. In some cases, investors like to see a separate Remuneration Committee which can suggest and approve any changes in salary. This could, for example, be the chair and the non-executive director representing minority shareholders’ interests.
Ask for warranties: These are signed assurances from the management team that form the basis for legal recourse if information they provide to investors proves to be misleading or has been deliberately withheld. This acts as an assurance from the management team that they have carefully checked all statements made in association with the investment. The real value of warranties is making sure that management makes full disclosure. According to Envestors, “actioning legal recourse is likely to be counterproductive, and in practice very rare.”
Make sure you don’t buy in at too high a valuation: Many entrepreneurs are blind to the risks associated with their venture, in some respects they need to be – if they just saw the downsides, they would never have left their safe, salaried job. For investors, however, the earlier the stage you invest, the higher the risk things will blow up. This means you should be getting more for your money.
Ensure you have minority protection: Seasoned business angels like to make sure their rights are protected by legal documents, including pre-emption rights (i.e. right of first refusal of any new share issue), or ‘tag along’ rights (if a majority shareholder sells their stake, you have the right to join the transaction and sell your minority stake on the same terms). There should be a list of actions which the board cannot take without the approval of an investor group approving them, or an investor appointed director. This should be detailed in the shareholders agreement or in the articles of association.
Ultimately, it is very important to do thorough due diligence on any deal you are thinking of entering as an angel investor. This is by no means a complete list and there is much more which could be written on this topic. The Armchair Trader will be returning to the fascinating topic of unquoted company investment in months to come. Be sure to sign up to our newsletter to be informed of future updates.