We all agree that working without capital can be extremely challenging, and for many startups, downright impossible. As a founder or entrepreneur, you will find this article useful, particularly if you are currently seeking investor funds, or plan to do so in the near future.
If you have started the fundraising journey, you may have noticed any or all of the following in your dealings with prospective investors:
- They do not respond to your emails or engage you;
- They respond initially, but go quiet, or eventually respond communicating lack of interest;
- They agree to come on board, but grossly undervalue the business
In deciding to invest in any organization, investors will want to ensure it is ideal for their portfolio. In addition to this, they typically carry out background investigation (often referred to as due diligence), engaging professionals, such as accountants, lawyers and finance experts in order to take an informed decision on whether or not to proceed.
As lawyers, we have carried out due diligence exercises and thought to give you some inside scoop as to reasons why investors have pulled the plug on some seemingly attractive investments. (To do this in detail would require a series of sessions, which we would organize towards the end of the year. Please send an email if you would be interested in attending).
In the meantime however, here are the ten most popular red flags for which we have agreed with our clients not to invest certain businesses:
- Lies – Your documents need to be very thoroughly prepared. Untrue statements, be they deliberately falsified facts or unrealistic, hastily done projections, reek of dishonesty and incompetence. They call into question your integrity and knowledge of your business and can be a major red flag. In the unlikely event that the investor is none the wiser and goes ahead to invest, keep in mind that your contract will contain warranties as to the information provided, which could entitle the investor to cancel the deal and expose you and your team to possible criminal liability.
- Leadership Challenges: An incompetent management team, a co-founder’s, messy reputation and infighting among co-founders is another red flag for investors. These bring up concerns about capability to manage the business when it grows, the possibility of a key man exit and a potential lawsuit and the ability of the Company to attract the right talent. The absence of co-founder agreements or dispute resolution mechanisms could also significantly worsen the impression.
- Fundamental mistakes e.g. wrong corporate structure– Sometimes you have registered with the wrong business structure/legal vehicle (e.g. as a business name which is unable to issue equity to investors), or not taken into consideration the specific requirements for companies within your sector, mostly due to ignorance. Such omissions, though sometimes reversible could be a sore point for investors, as it could disallow them from making the most of their investment or obtaining maximum value.
- Poor record keeping & irresponsible financial management – The lack of proper records indicate poor bookkeeping and could in fact throw doubt on projections and computations presented in your pitch deck. Seasoned investors can often see this, even when efforts have been made to conceal it. Your banking records will also be examined, so avoid mixing personal funds with business funds.
- Loans, Debt & financial obligations – An investor is interested in your financial obligations to all stakeholders – employees, government and other entities. In addition to worries that the funds to be invested would be used to settle such, high levels of debt, outstanding tax obligations and fines, represent more than a financial burden, but also suggest an inability to manage funds.
- Improper Intellectual Property (IP) Management – Lack of valuation, registration or relevant strategy to continually harness, monitor and commercialize intellectual property can be a discouragement. The risks involved, ranging from rights not being secure to possible infringement of another’s rights and the attendant consequences are symptomatic of a lawsuit waiting to happen, a risk which no investor wants to take. This could also be a reason for being grossly undervalued.
- Legal Issues – Well drafted contracts with employees, suppliers and service providers are non-negotiable, as the risk exposure from not having them in place could impact on the very core of a Company’s existence. We have found on several occasions that the entry of an investor sometimes results in unexpected requests for increased salaries and fees, as well as frivolous lawsuits from opportunists who decide to grab a part of the Company’s “windfall”. The importance of having written agreements cannot be overemphasized. It is also important to be honest with proposed investors about legal issues and ongoing disputes. It would be advantageous to manage their perception of the situation and explain the measures which are in place to mitigate risks or solve the problems, before such issues are discovered by their professional advisers during a due diligence.
- Poor Corporate Governance practices and Compliance culture – An investor’s lawyers would also typically examine your constating documents, internal policies, and laws put in place by your regulators (if any); and assess your level of compliance. Perpetual lateness or frequent fines could render you untouchable as many investors are strict with their tolerable levels of non-compliance. Furthermore, ensure minutes of directors meetings are properly kept as evidence of deliberations and approvals of key decisions.
- Human Resource Challenges – Information discovered in your staff records or actual conversations with your disgruntled employees could unearth red flags.
- It’s not you, it’s them – After all is said and done, you need to realize that sometimes it’s nothing wrong with your business, but a simple business decision from the proposed investor. Your venture might not fit into their investment criteria, or it no longer does following a recent change in direction, or a negative experience with one of your contemporaries. At other times, your startup might be considered too novel and extremely risky, due to insufficient information and understanding, and their inability to see potential exit value making it worth the risk.
As stated earlier, this does not constitute an exhaustive list, but the most common reasons in our experience. It is also important not to get overwhelmed, but rather to be informed and inspired to have the right documents, structures and practices in place, before you ever become the subject of a due diligence investigation.
Finally, due diligence exercises are not only used by proposed investors, but in several other business arrangements as well. Once you are open to receiving funds or dealing with other Companies, be sure to “keep your house in order”, as you may not know how thorough your proposed investor or possible foreign business partner could be. Meticulous preparation will maximize your financial value, and improve your business reputation.
This article provides general knowledge on the subject matter discussed and is not meant to be all-encompassing legal advice for your specific situation. Furthermore, technical details have deliberately been avoided in the hopes that we keep it simple and ensure non-lawyers truly benefit from our content. For further inquiry, please send an email to lawyerinlagos@gmail.com or lawyers@syntaxlaw.com.
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