Fools rush in where angels fear to tread
The argument goes that Britain needs a more US-style funding model and to start hurling bigger amounts of money at startups much earlier in their life cycle.
But that doesn’t mean you have to throw while blindfolded and without first identifying the target and weighing up the risks and rewards.
Ah due diligence – what a pain! You are the startup founder and KNOW you have the hottest proposition on the planet. Why don’t those investors see it?
You are the investor – angel, VC, friend, family or fool. You have money from a previous successful venture burning a hole in your wallet; or manage a fund that investors expect you to utilise to their benefit as quickly as possible; or (if you are in the FFF camp) you might have a bit put by for a rainy day that isn’t realising much interest sitting in the bank.
Right there’s the dichotomy – and the failure to resolve the disconnect is why half of UK startups still fail within five years.
The question is, would more or less startups fail if investors were more vigilant in doing due diligence on the target business BEFORE investing?
After all, companies can fail – have failed – for so many different reasons and not simply insufficient cash. The product or service may be overhyped; your ‘must have’ wearable technology could turn out to be the Emperor’s New Clothes. The management may be inexpert, inexperienced, or downright unfocused; maybe the business model or strategy are wrong. You might have hired the wrong people for the key roles or cannot identify the right people for those jobs.
There may be no markets for your product; if there are markets the macroeconomic backdrop might be so poor that no-one can afford to pay a viable price for your products or services. Customers can go bust on you or pay late and torpedo cashflow, triggering lack of confidence with your bank or other backers. The Government could hike tax; you might trip over a rat’s nest of red tape that stifles trade or Forex trade winds blow a hole in your bottom line.
The litany of what can go wrong has all us business owners scratching our heads from time to time wondering why we bother at all.
The only certainty in the arena of entrepreneurship is that there are no certainties. But you can increase the odds of success (or reduce the risk of failure) if you conduct thorough due diligence.
An excellent Nesta report drew on sheer hard evidence. A quarter of the investments in its sample were made with less than one day of due diligence; the median amount of time spent on due diligence was 20 hours.
Nesta adds with a sting: “By comparison, formal venture capital investors regularly spend hundreds of hours evaluating potential investments before making a commitment.”
Nesta’s data shows that those investments made where the investor spent at least 20 hours of due diligence experienced significantly fewer failures than those where less due diligence was involved.
It accepts that there are still some very successful investments made with little investigation but surely that reduces the process to pure chance.
Respected and experienced angel investor Peter Cowley, who heads up two such vehicles for Marshall of Cambridge and is a Cambridge Angel member, errs on the side of caution when vetting prospective investments.
He flagged up the “obvious dichotomy” between spending time getting to know an entrepreneurial team – how they behave, how they cope with pressure and negotiation, and doing due diligence on their past – and
getting the money to them quickly so they spend as little time as possible fundraising and get on with building the business.
He says: “As a very active angel, if I am leading (or even following) a deal, I like to spend several weeks getting to know the entrepreneurs, undertaking due diligence on the team, the technology, the market, the financials and any IP, whilst negotiating the terms.
“From experience, I am confident that there is a direct correlation between the amount of due diligence undertaken and the long term success of my investment in the opportunity.”
The dialogue was triggered by a call here from another respected long-term investor who had researched around 20 companies that “had failed to succeed” and surmised that in many cases the due diligence process had been dangerously wanting.
The discussion followed the fall of The Solar Cloth Company in Cambridge into administration. It ranks as possibly the most over-hyped startup in Cambridge’s history with big circulation national newspapers and local media trumpeting the solar fabric technology and citing successful deals that are not backed up by the balance sheet.
The Solar Cloth Company went under less than 18 months after raising almost £1 million on Crowdcube – half of it from one individual among 400 investors – cash that was burned remarkably quickly.
Cambridge equity-based crowdfunding specialist SyndicateRoom, which had previously been approached by the company for a potential raise on the platform, conducted thorough due diligence and turned away the ‘opportunity.’
At around the same time we were approached to run a story on “this fantastic company” but after making certain inquiries, declined to offer the oxygen of publicity until we saw more evidence of market validity.
Addressing the general issue of due diligence in a crowdfunding context, Peter Cowley adds that entrepreneurs would typically like to close a deal within a month (or less) and Crowdcube – and to a lesser extent Seedrs – facilitates that.
“Syndicate Room does not, as the lead angel will have done a lot of due diligence before the deal is listed on the platform,” he adds.
One can hardly be surprised when the due diligence process fails in a startup context when it can go so spectacularly wrong in the world of big business. There is no better example than HP’s legal battle with former Autonomy executives Mike Lynch and Sushovan Hussain over the $10 billion price paid for the Cambridge software business and subsequent write-downs which the American company is trying to lay at the duo’s door.
HP paid hundreds of millions of dollars to some of the world’s biggest banks, corporate law firms and accountancy practices to undertake due diligence and ensure it got the acquisition price right.
If there were any red flags raised during the process the bulls in HP’s management team failed to see them. Surely that was the time to charge!
The protagonists have now agreed to continue the legal battle in a London Court in 2018, according to Bloomberg.
So across the entire investment spectrum – from startups to corporate heavyweights – there is a clear argument that it is not merely the process of doing due diligence (paying lip service, one might say) that protects an investment but the quality of the due diligence undertaken and the professionalism and savvy of the people undertaking it.