Equity investment is all about partnering with people. Understanding how you and your team operate is important to potential investors.
From your first interaction, they will be assessing you, your approach, your ability to deliver your plan, how you work with others, how well you listen and consult and where you might need extra support.
For obvious reasons, perceived weaknesses in the founders or management team is rarely given as a reason for decline; however, it is a very common reason in practice. It is therefore important to maintain a pragmatic approach throughout the deal process – highlight your strengths, be realistic, be open about your weaknesses and areas for improvement, be thoughtful and reasonable in your negotiation and be patient with the rounds of questions and diligence.
It’s also important that, throughout the deal process, you are able to assess how well you work with your potential investors so that you can be confident their investment will result in a good and workable strategic partnership.
Management due diligence involves the assessment of the management team, highlighting areas of strength and weakness associated with individuals and the team as a whole.
Investors will be seeking to gain an understanding of:
They will also run basic background checks on criminal convictions or director disqualification. It is helpful to be up front about anything that would likely cause concern.
There are a variety of means for assessing individuals and the team dynamic, some more formal than others:
Spending time together
When you're trying to juggle running your business as well as a fundraise, it can be difficult to remember to spend time building this relationship. If time is tight, this can be done in part through making due diligence sessions face to face. It sounds obvious but it is fundamental and often missed - make time to invest in getting to know your investor.
Referencing
Investors will ask you and possibly other members of the team to provide references.
Questionnaires
You may be asked to complete a questionnaire that asks for the details of any historic convictions, directorships, alternative income or activities etc. which you may be asked to warrant at completion.
Psychometric testing
You may be asked to complete a psychometric test.
Consultants
An investor may formally engage a specialist consultant to spend time with you and the team and provide an assessment. The consultant’s scope may be to conduct psychometric testing, attend management meetings and meet with individual team members.
Below are a few of the more common areas of weakness identified by investors.
Lack of clarity in roles or reporting structures
This can result in misalignment and miscommunication across the team, as well as a lack of leadership on certain workstreams.
Ways to mitigate this:
Inability to discuss, debate and agree
When teams work well together, challenging discussions will result in constructive conclusions. Some management teams struggle to hold effective meetings which can result in poor decision making. This is of particular interest to investors as they will be seeking reassurance that the team can “cope” when things don’t go to plan.
Ways to mitigate this:
Misalignment in approach or personality
This can manifest in a number of different ways and is not easy to mitigate – if there is a fundamental misalignment of approach, then the partnership is unlikely to be successful.
A strong team dynamic is the best way to overcome this, if it becomes an issue in securing investment. A particularly driven and ambitious CEO, with the capacity to listen, alongside a more prudent operations or finance lead, may present a successful combination, while one of these individuals acting alone may not be considered investable.
Investors often seek to exert this influence through the Chairman position, as a good Chairman can often provide the guidance and direction required.
All institutional investors are required to carry out KYC checks on your company, key shareholders and directors.
These apply to the following individuals:
You will be required to provide the following information for these individuals:
Alongside the adoption of the revised articles of association and signing of the shareholders agreement, there are a number of other documents required to complete the seed round. Drafting of these documents should form part of the scope of works for your legal advisors.
A share certificate will be produced for each seed investor, setting out the number of shares they hold, the class of share (most likely ordinary shares for a seed round) and the nominal price per share (often a penny or a pound).
Each share certificate is signed by director of the company and witnessed.
A board minute will be prepared that will approve:
The board minute should also:
The board minute is signed by the Chairman of the board.
This ordinarily takes the form of one document with two resolutions:
The document is signed by the existing shareholders of the company.
If no warranties have been provided, then a disclosure letter is not required.
If warranties have been provided, then the warrantors and the company may wish to provide a disclosure letter, which sets out information relevant to the warranties.
For example, the founder (if one of the warrantors) may have provided a warranty that there is no outstanding litigation with any former employees. If there is any outstanding litigation, then this would be disclosed in the disclosure letter and referenced to that particular warranty. This ensures that the seed investors are aware of these issues and provides legal protection to the warrantor, as the investors would not be able to make a claim against the warrantor for breach of warranty in relation to that particular litigation. If the outstanding employee case was not disclosed and were to come to light after the transaction, then the seed investors may be able to claim for breach of warranty.
The disclosure letter is signed by the warrantors and the seed investors, to confirm receipt.
If there are any documents that are defined or referred to in the shareholders agreement, in particular, those referred to in the warranties, then these must be provided at completion, for example, a copy of the business plan, the investor presentation, the management accounts or any due diligence reports.
Alongside the adoption of the revised articles of association, signing of the shareholders agreement, there are a number of other documents and actions required to complete the round. Drafting of these documents will normally form part of the scope of works for the law firm representing the investor, who is also taking the lead on the investment documentation. It may be part of your law firm’s scope to review these documents and actions.
A share certificate will be produced for each investor in the round, setting out the number of shares they hold, the class of share and the nominal price per share (often a penny or a pound).
Each share certificate is signed by director of the company and witnessed.
A board minute will be prepared that will approve:
The board minute should also:
The board minute is signed by the Chairman of the board.
This ordinarily takes the form of one document with two resolutions:
The document is signed by the existing shareholders of the company.
A disclosure letter is usually drafted in response to certain individuals and the company agreeing to provide warranties.
The letter sets out any information that relates to the warranties.
For example, the CEO may have provided a warranty that there is no outstanding litigation with any former employees. If there is any outstanding litigation, then this would be disclosed in the disclosure letter and referenced to that particular warranty. This ensures that the new investors are aware of these matters and provides legal protection to the warrantor, as the investors would not be able to make a claim against the warrantor for breach of warranty in relation to that particular litigation. If the outstanding employee case was not disclosed and were to come to light after the transaction, then the new investors may be able to claim for breach of warranty.
The disclosure letter is signed by the warrantors and the new investor(s), to confirm receipt.
Any documents that are defined or referred to in the shareholders agreement, in particular, those referred to in the warranties, must be provided at completion, for example, a copy of the business plan, the investor presentation, the management accounts or any due diligence reports.
The investor’s legal counsel will carry out a number of specific pre-completion searches:
Make sure that you obtain power of attorney for any key individuals that are unable to attend the completion meeting and are unable to sign remotely. It is surprising how often completions are held up by availability.
If the company has restructured as part of the investment, ensure that a bank account has been set up for the entity that will receive the proceeds. It can take time to put a bank account in place and this can delay completion.
Once the fundraise is complete, you will need to:
Shares won’t qualify for SEIS or EIS relief if they aren’t paid for at the time of issue. Make sure you have a bank account set up so you are ready to take payment.
SEIS3 and EIS3 forms, which enable investors to claim tax relief, can only be issued to investors once the business has been trading for at least 4 months.
If an investor develops a connection with the company during the hold period (3 years for SEIS and EIS), then they will lose their tax relief.
If your company ceases to qualify for the scheme during the hold period (3 years for SEIS and EIS), then your investors will lose their tax relief.
Financial due diligence for early venture rounds is typically conducted by the investors themselves, but may also involve the appointment of an external consultant or firm to review the company’s finances depending on complexity of the business and size of the raise.
You should ask potential investors what their process entails and their specific approach to financial due diligence in order that you can prepare in advance.
Financial due diligence (also referred to as FDD) is the diligence stream that focuses on the company’s trading, balance sheet and forecasts. It's an important area of diligence for new investors as it covers how their money will be spent, the extent to which it is at risk and the return it is expected to generate.
FDD usually begins after the first meeting when the investor asks for a business plan / financial model and a copy of the company’s latest accounts.
A more detailed review will usually take place once the term sheet has been agreed. Where there are multiple investors, the lead investor will take the lead on undertaking due diligence.
The investor may:
Exactly what is included within an FDD scope will vary between investors; however, there are certain core items that crop up regularly.
Forecast cash flow
Investors will seek to ensure that their funding is sufficient and that you have enough cash headroom to deliver the business plan while keeping the business going.
Many companies at the venture stage are loss-making – in this case, the cash burn rate is of particular interest. Investors will assess the rate of depletion and ensure there is sufficient time and headroom before the business breaks even or raises the next round of funding.
We recommend including a forecast cash flow within your business plan / financial forecast model.
Balance sheet
Investors will assess the strength of the company’s balance sheet. Specifically, they will want to ensure that the value of assets is fair and not misrepresented, as well as understand how successfully the business converts work, orders and turnover into cash. In doing this, they will review your cash balance, aged debtors and work in progress ("WIP").
An "aged debtor" analysis illustrates how young or old the debtor balances are - if they are old, then that may be an indication that the business is slow to collect cash after invoices have been issued.
An "aged WIP" analysis does the same thing, but for work in progress, i.e. work that has not yet been invoiced. A high proportion of old WIP balances can indicate issues in getting invoices out to customers.
Investors may also review the value of tangible and intangible assets to ensure these are booked appropriately. For example, the value of stock and when the last stock take was undertaken.
On the liabilities side of the balance sheet, investors will be interested in creditor balance, i.e. how promptly the business pays suppliers.
They will also want to understand the details and terms of any debt items on the balance sheet, including overdrafts, term loans and shareholder loans.
Financial forecast or business plan
The financial forecast sets out what you expect to achieve with the new funding and provides a forward vision of what the business might look like at the point of exit, thus helping investors to estimated their potential returns.
We recommend preparing a short written document to accompany the Excel file, that sets out the key driving assumptions.
The following items are typically of interest to investors:
A note on revenue recognition
Many small businesses book turnover when cash is received or an order is placed. The more usual accounting practice is for turnover to be booked as and when services are delivered, for example:
A software business charges customers their annual subscription fee in advance
It is important to recognise turnover in line with the delivery of products and services in order to provide a reliable estimate of turnover growth, run rate turnover and profitability. Investors use these metrics for valuation analyses. If customers are charged in advance in a growing business, and turnover is booked at the time of cash receipt, this will overstate the company’s turnover and may result in difficult discussions when this emerges during due diligence.
Investors may also apply sensitivities to the assumptions within the business plan in order to understand how profit, cash and their anticipated return are impacted if things don’t go according to plan. It therefore makes sense to have a model that is built in Excel, integrated and can be flexed relatively easily.
To assess the feasibility of forecasted turnover, investors may ask to see a pipeline analysis, setting out discussions and progress with current and potential customers.
Historic trading
How the business has performed historically is one indicator for how realistic the forecasts are. Recent historic trading should ideally be included within the financial forecast model so that the forecasts can be sense-checked easily.
Investors may also ask for the company’s performance relative to budget in prior years, if sufficiently established to have set budgets historically. This is a mechanism for them to test the company’s ability to budget and perform in line with expectations.
Finance function
Investors may enquire about the finance systems used and their robustness, as well as who in the company runs the numbers. They may suggest additional resource or investment as a result of this assessment.
Cash controls
Investors will want to ensure that there are adequate cash controls in place so that the new investment is secure. These include permissions around who can set up, approve and make payments from the company’s accounts. Make sure these are set up appropriately with your bank ahead of the fundraise.
Financial due diligence (also referred to as FDD) is the diligence stream that focuses on your trading, accounts and forecasts. It's an important area of diligence for new investors as it covers how their money will be spent, the extent to which it is at risk and the return it is expected to generate.
FDD begins after the first meeting when the investor asks for a business plan / financial model and the company’s latest accounts.
A more detailed review will usually take place once the term sheet has been agreed.
Investors will typically:
Exactly what is included within an FDD scope will vary between investors and will depend on the business; however, there are certain core items that crop up regularly.
Forecast cash flow
Investors will seek to ensure that their funding is sufficient and that you have enough cash headroom to deliver the business plan. They will therefore want to understand, assess and stress test the forecast cash flow.
The financial forecast model should include a forecast cash flow.
Balance sheet
Investors will assess the strength of the company’s balance sheet. Specifically, they will want to ensure that the value of assets is fair and not misrepresented, as well as understand how successfully the business converts work, orders and turnover into cash. In doing this, they will review your cash balance, aged debtors and work in progress ("WIP").
An "aged debtor" analysis illustrates how young or old the debtor balances are - if they are old, then that may be an indication that the business is slow to collect cash after invoices have been issued.
An "aged WIP" analysis does the same thing, but for work in progress, i.e. work that has not yet been invoiced. A high proportion of old WIP balances can indicate issues in getting invoices out to customers.
Investors may also review the value of tangible and intangible assets to ensure these are booked appropriately. They will be interested in the capitalisation, revaluation and depreciation policies applied to assets. Specifically in relation to stock, they will want to understand the basis of valuation for stock, the method of provisioning and stock turnover.
On the liabilities side of the balance sheet, investors will be interested in the trade creditor balance, i.e. how promptly the business pays suppliers. They will want to understand any deferred revenue, i.e. turnover for which cash has been received but where the services has not yet been delivered.
They will also want to understand the details and terms of any debt items on the balance sheet, including overdrafts, term loans and shareholder loans, as well as any hire purchase agreements or finance lease commitments. Of particular interest are covenants attached to banking facilities, whether the business is in compliance with these covenants and how they are monitored.
Financial forecast or business plan
The financial forecast sets out what you expect to achieve with the new funding and provides a forward vision of what the business might look like at the point of exit, thus helping investors to estimated their potential returns.
We recommend preparing a short, written document to accompany the Excel file, that sets out the key driving assumptions.
The following items are typically of interest to investors:
Investors may also apply sensitivities to the assumptions within the business plan in order to understand how profit, cash and their anticipated return are impacted if things don’t go according to plan. It therefore makes sense to have a model that is built in Excel, integrated and can be flexed relatively easily.
To assess the feasibility of forecasted turnover, investors may ask to see a pipeline analysis, setting out discussions and progress with current and potential customers.
Historic trading
How the business has performed historically is one indicator for how realistic the forecasts are. Recent historic trading should ideally be included within the financial forecast model so that the forecasts can be sense-checked easily.
Investors may also ask for the company’s performance relative to budget in prior years, if sufficiently established to have set budgets historically. This is a mechanism for them to test the company’s ability to budget and perform in line with expectations.
Historic trading may also reveal seasonality or challenging trading periods, which the investor will want to understand and greater detail.
Finance function
Investors will want to understand what systems or software you use to manage your finance function, to ensure that it is robust enough to support your growth and whether it requires investment.
They will also be interested in the individuals within your finance team and their capabilities to understand whether further resource would help the business to deliver the plan.
Cash controls
Investors will want to ensure that there are adequate cash controls in place so that the new investment is secure. These include permissions around who can set up, approve and make payments from the company’s accounts. Make sure these are set up appropriately with your bank ahead of the fundraise.
A cap table (capitalisation table) summarises the ownership of a business pre and post a fundraise, demonstrating the full breakdown of the Enterprise Value, including shareholders, debt and cash.
It is an essential tool that enables you to see the mechanics of your individual fundraise and to calculate specific figures for the legal documents, for example:
We have built an easy-to-use cap table template specifically for seed rounds.
All you will need to complete the template is:
Step by step instructions are included within the template, which is built using basic Excel formulae and thus can be tailored to fit your business and fundraise.
There are also a number of built-in checks in the model below the cap table. If any of these show an error, you'll need to check your inputs:
A cap table (capitalisation table) summarises the ownership of a business pre and post a fundraise, demonstrating the full breakdown of the Enterprise Value, including shareholders, debt and cash.
It is an essential tool that enables you to see the mechanics of your individual fundraise and to calculate specific figures for the legal documents, for example:
We have built an easy-to-use cap table template specifically for venture rounds where new equity is being issued.
All you need to complete the template is:
Step by step instructions are included within the template, which is built using basic Excel formulae and thus can be tailored to fit your business and fundraise.
There are also a number of built-in checks in the model below the cap table. If any of these show an error, you'll need to check your inputs:
A cap table (capitalisation table) summarises the ownership of a business pre and post a fundraise, demonstrating the full breakdown of the Enterprise Value, including shareholders, debt and cash.
It is an essential tool that enables you to see the mechanics of the fundraise and to calculate specific figures for the legal documents, for example:
We have built an easy-to-use cap table template which encompasses an option pool (if needed), cash out (if needed) and the issuance of equity.
All you need to complete the template is:
Step by step instructions are included within the template, which is built using basic Excel formulae and thus can be tailored to fit your business and fundraise.
There are also a number of built-in checks in the model below the cap table. If any of these show an error, you'll need to check your inputs:
