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Saturday, February 24, 2007

The Problem with Investors

Everyone works hard to ensure that investment deals get completed once they're agreed in principle - but a surprising number don't. What are the most common problems, and how can you head them off?

If you're worried about going through due diligence, spare a thought for some of the world's less mature entrepreneurial environments. A staggering 70 per cent of deals in emerging markets fall through after investors have conducted background checks, according to a survey of foreign investment executives by Deloitte - often, it seems, because company founders lack the necessary 'integrity' for their investment. In the UK, start-ups tend to feature more reputable management teams, but - depending on whose figures you believe - anywhere up to a third of deals can fall apart after the initial terms sheet has been issued.

It's the last thing anyone wants to happen after all the hard work that's put into pitching for deals, but the final negotiations in any investment can be a fraught time. Either side can get cold feet when they're confronted with the reality of the deal. So what are the most common causes of deals falling down after they've been agreed in principle?

The first cause is when due diligence turns up something unexpected. 'In our experience of working with one of the early-stage investment funds, one in four deals have fallen through in the past two years,' says John Foundling, head of corporate finance at chartered accountancy firm Morley and Scott. 'But our whole approach to due diligence on behalf of investors is about driving into any issues that emerge as soon as possible, getting prompt responses and feedback and suggesting how we believe a potential risk area can be mitigated against in some way.'

This approach is reflected in the due diligence report it produces, which the investee company may be shown and asked to vouchsafe as to its factual accuracy. Foundling says it's like an 'exception report', drilling into any potential issues that may arise.

Foundling gives the example of financial projections, which can cause problems but are usually not a deal breaker. 'We look at the mechanics and the structure, the assumptions behind them and check all the basics, and if we find a problem, in conjunction with the investor we may ask for a new set of projections.' Problems usually revolve around technical issues - such as a creditor or debtor not being factored in correctly, or some other discrepancy between the cash flow and the balance sheet. Morley and Scott may even recommend that a new management accounting system be introduced - it's that practical.

It will also look at the credibility of projections, running what Foundling calls a 'sensitivity test', and will flag up if they seem over-optimistic, although the ultimate say on believability rests with the investment manager themselves. A set of projections was highlighted in a recent deal because they appeared to be too linear, for example. 'That's not necessarily a problem, but it implies a simplistic approach. It depends how bullish they've been as to whether it's an issue or not.'

More likely to emerge as a problem in due diligence is the issue of Intellectual Property (IP) ownership, according to Ted Dewhurst, an associate at legal firm Nabarro. 'The area where most early-stage high-tech companies encounter problems is to do with IP, and the most common thing we find is they don't own their technology. If it's owned by the founders, that's quite simple to sort out. But if it's licensed from somebody else that can be a problem.'

Dewhurst says once you look into the licence, alarm bells start ringing if it's capable of being revoked at short notice, or if it's non-exclusive or ambiguous. 'If the business is built on licensed software you want that licence to be perpetual and irrevocable. If it can be terminated or it's not exclusive, then that's not good news.'

A third reason for a deal falling through - and probably the most common - is that the two parties fail to agree a price, or the entrepreneur has a better offer, otherwise known as gazumping. Dewhurst says this was more common last year and the year before when there were a lot of funds looking to invest in a relatively small pool of investment-ready companies.

It's not necessarily a bad strategy for a start-up to get to an advanced stage with a couple of investors - in fact, it can help push a deal through if you let it be known that another investor is waiting to step in. But the investment community is relatively small and deals that are done on trust can be soured if you don't play the game with a straight bat. 'We always assume that having got that far, the investee company will complete the deal,' says Dewhurst. 'But over the last two years there has been sufficient competition for good deals for gazumping to happen.'

Time, of course, is of the essence, and advisors are all too aware of the need for speed. Dewhurst says Nabarro is typically asked to have its draft assessment documents with the client within 48 hours and to complete the assessment in two to three weeks. Foundling, however, points out that for smaller deals, early-stage investors will be unlikely to want to expend too much time on a complex due diligence, given the associated opportunity costs. 'I would say that investors tend to be relatively risk averse,' he adds, 'by which I mean that if by waiting a few more weeks the risk in the investment becomes clearer, then they will wait. It's much easier to wait for the circumstances to change than decline an investment or rush forward with an investment they're not comfortable with.'

Which helps explain the next reason - a downturn in the company's fortunes. 'Poor results in terms of the current trading falling short of projections is a reason deals fall through,' says Dewhurst. 'It could be that trading has taken a turn for the worse or perhaps it's never picked up in the way they were projecting.'

The final reason is perhaps the hardest to guard against - the human factor. Dewhurst says that if an entrepreneur isn't used to dealing with VCs, they can be intimidated by the documents when they first see them. 'When they start talking to investors it's all very friendly, but when they see what they're asked to give in the way of warrants and assurances, restrictions on employment, service contracts, share transfers, putting in place share option schemes - they sometimes think it's outrageous. We can usually calm them down and it won't throw the deal.

'When VCs invest millions in a company, it's their duty to protect their clients' investment and they really have no power other than what's in the investment document.'

Foundling, whose firm also acts as a lead advisor to companies seeking investment, adds that it's important to think about the deal in the round from the very start. 'At the beginning, the focus in nine out of ten cases is on the percentage [of equity they are giving away]. It's only later, as they take legal advice and tie up the legal documents, that they understand the warranties they have to give - that the business plan is accurate and complete and not misleading, for example. What I try to impress on companies as a lead advisor is that they shouldn't be afraid to give warranties, because if they're asked to give a warranty they're not happy about, then there's already a potential problem between them and the investor.'

He concludes: 'At the end of the day it's about the convergence of interests between the investee and the investor. It's important that you choose the right investor, and what the deal means for you is often hidden in the terms and conditions and the details.'

By David Longworth, Webster Buchanan Research

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