Monday, 9 March 2015

An introduction to self help due diligence

Over the past 4 years, we have seen pitches and investors' comments on the ECF platforms that show only too starkly how both have very little knowledge about starting and running a company.

More recently we have noticed that far fewer questions are asked of the pitchers. Why would you part with several thousand pounds when you really have little clue what the business will achieve?

So we thought a simple short crash course in self help due diligence might help - ignore this post if you know what you are doing!

Our advice is only invest in either something you are interested in or you have a special level of knowledge in. Forget what the platforms tell you about their own thorough DD - it doesnt exist. They cant afford it and they dont make any money by turning away business. The two key areas to check out thoroughly are the financials and the people involved. SME's are all about the people behind them.

Go over the financials, compare them where possible to filed accounts and competitors accounts - checking if you can for the norm when it comes to things like payment terms, GPM and marketing spend in relation to sales growth. Anyone breaking the trend is probably clueless and unless they have very good reasons to be outside the mould, they should be shunned. Ask them on the forum.

Ensure that the founders have a good slice of skin in the game . If you have read our post here  - Pre packed deals and Equity Crowdfunding, you will see why. As an ordinary shareholder, you will little control, if any, on the actions of the directors. Even if you have voting rights, your holding will be so small that they will be irrelevant. The only way to ensure that directors dont suddenly bunk off is to know that they have a lot to lose if this fails. You want them to have put cash in, in return for equity - not a loan.

Check that the market this business is in is one the founders have experience in. What experience? Running a company is rather different to working for one. Have they set up a company before? Its not the end of the world if they haven't but it certainly helps. If they make sure you check out how that company fared and if it closed why. Meet them if you can. Most platforms provide this service.

If you are dealing with a consumer product pitch or service pitch, check the web for reviews. Mumsnet, the student room and other gossip places are useful sources of independent information. B2B is more difficult - their own site will have recommendations so you could ring these companies up. It has been known for some of these to be fabricated. New tech pitches, unless you understand the market are a nono - exciting as they may seem. Forget about investing in the next Facebook; thats just the ECF industry sales pitch.

When using sites like that if you are searching for a director's history, they are often listed under different styles of one name. IE John Smith may well appear as John Smith and in another ID as John William Smith. As you need to know what what Mr Smith has been up to, you need to check all the variations. Some people we have found have 5 or 6 of them. Likewise always check their open companies documents page - although accounts maybe unavailable, recently filed company documents will give you some clues.

Check their status at CH. One company pitching on a FCA regulated ECF site turned out to run by a disqualified director - still serving his term.

Financials. This is where we feel the current model as operated by Crowdcube, fails. You have to assume from the outset that the sales projections will be over egged by a factor of between 2 and 10. Incredible yes, but all the evidence so far from funded pitches puts the average over egging at around 5 times the actual sales. Crowdcube is run by two PR people - they know very little about business. For them the pitches projections only have one purpose  - to sell you the firm's equity. Check that the cash flow has plenty of room for this fall in sales - ask the pitchers what ifs. If you get back the most common answer on Crowdcube to this Q - ''Our sales projections are very conservative'' - move onto another pitch. If they have a track record of taking a business from zero to £1m in sales in its first year, then of course it might be worth a punt, providing its in a similar market.

A trick we noticed recently was the re-arrangement of certain elements on the pitch's balance sheet to make things appear better than they are. Unfortunately you cant check this if their accounts have not been filed, so you just have to believe the figures they give you. Really the FCA should demand that any company pitching that is more than 18 months old, should have to produce filed accounts up to the current date, whether they are technically due or not. Filing in the UK has a 9 month lag. It could be made a prerequisite for EIS and SEIS.

Never believe statements like '' We have almost £1m in orders pending'' unless they can prove it.  A recent pitch on Crowdcube stated just that and then later, when they were back for more cash, it turned out only 20% of these orders had come to fruition. If a company is heavily reliant on one major customer, ask them about it. Large companies have a habit of using smaller ones for short periods, then moving on to the next best thing - especially in consumer goods. What % of the projected turnover is reliant on these large customers and what if any contracts are there. You will be the last one to hear about a delisting.

Be wary of claims that seem to good to be true.  Like a very rapid growth in a customer base from scratch. This maybe due to the brilliant product and marketing or it maybe the use of promotions on sites like Groupon. The latter will not necessarily deliver retained customers. Just ask them how they did it and search the web for clues.

Likewise beware of the term ''award winning''. Just because the business plan for a pizza start up won an award at the management school the founder was attending, has little or nothing to do with the public's reaction to the pizza.

ECF platforms have been known to confuse grants from bodies like Wayra with investment. Just because a pitch has won a grant of this kind does not mean it is more likely to succeed. Crowdcube's first failure back in 2012, Bubble and Balm, had won a BT business award for tens of thousands of pounds. Be sceptical.

You would be amazed at the number of projections that defy gravity. If you are producing a product that requires WIP or selling a product that requires certain monthly overheads to allow sales - then you need the cash in the bank before you start the month, not at the end. So if sales dip one month - maybe like the example we gave in another post here where they didn't realise that the City wasn't busy on a Saturday (!!), it will have a knock on effect if they haven't built this in. They will be unable to function the next month as they have no goods for WIP or they cant pay suppliers. Its one of the main reasons for failure and with thought, it is avoidable. If you look carefully at the outgoings per month on the CF and then check this against the cash coming in and opening cash position - you can see just how tight the pitch has made this. Too tight is not good and shows a lack of real experience.

Always check the dynamics of a plan - the numbers that go into the final projections. If a company has a six day sales week and it turns out that day six is not busy, as in the case of the City fast food pitch, then the figures will be out by a sixth before you start.

Finally whatever you read on LinkedIn - ignore it.

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