Over the past decade or so I have reviewed many offer documents on startup and early stage businesses seeking additional capital. In the vast majority of cases, the documents were been wholly insufficient for the purposes of making an investment decision, and the expected returns-for-risk were worse than playing roulette at the casino.
I have set out below an overview of the approach I take when considering an opportunity to invest in the ordinary shares early stage and start-up businesses. A similar approach could be taken when investing in most companies, including in the shares of blue-chip companies. That said, as a relatively miniscule investor in blue-chip shares one would probably find it difficult to get the information one needs. It is unfortunate for prospective investors that (due to legislative and regulative requirements) the information one needs for an investment decision is not included in product disclosure statements.
The approach I take involves understanding the risk profile (the prospect of the business achieving its forecast financial results) and establishing whether that risk profile meets my personal circumstances, whether I am being offered at least fair price, whether I can reasonably expect to be adequately compensated for taking on those risks and whether the expected return-for-risk is higher than my other investment opportunities.
My golden rule is to have at least a basic understanding of the business before investing my hard-earned. Knowing what the business does, what products it sells or services it provides and how they compare with competing products and services, is only part of the answer. I also want to understand the cost & revenue structures and want to know what the key variables are and how reasonable changes to those variables could impact the business.
I prefer not to make assumptions in this regard. The company wants my money, so it is up to them to give me sufficient information (and in a succinct form) so I can understand the dynamics of the business. If I do not get the information I need or otherwise do not get to understand it, I do not invest.
I want to know where the business is now (its current financial and operational position), where it wants to go (what its financial and operational projections are) and how likely it is to get there (how achievable those projections are).
In other words, I want to know where the business is now, how it proposes to get from its current position to the next stage and from there to the following stage and so on. I then want to know what assumptions about future events have been made, whether they are reasonable and importantly what impact will there be on the business if there are reasonably expected variations to those assumptions. I typically prepare a ‘sensitivity analysis’ showing the impact on the financial projections where reasonable changes (positive and negative) to the crucial assumptions occur.
Financial projections without a reasonable supporting argument should be dismissed in their entirety together with the investment opportunity. If, for example, the projections show sales increasing by 10% I want to understand how that is to be achieved and what impact it will have on costs.
As a mere investor I would have no involvement in the business and need to rely on management to achieve their projections for the business, so need to assess the capability of management. I want to be confident that the management team has an in-depth understanding of the business and its dynamics, knows what is required to achieve the projections, understands what could reasonably go wrong and is committed to the business.
Some of the questions I consider in this regard are:
- What does the offer document reveal about management’s understanding of the business? Does it clearly articulate the nature of the business, does it describe the dynamics of the business and set out its revenue streams, cost structures, key variables, the core assumptions that underpin its financial projections and the results of a sensitivity (‘what if’) analysis? Probably not, so one will need to seek answers from management.
- What do the profiles on each of the management team reveal? Do they have the skills and experience for a business of this nature? An outline of where they have worked in the past gives me little comfort. If the person held a senior position in a large company and is now managing or on the board of a much smaller company, rather than give me comfort, it causes me concern. I much prefer taking an evidence-based approach to this question. I basically look for two things: Management and the board need to demonstrate to me (preferably through the offer document) that they understand the business and have the skills and motivation needed to achieve the financial forecasts. I want to know what they have achieved with the business over the past few years and what they have actually achieved in other similar businesses.
- Who is advising management (who are the company’s accountants, lawyers, marketing firm, etc.) and are they reputable?
- Are management’s interests aligned with those of the investors, particularly the new investors?
- Whether and to what extent each of the core management team has invested (hard cash rather than ‘sweat equity’) in the business?
The Board / Corporate Governance
When reviewing the board members, my focus is not on their expertise but on whether they can be relied on to protect the rights of the minority shareholders, align the interests of shareholders and management and ensure the management is held to account. Some questions I ask myself in this regard are: (For the purpose of this exercise I have assumed that I am a prospective minority shareholder.)
- Are the directors mostly executive or non-executive?
- Who of the board members can be expected to act in the best interests of the new investors and how effective are they likely to be in that regard?
- Whether the interests of the non-executive directors are aligned with those of the new investors? This includes asking whether and to what extent the non-executive directors have invested (‘hard cash’) in the business.
- Who are the non-executive investors and what expertise do they bring to the board? (Here I am looking for a party that understands ‘corporations law’ and another that understands financial reports.)
- Who are the company’s accountants, on what basis have the financial statements been prepared?
- What rights will I have to receive audited annual and half-yearly financial statements, monthly (or quarterly) management accounts and other periodically produced reports on operational performance?
- Is the value offered to the new shareholders fair and reasonable?
- Is the exit strategy (for the minority shareholders) clearly articulated and reasonable and can the board be relied on to ensure that management implement the strategy and expected outcome for the existing shareholders?
- What controls are in place to ensure that executive directors do not enrich themselves at the expense of the new shareholders – for example, what can the minority shareholders do if the executive directors award themselves overly generous salary increases and performance bonuses?
- In the (hopefully unlikely) event that management under performs, what rights do the non-executive directors and shareholders have to hold them to account (i.e. kick them out and bring in another management team)?
Having satisfied myself that the board can be relied on to protect the interests of the minority shareholders, I want to be satisfied that the board (as it will be giving directions to management) also understands the business. As with assessing the management team, the mere fact some of the directors may have held senior positions with large companies gives me little comfort. I want to see evidence that they understand the business and its dynamics.
Knowing how one will get out of one’s investment and having confidence in that arrangement is crucial, particularly if one is investing in a private company or an unlisted public company. It is also important when investing in listed shares with little trading activity.
It would be wholly insufficient for the offer document to merely state that the exit strategy would be ‘a sale of the business’ or ‘an IPO’. One does not only need to know what exit strategy is contemplated for the investors, one also needs to have confidence in the success of that strategy, the value multiple that is likely to be achieved and why and what one’s rights would be in the event that the board does not implement the strategy or implements it too slowly.
Before investing I want to be confident that I can sell out at a price within a predetermined range and within a predetermined timeframe. I would not want to be at the mercy (after having invested) of the directors unilaterally deciding at the time not to implement the strategy or deciding to delay it.
The Value Proposition
Establishing the value proposition offered to investors is absolutely crucial. A business seeking capital may be fantastic in all respects, but if the offer is not attractively priced, one should not invest.
The first task is to determine the value of the business ‘as is.’ In the case of well-established businesses, one would apply a multiple to its sustainable profits. The multiple ones would use is based on the return on investment one requires. Divide this return into 100 to get the multiple. For example, 100/20 = a multiple of 5 times, where the ‘20’, is the 20% pa return one requires. Having established the ‘as is’ value, add the amount of the new capital being sought to calculate the ‘post-investment value’. If one is providing all the ‘new capital’, one should expect one’s shareholding to be the percentage the new capital represents of the post- investment capital. That is, the shareholding for new shareholders will be equal to the amount of new capital divided by the post- investment value.
The problem with start-ups and many early state companies is that they are not yet producing a sustainable level of profits. In these cases one needs to consider the price the shareholders would get if they sold the business ‘as is’, before the new capital is invested. As a business with financial strength is unlikely to ascribe any value to an idea or a concept, one should determine what the business has achieved to date that is valuable. The amount of money or time and effort invested todate is irrelevant. Having established the post-investment value (the ‘as is’ value plus the amount of new capital) determine what percentage the new capital represents of the post-investment value.
Now compare the ‘post-investment value’ to the value of the business implicit in the investment offer. One could consider the investment offer to be ‘fair and reasonable’ if the post-investment value is similar to or more the value of the company implicit in the offer. In the case of the vast majority of start-ups and early stage companies I looked at, I came to the conclusion that the value of the company implicit in the offer is well above the level I considered to be ‘fair and reasonable’. In other words, the shareholding offered to the new investors was way too low.
If one considers the offer to be ‘fair and reasonable’, the next task is to establish whether the business is adequately compensating one (as the new investor) for the risks one is taking on. This involves determining one’s expected return on investment, which as I have outlined above is dependent on one having confidence in the financial projections for the business during the period of one’s investment and thereafter. As I have indicated above, if one does not have confidence in the financial projections, one should not invest. Over the years I have reviewed the offer documents of many start-ups and early stage businesses. In most cases, I had little confidence in the financial projections (where they were even provided) and so declined those opportunities to invest. I would have had better odds of success playing roulette at a casino!
The process for determining the return on investment one could expect involves a rate of return calculation using the value of the amount of capital one invests as the ‘present value’, the net exit price as the future value and any dividends or other distributions one expects to receive during the course of one’s investment as the ‘payments’. Do this calculation on each of three forecast scenarios – pessimistic, optimistic and reasonably likely. Having calculated the expected return on investment under each of these three scenarios, consider whether those expected returns are sufficient to justify taking on the associated risk. Basically the greater the level of uncertainty (as regards the business generating the forecast profits and exit price), the higher the return on investment one would ordinarily expect in order to adequately compensate one for the risk. If satisfied that the expected return on investment will adequately compensate one for the risks involved, one should compare the expected return to the returns offered on other investment opportunities. Only consider investing if it comes out on top of the expected return-for-risk comparison.
Having read the commentary above you have probably concluded (quite rightly) that I generally struggle to find what I regard as attractive opportunities to invest in the ordinary shares of start-ups. I have less difficulty with early stage businesses, businesses that are yet to reach maturity but have proven their credentials. Basically, I want to be satisfied that the business fundamentals have been ‘proven’, the business has enormous growth potential, the strategies for growing revenues and profits appear at face value to be reasonable, that I will be fairly and adequately compensated and that my interests will be protected.
Prepared by: Mark Morris