In the third of our series of articles looking at the legal considerations to angel investing, Daniel Hayhurst, Private Equity and Venture Capital Associate at Brabners LLP, continues the theme of risk and looks at the steps to consider in managing risk at the start of an investment.
Managing risk at the start of an investment: 5 steps to consider
1. “Buyer/Investor beware”
“The law operates on an “investor beware” basis – it is for investors to make their own investigations into an investee company.”
Although the contents of an Information Memorandum (if one has been prepared) will be treated as actionable representations by the company and its directors, when investing, the law operates on an “investor beware” basis.
It is for investors to make their own investigations into an investee company and the company/its management are not generally under an obligation to disclose any material information to prospective investors. Unless you make specific enquiries and/or seek appropriate warranties, you would have no recourse for a company failing to disclose material matters (such as adverse litigation) which may impact your investment decision.
It is therefore vital that you take the time to establish the assumptions and facts behind the Information Memorandum and the other key assumptions which you are making in relation to the company through due diligence and seek warranties to validate such assumptions.
2. Business Plan
“Fully understanding the company’s business plan is key to success – consider carrying out an element of ‘stress testing’.”
In any investment, fully understanding the company’s business plan is key to success. A well prepared business plan should set out a company’s fundamental business proposition, how it intends to utilise the investment and its projected future financial performance. The business plan should also set out the assumptions on which future forecasts are made.
It is important that you understand these assumptions and satisfy yourself that they are reasonable. In considering the assumptions, you may consider carrying out an element of “stress testing”, where you ensure you are comfortable that the business plan would still work in the event a future performance is less than assumed, or an assumption relied upon in the Business Plan turns out to be incorrect.
Business plans are not crystal balls and few, if any, companies hit exactly the position forecast in their initial plans. However, it is possible to seek protections from a company that its business plan has been properly prepared with reasonable care, is based on reasonable assumptions and the company is not aware of any facts which undermine the business plan or make it unachievable.
3. Due Diligence
“Once happy that no material issues were identified in the due diligence, you can seek appropriate warranties to provide legal confirmation of your understanding of the company.”
Due diligence (from a legal perspective) is the process of enquiring into the affairs of a company to identify matters which may be material to the decision to invest, or that may undermine early assumptions.
Comprehensive due diligence would normally include use of professionals to undertake financial due diligence against the models in the Business Plan, commercial due diligence on the market and the competitors in the market, any customers and their feedback, and legal due diligence.
The role of the legal advisor in due diligence can vary widely from simply providing a list of enquiries (with the company providing information directly to the investor), to producing a full narrative report on the company. For smaller investments many angels may choose to undertake their own investigations and to review a large amount of the due diligence information themselves, seeking advice only on key points of interest (such as a legal review of a key contract).
Typical areas covered by legal due diligence include legal ownership and validity of intellectual property, corporate structure and shareholdings, key contracts, key customer and supplier relationships, employees and litigation and disputes.
As mentioned in our last article, where Intellectual Property (IP) is a key asset or protection against competitors, conducting thorough due diligence into the intellectual property of a company is key to any tech investment. IP can often be developed outside of an investee company (such as by a manager prior to the incorporation of the company or through a manager’s employment at a university, with the IP subsequently being spun out).
It is vital to confirm through due diligence that any IP developed outside the company has been properly transferred to the company’s ownership and that employees involved in its creation do not have any rights to the IP. It is also important to ensure that you validate any IP from a technical perspective, for which a patent attorney may well be engaged.
Once you are happy that no material issues were identified in the due diligence which would put you off the investment, you can seek appropriate warranties to provide legal confirmation of your understanding of the company. Warranties provide a mechanism whereby the company validates or represents the positions disclosed through due diligence. Should you later discover that any of the warranties are untrue in a way that has not been disclosed, you would be entitled to bring a claim for damages against the company/its management.
4. Tax
“Consider the tax position of the investment and whether any legal protection needs to be sought in this area.”
While not typically within a lawyer’s scope of advice, it is important that you consider the tax position of the investment and whether any legal protection needs to be sought in this area. For instance, where you expect the investment to qualify for enterprise investment scheme (EIS) relief, it is important to ensure you are happy that the EIS process has been run properly, that advance assurance has been obtained by the company and for you to consider seeking warranties to support any assumptions in this area.
5. Syndication
“One way to spread risk is to “syndicate” the investment with a number of other angels.”
One practical way of spreading risk when investing in a private company is to “syndicate” the investment with a number of other angels (reducing each angel’s individual exposure to the company). In addition to spreading financial risk, syndication provides an opportunity for angels to pool their expertise.
The best angel syndicates for a specific investment will include angels with knowledge of the relevant market who are able to assist with the commercial due diligence, as well as others with financial acumen able to investigate the Business Plan and model. Angels able to understand the dynamics of the management team and to take a board level role will be key to the future success of the investment and the investors’ relationship with the company and its management.
When operating on a syndicated basis, it is common for one angel in a syndicate to take on a “lead angel” role. Typically, the lead angel will take responsibility for driving the investment process forward and will coordinate input from various advisors to bring the investment to completion.
Where one member of a syndicate is taking a lead angel role, it is important for all syndicate members to understand specifically what responsibilities the lead angel will be undertaking (and what responsibilities each individual angel will still need to perform themselves). It is also important to ensure that all key information is distributed to the entire angel syndicate, and not just to the lead angel.
Where professional advice is sought in relation to an investment, you should take care to understand to whom the relevant advisors are providing their advice. With a syndicated approach, you would need to know whether the advice is being provided to the syndicate as a whole, which would save costs and make for a more efficient transaction, or only to certain specifically identified investors.
Look out for our next article where we will consider the provisions that should be incorporated in investment documentation to manage risks throughout the life of an investment.
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