Investing

Before You Invest: The Basics of Financial Due Diligence

Huiwen Leo | August 8, 2016

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Interested in investing in a company that is raising funds under Regulation Crowdfunding (Reg CF), Regulation A or Regulation D? That means doing your homework— understanding what you are investing in and making an “informed investment decision.  In other words, due diligence.

In this article, we’ll explore the basics of financial due diligence, which includes assessing the financial health of a company, its valuation, and reviewing the terms of the offering. An earlier article covered the legal and business issues to consider when conducting due diligence.

FINANCIAL DUE DILIGENCE

When it comes to assessing a company’s financial health, your first step should be reviewing the company’s financial statements. Financial statements are reports that companies produce to summarize their financial activity and condition—including income statements, balance sheets and cash flow statements. Unlike public companies, which report quarterly, financial statements for startups are usually produced annually, and sometimes semi-annually. Analyzing financial statements can be complicated. For a good introduction, see the SEC’s Beginner’s Guide to Financial Statements.


How reliable are the financial statements? Did anyone check them?

In general, financials that involve a qualified accountant are going to be more reliable and give a better picture of a company’s financial condition that ones that do not. Preparing financial statements is a complex process, and it’s easy to make unintended mistakes, so a professional’s oversight is valuable. There are various levels of involvement of outside accountants— Compilation, Review and Audit, with audit being the highest level of involvement. An overview of what each level of involvement entails is available here.

What type of financial statements are required?

This depends on the type of offering the company is conducting.

Regulation CF: If the company is raising under $100,000, only the total income, taxable income, and total tax as reflected in the company’s federal tax returns and financial statements certified by a company officer are required. If the company is raising between $100,000 and $500,000, then the financial statements must be reviewed by a CPA. If a company is raising over $500,000, audited financial statements are required. However, if the company is raising funds under Regulation CF for the first time, it only needs to provide reviewed financial statements for a raise over $500,000.

Regulation D (Rule 506): Because these offerings involve only accredited investors, there are no legal requirements, so whether financial statements are presented will depend upon the policies of the investment platform. Typically, companies raising money under this exemption provide only unaudited financial statements. Sometimes, very early stage companies may produce “projected” financial statements, based upon company management’s assumptions and estimates. In these situations, review the assumptions (if there are any; if there aren’t, ask what assumptions the company was working under) and consider if the estimates are realistic.

Regulation A (Tier 2): Audited year-end financial statements covering the prior two years are required.

What should I look for in the financial statements?

• Compliance: Did the company produce the type of financial statements required?
• Burn rate: How much is the company is spending and what is it spending on? What does the company anticipate for future expenses? What will the company do if it runs out of funds before reaching certain milestones or if something unexpected happens? How long will it take for the company to use the funds? Is that a reasonable rate?
• Projections: What are the assumptions underlying the projected financial statements? Do you agree with those assumptions, and do you think they are reasonable?
• Financial conditions and trends: What are the company’s anticipated expenditures and anticipated profits? Are there any recent changes in the company’s operations or financial condition? Can you identify a trend? Will it continue?
• Previous capital-raising: Has the company raised money in the past? How have they used the funds?
• Subsidiaries: Does the company have any subsidiaries, or is it a subsidiary itself? What is the relationship between the different companies – how do they organize debt, revenue, other shareholders (if the subsidiary is not wholly-owned), etc.? Which company are you investing in, and which company is making the money?

VALUATIONSfind-the-number

Before a company can sell shares to investors, it has to have a sense of how much it is worth—that is the company’s valuation. Valuations are a critical component in determining whether the shares are priced fairly. There are several ways to value a company discussed in many articles, including this one. Different methods of valuation produce a different answer as to what your investment is worth. The earnings approach, for example, is based on assumptions about the future and typically produces higher valuations, while the liquidation value and book value approaches are more conservative and usually produce lower valuations.

Startups rarely have the resources to get a third-party valuation, so consider the following:

• How was the proposed valuation decided?
• Do you agree with the company’s method of valuation? Would the result be different if you used a different method of valuation?
• Do you agree with the company’s assumptions and conclusions?

THE TERMS OF THE SECURITIES

So what exactly are you investing in? Investors need to understand the terms of the securities they are considering purchasing. The way investment offerings are structured may vary widely, and important terms may be buried in fine print. Some things to consider:

• Terms of securities: What type of security are you purchasing – common or preferred stock, bonds or convertible notes? What are the characteristics of your “class” of securities, and how does it differ from the other classes – what rights do other shareholders have? Is this a good investment for you? Are you prepared to wait for a potential return on your investment?
• Revenue sharing: Is there a revenue sharing arrangement, and how does it work? We have seen more deals use a revenue sharing model, which typically consists of a grace period where no repayments are made (such as one year, or until the company makes at least 10% gross or net revenue a year), followed by repayments to investors until a specified amount is paid (such as twice the principal amount). Do you understand how your specific revenue sharing arrangement works? Are you prepared to wait until the company starts making payments, and accept that in some years no payments may be made due to lack of revenues? What happens in the event of bankruptcy – do the investors have a security interest in the assets of the company (and become senior debt holders) – would that be sufficient to recover the principal invested?
• Pricing: How did the company reach the price for the securities (see Valuation above)?
• Investor rights: What types of rights do you have as an investor of your class of securities? How can those rights be limited, diluted or modified? Will you have a say in how your rights are modified, or is that determined by the majority stockholder?
• Dilution: What will happen when the company increases the number of shares outstanding, e.g. through another offering, employees exercising stock options or conversion of convertible bonds into stock? Are you comfortable with the potential reduction in value, ownership percentage, voting control and earnings per share? Do you have anti-dilution rights, i.e. a right to a proportionate share of any new offering to keep your percentage ownership constant? Do you want such rights, given you will have to pay more to maintain your percentage, or does it not matter to you?
• Minority shareholder status: As a crowdfunding investor, most likely you will hold very small numbers of shares in the company, and may hold non-voting shares. Are you comfortable with potentially being negatively impacted by decisions made by the majority, such as acquisitions, additional share issuances or related party transactions?
• Resale of securities: When can you resell your securities, and under what circumstances?
• Record of ownership: Does the company keep track of its own stockholders, are they using special software or paying for an SEC-registered Stock Transfer Agent (STA)? Is the chosen method reliable, considering the number of security holders the company has or expects to have as it grows?
• Valid issuance of securities: Have the securities been properly issued in accordance with the company’s governing documents? You’ll want to see a representation from the company that the shares are “duly authorized, validly issued, fully-paid and non-assessable” or that bonds or notes are “legal, valid and binding.”

At the end of your financial due diligence, you should be able to answer the following questions:

  • What is the company’s fiscal health? Is the company able to:
    o Generate cash?
    o Cover short-term operating expenses?
    o Cover long-term debt?
    o Plan for the future – e.g. pay for equipment it needs to expand, pay for additional employees required, etc.?
  • What do you think of the valuation of the company?  What is the basis of the valuation it provides, and do you agree with the assumptions?  Is the company over-valued?
  • What type of securities are you buying? What kind of payout can you expect, if any, and in what timeframe? Are you prepared to wait for a potential return on your investment? How, when, and to whom can you sell your securities? Where can you sell your securities, is there a secondary market? What are the terms of the securities? Is there a minimum purchase amount?

You should be able to review enough information to make an “informed investment decision.” If you don’t think your decision is “informed,” don’t invest!

This is the second part of a two-part series on due diligence. Part 1 on legal and business due diligence can be found here.

Huiwen Leo is General Counsel and Director of Investor Services at CrowdCheck, Inc., a due diligence provider to a number of crowdfunding platforms. More resources can be found here.

This is not legal or investment advice. Please consult your attorney or registered investment advisor for specific advice for your unique situation.

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