Investing

For Investors, The Key to Crowdfunding Success is Due Diligence

Huiwen Leo | July 26, 2016

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Thanks to the JOBS Act, average Americans can now invest in startups and small businesses, including companies raising funds under Regulation Crowdfunding (Reg CF) and the revised Regulation A. This is new territory for investors, who may be wondering, What should I consider before investing?

Are you the right person for this investment?
A key consideration is your tolerance for risk. Investing in startups is risky business. Startup failure rates vary by industry, one study showed the percentage of startups still operating after four years to range between 37% and 58%. Are you prepared to lose your whole investment? Even if you don’t lose the investment, it could be several years or more before an exit is available, and your return on investment is not guaranteed.

Another thing to be aware of is that different investments have different requirements of their investors, in terms of who can invest, and how much. Offerings under Tier 1 of Regulation A are open to all investors and have no investment limit. Offerings under Tier 2 of Regulation A are also open to all investors, but include investment limits for non-accredited investors. Regulation CF offerings are open to all investors after they show they understand their investment, and are limited in dollar amount. Regulation D offerings under new Rule 506(c) are open to accredited investors only, i.e. you must have a net worth of at least $1,000,000, excluding the value of your primary residence, or have income at least $200,000 each year for the last two years (or $300,000 combined income if married) and expect to make the same amount this year. These limits are currently under consideration and may change.

So how can investors reduce their risk?

Due diligence. This is the investigation that an investor does before making an investment, to evaluate the disclosure provided by the company and consider whether the investment is sound. Seeking to avoid fraud is obvious, however as mentioned earlier, startups are risky and many fail even if everyone is well-intentioned. You can do your own due diligence, or rely on someone else to do it. (Our company, CrowdCheck, is an independent due diligence provider to a number of crowdfunding platforms and produces reports that outline the results of our legal due diligence).

What should you be looking for when you do your due diligence? In this article, we’ll look at the legal and business aspects of due diligence. In a second installment, we’ll cover financial due diligence, assessing valuations and terms of securities. Through a combination of your own work, reliance on the investment platform and information from third parties, you should be able to make an “informed investment decision.”

BUSINESS DUE DILIGENCE
Business due diligence is fairly straightforward: you want to feel comfortable with the company’s business model and prospects, and the people running it. Do you agree with the company’s business plan and the assumptions it is based upon? Is this a product or service that you would use? What would you pay for this company? Do you think the business will grow? Does management have the right mix of experience and skills to execute the business plan to its full potential? (It also helps to keep in mind the old adage, invest in what you know.)

The following is a broad overview of business due diligence.

Business plans include items such as:

– Plans: What are the company’s current and planned operations? Do you agree with the projections about future results, and the underlying assumptions?

– Competition: How does the company plan to cope with competition? Who are the company’s existing competitors? What are the barriers to entry for new competitors? How does the company differentiate itself? Do you think the plans are achievable by this company? Do you think the company can maintain its lead on its competitors?

– Use of proceeds: How is the company planning to use the funds raised? Is the amount sought reasonable considering the company’s goals, e.g. purchasing new equipment, project development, costs of crowdfunding, etc.? Do you agree with the priorities the company is placing on the use of proceeds? Is the company specific enough about what it plans to do with the funds raised?

Operations include items such as:

– Customers: Who are the company’s major customers? Is the company over-reliant on a particular customer? What will happen if the company loses that customer?

– Suppliers: Who are the company’s primary suppliers, raw materials and vendors? Are they reliable? What happens if the supply of raw materials is cut off or a manufacturer fails to deliver under its contract? What are the company’s alternatives?

– Lease: Does the company need to lease any space? Is the company’s factory or other space adequate for its current and future needs?

– Insurance: Does the company currently have any insurance? Is the insurance that the company has sufficient – does it cover what the company requires by law, e.g. worker’s compensation? Does the company have any expensive assets that need property insurance? Is the company reliant on one person, so a “key man” insurance might be required?

– Material contracts: Does the company rely heavily on a particular contract, e.g. a technology license or a franchise agreement? Are you able to review the contract? Does it have any unreasonable terms, e.g. excessive fees, length of contract terms, exclusivity or non-compete clauses?

Products or services include items such as:

– Products or services: Have you tried the company’s products or services? Do you like it? Is there a demand for it? Is it priced appropriately?

– If the company is local: Have you visited the company’s location, if possible? Are there people working there?

Management team include items such as:sherlock-holmes-147255_640

– Who: Who are the key players in the company? Is the company dependent on one person who plays multiple roles? What will happen to the company if the key person leaves? What are the relationships (e.g. friendships, relatives) between the key players such as founders, directors, officers, major shareholders, advisors, key employees, etc.?

– What: Did the platform or any due diligence provider perform background checks or “Bad Actor” checks? Was there any derogatory information that emerged? How long has management been with the company? Are there any plans to change management? Has key education or employment information been verified? Does management have any startup experience? If so, were the previous startups successful, or at what stage did they flounder?

– Key persons’ employment relationship with company: Are there formal employment agreements? Is there a non-compete clause (i.e. if a key person leaves the company, they are not permitted to work in the same industry for a certain period of time, usually a few years), and an assignment of intellectual property clause (i.e. any inventions or trade secrets that the employee develops while working with the company, belongs to the company)? Are there any unusually large payments when a key person leaves the company, such as any excessive severance provisions or golden parachutes?

– Employee and management compensation: Who determines the amount and type of compensation for senior officers? Is there an arm’s-length arrangement? Are there bonus payments, and how are they determined? Do management incentives align with the good of the company?

– Related party transactions:  What are the relationships between company officers? Are there any transactions, e.g. leasing space, purchasing goods and services, from a relative of one of the controlling persons? If so, is the transaction at “arm’s length”, i.e. at market rate or less?

LEGAL DUE DILIGENCE
When a company goes public, Wall Street underwriters typically handle the legal due diligence function. But with crowdfunded investments, it’s mostly up to the investors (although the crowdfunding platform will do a basic level of vetting, such as weeding out “Bad Actors.”) Legal due diligence tends to be the most tedious part of due diligence. You can do your own due diligence, or rely on a third party like CrowdCheck to do it.

Related: The Basics of Financial Due Diligence

Legal due diligence involves items such as making sure that the company is properly incorporated (i.e. that it legally exists), that actions are taken in the name of the company (and not personally by the founder, a frequent oversight but potential problem should the founder leave the company), and that the company has taken the necessary steps to issue the securities it is offering. It also means checking that the company has taken the steps necessary to be able to protect its business, like registering its intellectual property.

A broad overview of what to look for in legal due diligence includes the following:

Corporate information includes items such as:

– Proper incorporation and good standing: Has the company has filed all paperwork and fees required by a jurisdiction?

– Corporate form: Is the company a “C” corporation or an LLC? How is the company governed and who makes decisions?

– Agent for service of process: Who will you contact if you need to sue the company later on?

– Bylaws or operating agreement: Have the decisions made previously by the company (e.g. appointment of directors, previous capital raising, etc.) been in compliance with the company’s internal corporate governance?

– Minutes of meetings of board of directors or managing members: Has the company documented its decisions, and have those the decisions been taken in accordance with the company’s internal governance policies (e.g. unanimous written consent, majority vote, etc.)?

Operational information includes items such as:

– State and local registration, relevant permits: Has the company obtained the relevant permits and registrations required to carry on its business?

– Website ownership: Does the company own the rights to its website, or do the founders (a problem if the founders leave)?

– Separate bank account: Does the company have a separate bank account in its own name? Will the funds from any investment you make go into the company’s bank account or the founder’s account?

Potential liabilities include items such as:

– Litigation: Is the company involved in a lawsuit that may impact the potential value of the company?

– Bankruptcy: Is the company currently in bankruptcy? Has it previously been in bankruptcy?

– Taxes: Has the company filed its federal and state taxes?

– Liens: Does the company have any liens on its property or assets?

Intellectual property includes items such as:

– Patents: If the company has patents, does it own such intellectual property in its own name? Have the inventors assigned the patent to the company? Is there an assignment of patents to the company in the employment agreement?

– Copyright and Trademarks: Has the company filed for trademark or service mark protection of the names and logos that are important to its business?

– Licenses: If the company is licensing technology or designs, are the terms of the license appropriate? Will the company be able to use the license for a sufficient period of time? What happens if the company loses its license?

– Intellectual property audit: Has the company assessed all its non-physical assets and considered what patent, copyright and trademark protection it needs?

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

  • Is this business a fraud or are any of the people involved fraudsters?
  • Are the claims being made by the company fraudulent? Even if well-intentioned, are the claims overly optimistic, or reliant on assumptions that you may not agree with?
  • Does the management team have the right mix of experience? Are they working for the benefit of the company, or to enrich themselves? Is this company organized to be able to deliver upon its potential? A great business idea can be totally undermined by poor execution if the company has dysfunctional management.
  • Is the idea for the product or service a good one? Will people want to pay for it? What are the company’s growth prospects?
  • Is there competition and can the company cope with the competition? What are the barriers to entry for new competitors to emerge?
  • Has the company protected its assets, e.g. insurance, intellectual property protection, etc.? Is the company embroiled in any litigation or tax disputes that could take up all its resources? Does the company have all its legal bases covered – having the required permits, having a separate bank account, etc.?

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!

Stay tuned for a second installment covering financial due diligence, assessing valuations and terms of securities.

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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Comments

  1. Thanks Huiwen,

    As someone with a lot of contact with crowdfunders here in London through my work with FinTech valuation platform: AlgoValue; am very concerned that even professional investors are unaware of how to evaluate risk and very much like CrowdCheck and actively recommend to my network.

  2. For most inexperienced angel investors, those who will be attracted to Title III (Reg CF) equity crowdfunding, due diligence is not practical. Investment decisions will be mostly based on social considerations, not return on investment or liquidity. The minimum investment for most Title III offerings is $100. Very few “new” angels are going to devote time to conducting thorough due diligence for a $100 investment. They’ll care more about the founders, the social impact of the startup, community development, and “coolness.”

    Socially motivated angel investing might not help build a stable market for crowdfunded securities. But it’s the reality.

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