Wednesday 2 September 2015

Reducing risks in VC investments Part I: risk and due diligence

If only ...
Here's the first part of a two-part feature on venture capital, risk and investment, by Martin Callinan (Source Code Control) and Kate Andreeva (Protecode). This post deals with general issues regarding due diligence, which this blogger regards as a small headache that one suffers in order to avoid a heavy hangover at a later stage. The second post, which will be published tomorrow, focuses on the special issues facing anyone thinking of investing in innovative software.
What should be included in the due diligence process?
The rapid pace of innovation in the technology sector attracts both venture capital (VC) and private equity investment into UK companies, with the bulk of investment in London-based organisations. The first quarter of 2015 saw London technology smash previous funding records. The amount raised by London companies comprises 80% of all UK companies with a value of $856.7m.With the technology sector being so buoyant, investors are inundated with deal flow, which influences the way investors exercise risk assessments. Early stage investors would review a few good companies each week. With such a competitive landscape, the challenge for technology entrepreneurs is getting the attention of investors. Key to this is clearly presenting the company’s strategy. A solid business plan is important but, if the overall strategy is weak, investment is unlikely to result.
Risk versus reward 
VCs are cautious with their investment money with good reason. Generally, they take enormous risks on untested ventures which they hope will eventually transform into the next big thing. With mature organisations, the process of establishing value and the prospect of a sound investment is reasonably straightforward, as there is a track record of sales, profits and cash flow with early stage ventures, VCs will delve deeper into the business, the opportunity, and the underlying technology behind the business.

Key considerations by late round investors include
  • Management: who is the team behind the organisation and what is its track record? 
  • Size of market: demonstrating the target market opportunity which will indicate the returns investors might expect from any investment. 
  • Product quality: investors want to invest in a great product with a competitive edge that is long-lasting and sustainable. 
  • Current revenue status of the early stage company. 
  • Generation of actual and pipeline sales prior to any investment. 
  • The risks: VCs take on risk; their skill as investors is understanding all risks and making fully informed decisions for a successful outcome. 
The entrepreneur needs to understand that not all money is the same and not all funding sources are equal. The entrepreneur must carefully consider the implications which may follow from the investor and other requirements of various financing sources. Some examples:
  • Require board member status for investors.
  • Require the employment of advisors.
  • Require the creation of an advisory board.
  • Investor invests and observes, but does not play an active role.
Business risk 
The business risk investors look at will depend on whether it is an early stage investment or a late round investment. 
The skill of early stage investment funds is being able to identify the potential of a technology even if the product (today) is not right or needs significant evolution to become successful. This way allows an early stage investor to maximise its return while minimising its initial investment. 
Outside of the technology, early stage investors will view the current revenue status of the early stage company to decide which investment fund(s), if any, the company would fit into. 
Late round investors would, by nature of the investment, seek clarity in the company’s business plan, which would include:
  • Is this the right product for today and the future?
  • Is there enough money in the fund to fully meet the opportunity?
  • Is there an eventual exit from the investment, a chance to see a return?
  • What are the regulatory or legal risks?
About the authors

Martin Callinan has over 20 years’ experience in the software industry with a focus of Software Asset Management, IT Governance, and risk avoidance. He is currently the director at Source Code Control. Martin contributed to Working Group 21, the group responsible for authoring Standards relating to Software Asset Management, such as ISO/IEC 19770-1. In the past, he worked for Microsoft Limited, FrontRange Solutions, Centennial Software, Snow Software, and Express Metrix Limited.
Kate Andreeva is the Director of Solutions at Protecode and has over 15 years’ experience in the technology industry as an engineer and sales professional. With a background in electrical engineering and software development, Kate has honed her skills at companies including Performance Technologies, Level Platforms, Klocwork, and Coverity.

1 comment:

ShawnM said...

Well pointed! Indeed, venture capital is attracted by new technology because it means new opportunities and therefore new benefits. When speaking of investment there is one item that is necessary – due diligence. Today, as far as I know, the most common is data room due diligence when third party can get access to all the necessary documentation online.