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How Due Diligence can help mitigate the risk of investing in start ups

Deloitte outlines key risk areas in transactions involving start-ups

Zubeir Chikte, Senior Manager, Financial Advisory, Deloitte Africa

The Financial Times reports a boom in start-up growth, fuelled in part by the Covid-19 pandemic. Investing in start-ups is increasingly more prevalent as these companies, when successful, often cause disruption and are at the forefront of innovation. A major South African logistics group creating an innovation and venture capital fund to invest in start-ups, is one example of major corporations putting their weight and investment capital in start-ups.

Traditionally, investors have been quite cautious when considering the risks associated with investing in start-ups, preferring to much rather allocate capital to established businesses with a solid track record and growth trajectory. Due to the fast-paced changes in the market, investors are now more open to investing in start-ups, despite the increased risk attached.

Notwithstanding the increase in start-up transactions, the risk of failure is still a reality and relatively high and it is therefore important for investors to perform a tailored financial and tax due diligence prior to investing. Investors should focus on validating the key valuation drivers and understanding and mitigating the key risk areas in the business, which may impact the purchase price.

Reliability of financial information

One of the key considerations for investors is the reliability of financial information, as the accuracy of the historical financial information directly influences the forecasts and, ultimately, the valuation of the business. Depending on the age of the business, many start-ups will not have an established finance function. While this is understandable considering the limited funding and resources available, it often leads to accuracy and control issues.

Understanding the key drivers of cost and revenue

In established businesses, historical revenue growth, adjusted for known changes, is often a good indicator with which to assess forecast revenue growth. In start-ups, however, historical revenue growth is often erratic and year-on-year changes can be significant as the company starts to scale. Historical revenue growth therefore cannot be used as a measure to sense-check forecast growth. For due diligence purposes, our focus is therefore on validating key assumptions underpinning revenue that are used in the forecast. These assumptions vary from business to business and are also dependent on the sector in which the business operates.

Staff vacancies and backpay

Depending on the stage of the business and the level of cash flow available, key positions such as CFO may not currently exist in the business. It is therefore crucial to understand which of these positions are open and whether there are any plans to fill the vacancies in the near term. Furthermore, founders and other key staff may not be extracting salaries or full salaries from the business until a certain milestone is achieved. It is therefore important to understand such arrangements and the impact on the business going forward.

Superstar founder

Start-ups are typically owned, funded and operated by the initial founders. It is therefore important to determine whether the founder will remain with the entity, or exit, and what impact that will have on the business going forward.

How the business was funded previously

It is important to understand how the business was funded historically that is debt, equity or a combination of the two and any repayment terms attached.

Furthermore, prospective investors will be interested in understanding whether any convertible arrangements are in place which may lead to dilution in future funding rounds. The income tax treatment of convertible debt is a complex area. The terms of the loan agreements need to be carefully considered to determine if there are any adverse income tax consequences for the start-up and/or its investors. Special attention should also be placed on related party loans and whether these are at arm’s length terms.

Quality of net working capital

As start-ups do not have a long, established history with its customers, assessing the quality of debtors is important to understand whether cash collection risk is evident in the business.

Many start-ups will not have a provision for doubtful debts policy in place. Historical earnings and working capital levels may therefore be overstated.

Intellectual Property, Trademarks and Copyright

As most start-ups offer a new or improved product / service to the market, intellectual property ownership is an important consideration for any investor.

Permanent establishment and Transfer Pricing

There are many start-ups in South Africa that also seek opportunities in foreign jurisdictions. Invariably, the start-up employs personnel or incorporates a subsidiary in a foreign jurisdiction that will undertake activities, such as sales and marketing.

These activities could result in a tax presence (permanent establishment) of the South African start-up being formed in the foreign jurisdiction. Additionally, transactions between the South African start-up and its foreign subsidiary would be subject to the transfer pricing rules, which require that the transactions conducted between the two parties are at arm’s length.

We have identified these key risk areas through experience advising on transactions involving start-ups. Based on this experience, it is imperative that any transaction that involves a start-up is subject to, at minimum, a tailored and focussed financial and tax due diligence to understand and mitigate those risks.

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