Angel Investors: Are They Flying Blind?

Investing in private companies is risky at the best of times. When it comes to start-ups, the risks can be huge.

At a recent meeting for investors in early stage companies, I listened to a report by the CEO of a local VCC fund. The portfolio of investments included more than 60 companies, only 4 of which were nearing exits. A large number of these investments were made between 2004 and 2006.

When I asked about the availability of financial information on these companies, the CEO of the fund admitted it was challenging to get any kind of financial reporting from their investee companies. As a prospective investor in the fund, this surprised me. I would need access to detailed financial information about the portfolio companies before investing.

VCC investment funds should enforce a little rigour around financial reporting for their portfolio companies. There are clearly a number of benefits around improved reporting for these companies:

  • Better and more timely management information for investors and management (earlier identification of risk)
  • Much faster turnaround of SR&ED claims for technology companies
  • Makes companies more attractive for take out by later stage investors
  • Reduced due diligence costs for later rounds

How to Get  Financial Info from Portfolio Companies?

Investors in early stage companies should have the upper hand when it comes to demanding financial reporting from portfolio companies. It is damned hard for start-ups to raise money outside of their ‘friends and family’. For many, that won’t take them very far.

The best time to get commitments to regular financial reporting is before the investment takes place.  It starts with realistic valuations. In my view the valuation methodologies being used in BC are much too generous – especially for seed stage companies. Investments in start-ups should be phased – even if that means paying back tax credits.

Let entrepreneurs earn ‘sweat equity’ when technical and financial milestones are met. This should force entrepreneurs to provide better reporting to investors. If it doesn’t, investors should be concerned that things aren’t going well.

If companies that don’t voluntarily comply with demands for better financial reporting, they can be effectively pressured by shareholders to do just that.  Companies registered under BC or Federal statutes are required to provide audited financial statements to shareholders:

Example fron BC’s Business Corporations Act

“Waiver of financial statements

200  (1) Directors are relieved from their obligation under section 198 to produce and publish financial statements

(a) if all of the shareholders of the company, whether or not their shares otherwise carry the right to vote, resolve by a unanimous resolution to waive the production and publication of the financial statements, or

(b) if and to the extent provided by a court order waiving the production and publication of some or all of the financial statements and on any terms the court considers appropriate.

(2) A waiver referred to in subsection (1) of this section may be given before, on or after the date on which financial statements are, under this Division, required to be produced and published and is effective for those financial statements only.

 

The cost of an audit for non-compliant companies may be prohibitive – particularly if the records are a mess. In some cases the mere threat may be enough to motivate recalcitrant entrepreneurs to cooperate.

 

Published by Rob Farrow

accountant, entrepreneur, former chef, occasional artist, angel investor, business advisor, corporate tax specialist

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