All money is not good money

Starting up a new venture can be a risky business. First of all, there’s the initial idea. Does it have potential? Can it find a profitable home in the market? Do you have the skills and expertise to get it off the ground?

It is understandable that for many new ventures the focus rests entirely on bringing that idea to life and bringing it to market. And, of course, to do so you need financial capital.

Entrepreneurs are constantly scrambling for the funds necessary to make their new venture work. The excitement of being offered that vital cash injection can make entrepreneurs less discerning than they should be.

The prospect of funds with its promise of a viable future for a nascent business can be tempting enough to throw caution to the wind.

Investors generally spend considerable time performing due diligence on target companies. This involves financial, market, legal and other due diligence (including making entrepreneurs take medical checks) and is essential in many cases to successful fundraising.

However, entrepreneurs also need to look carefully at potential investors as not all money is good money. Angel investment and venture capital come with strings attached, and these strings are firmly tied to the people behind the capital.

Inviting these people to play a part in your business without exercising your own due diligence can prove disastrous.

I once sat on an executive advisory board in the United States for a new medical venture. This new venture had two main investors. One was a physician who was constructive, encouraging, insightful about the market, and as a result added a lot of value to the business.

The second venture capitalist was a businessman with little experience in medicine or healthcare. He was disruptive, hyper-critical, overwhelmingly negative and impeded progress. He raised more problems than he solved and was rarely available when needed.

Eventually, the company failed. It transpired that the second venture capitalist had another investment in the same market space, in what was essentially competing technology.

The second VC’s starting position was to invest in two similar companies, planning to strike as soon as he had decided which one to back.

Once he made his choice he became the enemy within, dragging his feet to delay progress to ensure the other company crossed the finishing line first. He had no scruples about the ethics of his manoeuvrings; he was simply determined to recoup on his investment. The losers were the unlucky entrepreneurs who accepted his money.

Although this is an unusual scenario, it is not unheard of. The point is that entrepreneurs must exercise due diligence when it comes to investors to ensure that they add value to their start-up.

Furthermore, another factor that needs consideration is the ‘chemistry’ amongst the investors who will be directors. If the investors do not get along - if there is bad blood between them - then it will be very difficult to have an effectively functioning board. This is especially true where a board consists of only a small number of directors.

If board room chemistry is dysfunctional, a company’s decision making powers could potentially be undermined – a catastrophic situation for any business.

While my note of caution is that entrepreneurs should look carefully at the people behind the investment in order to avert problems before they arise, it’s not all bad news. Many entrepreneurs are not aware that they do in fact hold a lot of power.

In terms of angel or venture capital, investors often want either to have a place on the board for themselves or the power to appoint a member of their choice to ensure that they have effective oversight of that investment.

Entrepreneurs should be aware that where investors do join the board - at least in the case of incorporated companies -those directors will have certain duties towards the company and, therefore, will be subject to certain legal obligations. Although the following should not be construed as legal advice, consider these facts:

Directors in the UK have a duty of care and skill towards the company; directors are obligated to act with a reasonable standard of skill and in the best interests of their company. Directors who are negligent in the performance of their duties may be liable to the company for damage caused.

Directors also have a fiduciary duty to act in the best interests of the company; they must not place themselves in a position where they are in a conflict of interest with the company. Where a person has undertaken to act for or on behalf of a company in circumstances that give rise to a relationship of trust, the law may hold them accountable for their acts.

There are also many statutory duties, primarily under the Companies Act 1985, which, in addition to needing the skills of a legal professional to decipher, are too numerous to mention here. However, for entrepreneurs the most important are in respect of disclosure; this means that a director must disclose all relevant interests in contracts. The Companies Act also contains many remedies for shareholders against directors.

These laws apply to all incorporated companies in the UK whether they are private (ltd.) or public (PLC). I would advise for all entrepreneurs to consult a lawyer prior to accepting outside investment.

Of course, while it is comforting to know that the law can protect entrepreneurs in certain circumstances, it is better not to have to seek reparation through the courts. By that point, your business will either have suffered serious damage or have failed. It is much wiser to proceed with caution and choose your investors wisely from the outset. Accept venture capital in haste and you could be set to repent at leisure.

Professor Steve Currall is Professor of Enterprise and the Management of Innovation at University College London and Visiting Professor of Entrepreneurship at London Business School.

He is also Director of the Centre for Enterprise and the Management of Innovation (CEMI) at UCL. CEMI has developed the Technical Ventures and Foundations of Entrepreneurship (TVFE) MSc degree, a unique one-year programme designed to help aspiring entrepreneurs turn their business ideas into reality.

Launched in 2005, UCL is now welcoming applications for 2006-07 entry. For more information, go to http://www.ucl.ac.uk/cemi/teaching/index.html