Due Diligence Investments in Small and Midsized Companies in Kenya by Nani Mungai Introduction Kenya has seen an increase

in interest by investors in small and midsized companies both startups as well as established companies. Investments groups and clubs are all the vogue.Small and midsized companies are routinely making presentations to these groups or inviting investors to participate in private placements. Boutique private equity and venture capital firms have either sprang up or parachute in to appraise and invest in Kenyan companies. The purpose of this presentation is to examine what should be the due diligence for firms and investors that are seeking to invest in small and midsize companies in Kenya. Despite the recent events of December 2007 it is clear, from the flurry of activity witnessed as well as the deals reported in the business press, that venture capitalists and private equity firms see strength in the future potential of the Kenyan economy and its people, as well as Kenya as hub for the region. Making any investment, even in a sector/region/country where there is clear growth, still requires due diligence to determine the appropriateness of the investment. In order to examine what should be the due diligence process for firms seeking to invest in small and midsize firms, we will look at the proper due diligence process from a theoretical process. Here we look at the process that should be followed and why these processes of due diligence are important. More so in light of Kenyas stated circumstances. The First Step: Is the investment genuine? The first step in determining the appropriateness of an investment in a small or even midsized company is to determine if a company or entity is a rogue. This may seem odd, however even though most small and midsized companies are run by well-intentioned individuals who may seek to fund growth through the acquisition of venture capital or private equity there are those individuals who have other motives for raising money from investors (a recent case in point is Sasanet).There are individuals who set up a business entity and have the appearance of running a typical company. However, the reality is that these rogues are simply seeking to take money from others with no real intent to run a business. This first step of the due diligence process calls for overcoming any initial charm that from the presentation/presenters of an investment opportunity, rogue promoters tend to be smooth talkers. The investor must investigate the people running the company as well as the people behind it (not always the same people!! ), as well as the company itself. In the Kenyan context in particular it is fairly usual to have silent/invisible partners in business ventures. Since none of this information will be at the Registrar of Companies having advisors with knowledge of the Kenyan business

landscape and practices is important particularly for foreign investors. Preliminary Screening: Quantitative Evaluation The next step in the due diligence process is a preliminary screening process to determine if further detailed due diligence is necessary. Once potential investors have determined that a potential investment company is real and is in business for business, it is time to conduct a preliminary screening by looking at some basic information to determine if further due diligence is worth the time and effort. This initial screening process is really about quantitative data to make a decision about whether the potential investment shows any potential value based on what the investors desire in an investment. For example, investors might determine that they want a small company that has annual revenue of at least Ksh 30 million. If a company that is being considered for investment is found to have annual revenues of less than that amount, then continuing with an in-depth due diligence process is not necessary. In addition, investors might want a potential investment to have been in business for a specific number of years or to have a certain level of sustain customers. Again, not meeting or exceeding these quantitative criteria would render further due diligence to be unnecessary. This means that Investors should have fairly clear investment objectives and should have an eligibility criteria that incorporates the quantitative measures that they will want to look at the preliminary screening stage. The Due Diligence: Investigation and verification Once the initial screening process has been completed and a potential investment has passed this process, then the true due diligence work begins. Whereas the initial screen process involved the collection of a small amount of quantitative data, the full due diligence process requires the collection of a large amount of data about the potential investment. First, investors should acquire a complete picture of the affairs of the company in terms of how the company has been run from its inception to the present. It is important to realize that having a picture of the assets and liabilities of the potential investment is not enough. It is also necessary to know the location of the assets that are held by the company. Even more, it is important to completely understand the liabilities of the company. This means understanding the different type of liabilities that are present, such as loans or even legal actions. It also means understanding how much of the potential investment company's budget goes to paying for and handling liabilities, especially legal liabilities. Where the company has prepared an information memorandum which summarizes the key information the due diligence will be to verify the information provided but to also look at information that is not provided (an information memorandum is primarily a marketing document ,the due diligence exercise wants to go beyond the information memorandum).

The scope of the due diligence will depend on the company and its operations. It is crucial to have experienced advisors who know what to look for and where. Private equity investments in small and midsized companies by professional investors or third party investors not related or well known to the owners has until recently be minimal .The target companies tend to be family or closely held and do not keep records in an organized manner .Collating the required information is often a tedious exercise that calls for patience. Apart from the information that might be found on a balance sheet or in legal documents, the due diligence process also requires the investors to undertake establish public perceptions about the company in question. An understanding of how the company is viewed by the public, as well as the level of respect that is present for the company's products or services should be put together. At the same time, any existing relationships between the potential investment company and other entities or companies should be known. All of this information really points to potential future growth or operations that might be built off of existing operations and the background of the company in question. Analysis: Projections The next step in the due diligence process is to use the information that has been obtained about the company and its products or services to determine if there is room for future growth. This part of the due diligence process requires both information about the existing technologies or services that are present and putting that together with a plan that would hopefully result in growth . This is where investors and company leaders must come together and make decisions about where the company is headed in the future. In addition, discussions and decisions about possible research and development into improving existing technology or services, or creating new technologies and services, must take place. This is the point of the due diligence process where investors have to take what they know about the company and its technologies or services and determine if they think that future growth is possible. It is this point of the process that requires listening to the goals and ideas of the business owner or owners and their projections of the business .It also requires the investors to think about the positions they intend to take within the company if they invest. How active do they want to be in the running of the company. This is the part of the due diligence process where investors have to gauge and determine the level of commitment of the company's owners or operators to work with them if an investment is done. Lifestyle Company vs. Shareholder Value Investors should realize that a potential investment may pass all the steps of the due diligence process. However, if the current owners of the company do not have the proper attitude or desire to work with investors, then the potential value of the investment may be in jeopardy. The purpose of

investing money in a company through venture capital or private equity is to reap returns on those investments. The owners of a company may not have the proper desire or attitude that is necessary to work with investors to create the largest potential growth for all parties involved. Investors need to avoid creating lifestyle companies that generate just enough earnings to sustain the lifestyle of owner managers and pay creditors but with little or mediocre returns to inventors as this will give rise to years of fighting and disagreements that could actually hurt any changes of growth. Structure of Investment and Governance Another part of this final step in the due diligence process is to make decisions on the appropriateness of the structure of a potential investment. Many small businesses in Kenya are run by the individuals or families that started them. However the transition from small to midsized companies and in particular the roping in of external investors may require the companies to be decentralized from the original founders. This decentralization of power and authority in the company and the transition from private ownership to having investors is more often than not difficult, particularly for owners not used to challenge or being accountable to strangers. At the same time, this decentralization of power could also mean differences in how the company attracts talented workers and the type of benefits or working environment that is present. All of these variables can play a factor in the potential future value of an investment. A structure that enables a smooth transition is necessary. Think months not weeks!!! In a nut shell the above discussion of how the due diligence process should work indicates that a lot of time and work goes into the investigation of a possible company in which to invest. While the discussion might make it seem like the information that is needed for a full due diligence to take place can be acquired relatively fast and easily, this is not the case at all. It often takes months to fully investigate a company and its products and structure. This is especially true for small and family/closely held companies that may not have the same type of formal record keeping system as larger companies. Quicker turnarounds for deals will only happen where the company may have retained advisors to assist in fund raising and the advisors and the company have prepared by documenting and collating information and preparing an information memorandum. The process of due diligence is about obtaining as much information as possible so that investors can make a decision about whether they believe a company's growth potential is large enough to enable them reap the type of dividends/returns desired from their investment. In this regard, due diligence is somewhat subjective in nature. While information and data are used to make the final investment decision, investors also have to determine if the conditions are such that they feel comfortable taking the risk of investing in

a small or midsized company over a several year period. Due Diligence practical observations As with so many things, there is a great difference between theory and practical application. This is particularly true for the due diligence of investing in small and midsized companies in Kenya. Bet on the jockey not the horse Unlike more developed economies where the public domain contains considerable information, even for small and midsized companies, the same cannot be said of Kenya. Gathering in-depth information about a small or midsized company is often not possible. The reason for this, especially for a small company in Kenya, is that there is simply not enough information for a true formal evaluation to take place. Not in the public domain and at times not even within the company!!! Much of the due diligence evaluation is based on the actual owner or entrepreneur of the company. Investors have to look to see if they like the qualities of the key person(s), such as leadership ability, ideas about the product or service, and crucially the business plan that the individual has put together for the future of the company. In this regard, the due diligence process is to an extent subjective and more about how the investors feel about the person running the company and how they view his or her plans for the future and his or her ability to see those plans through to fruition. Exit: Ability and Value An important consideration in determining if an investment in a small or midsized firm is appropriate is the ease of a trade sale or now with the increase of awareness and activity in the capital markets, the ease of taking a company public as an exit strategy. The investors should be concerned with their ability to exit and to reap financial rewards in the form of an IPO or a trade sale .A shareholder agreement with clear, enforceable and robust exit clauses though crucial will be of no use if the external circumstances do not allow for an easy and profitable exit. Ability and value of exit. Risk Premium: Look for Growth Investors in small and midsized companies look for higher rates of return because they are taking on riskier investments. As such focus should be on a product or service that has growth potential, not only in the product or service but also that it is targeted toward a growing sector of the country's economy. This might be an expanding area of consumer demand or an untapped market where there is very little competition. In either case, the idea is to find a company that is directing its product or service toward those consumers where a demand exists or is likely to exist.

People are Key Investors as stated should be concerned about the leadership qualities of the owner, as well as the type of structure that is present in the company. Is there strong leadership and a robust structure to oversee the various internal functions of the organization? Conclusion If one is to invest in small and/or midsized companies it is crucial to undertake through due diligence .However in Kenya the dearth or absence of in depth information often means that the due diligence ends being a due diligence on the business owners and their business plans than a detailed review and analysis of hard facts and figures. Business Daily ,October 30, 2007 The Great Sasanet Rip-Off Which details how investors lost millions of shillings of what they thought was an investment in an ICT venture sponsored and organized as Sasanet Investment Co-operative Society Ltd.