Why could a recycled entity be a red flag for an investor?

Reusing established entities might seem like a good idea that saves a startup a couple of hours and some money. However, it’s a big question mark and a potential risk from an investor’s perspective. And so, while all that a startup wanted was a shortcut might essentially be an unsolvable roadblock. 

„Don’t be ashamed to look like a young company rather than a recycled entity. Pretending to be well-established isn’t necessarily a benefit: on the contrary, a myriad of problems could be inevitable,“ says Vit Hanus, Partner at ZGC. 

Due diligence threats 

VC investors usually review the potential investment and do their due diligence. According to Hanus, there are several areas they’re looking into, especially from a financial, legal, and business perspective. The first one is KYC: Know Your Client or, simply put, a set of standards that analyze the risk and financial profiles of the startup. 

Another one to remember is AML: anti-money laundering, which means investors investigate any questionable funding, illegitimate income, or financial fraud. A clean criminal record and settled taxes and debts are imperative. „The older the business or entity, the more complicated due diligence is. That means otherwise unnecessary additional effort for an investor, which we’d rather avoid,“ Hanus explains. 

Besides, it’s a daunting task to determine how old the business truly is if it’s wrapped in a package of a recycled entity with a questionable history. Investors want to know how long have the founders actively cultivated the actual idea and innovation. „How can we prove the speed of innovation in the eyes of the eventual follow-on investors when the business is ten years old on paper? It’s hard to recognize a dynamic startup when a shadow of the previous years lingers,“ says Dusan Duffek, Partner at ZGC. 

A stop sign for the EU capital 

Another problem would be the framework of capital operating within the EU. Startups can access grant money or finances dedicated to fresh products and innovative technologies. But the project’s age is consistently among the criteria. The age of the product or idea is assessed by the age of the entity itself, while spin-offs are not allowed. Therefore it’s limiting to prove that a brand new startup is hiding within a 15-year-old entity. 

Essentially, such recycling disqualifies the startups from a lot of financing, and more often than not, there’s nothing that can be done. All in all, the hopeful companies find themselves trapped with no way out.

Lastly, each investor will investigate whether the founders aren’t trying to present an already failed idea as a new project. „We’d recommend startups be as transparent as possible and avoid complications related to recycled entities. It certainly leads to smoother due diligence, and as a result, it improves the chances of the funding,“ concludes Duffek.