DUE DILIGENCE

Introduction
Phase I Due Diligence – the “Minimum Requirements”
Phase II Due Diligence - Assessing Business Risks
Phase II Due Diligence – Assessing Value Drivers
One Party’s View

Introduction

The assessment of a Seed Stage or Series A Stage company is essentially in two phases:
A preliminary screening phase is used to determine whether the “minimum requirements” will be met. And if met, a more subjective due diligence.

Given the relative immaturity of these companies, the more detailed due diligence process for these early stage companies is less about assessing what they do have, and more about assessing their potential for value creation. The potential for value creation itself can be segmented into:

• understanding the strengths the company has in its favour
• assessing the risks that they will face in executing the business plan.

Phase I Due Diligence - the “Minimum Requirements”

This list of investment criteria includes:

• Company’s product is addressing a very large, global market (i.e. US$1 billion or more).
• Customers are experiencing “pain” from unsolved problem (i.e. market pull) - not just a “vitamin” (i.e. technology push).
• Customers have budgets today to pay for solutions to that problem.

• Investee has a defensible plan to reach $100 million in revenue within 10 years.
• Investee has a defensible plan to reach $20 million in revenue in a 3 to 5 year timeframe.
• Investee will reach breakeven in a 12 to 24 month timeframe.

• Investee’s technology/product is disruptive, not just “evolutionary.”
• Investee has a sustainable competitive advantage (e.g. patents), not just First Mover Advantage.
• Investee is likely 9 to 18 months or more away from commercial product.

• While the Investee likely has an incomplete management team, the Founder team is strong in their respective expertise, with real strengths in technical staff.
• Founding team includes:
• Technical strength;
• Domain knowledge;
• External/customer focus; and,
• Passion.

• Founders are open to an eventual “change of control”.
• Founders are open to devolving management control to Board and/or new management.
• Founders are likely committed to Investee, even under such changes in control.

Phase II Due Diligence - Assessing Business Risks

The very immature nature of Seed Stage and Series A Stage companies means that the business faces significant risks to challenge the management team and the execution of the business plan. While the nature of the risks is important, it is also imperative that the management shows foremost that they understand the risks. Sometimes, the proposed response to a risk is less important to an investor than having the risk identified in the first place.

In addition to determining whether all of the material risks have been identified, a business plan will be evaluated on what the intended response is to the perceived risks. Can it be removed? Can it be mitigated? And if little can be done about the risk, is it a “deal breaker” to the investor?

A risk assessment can be done in the major areas of business planning, with examples including:

Human Resource risk:
What are the quality and “horsepower” of the management team?
Is the team complete?
Does it have the best skills available for the business plan proposed?
What has been the team’s performance to date?
Has the CEO successfully started and operated a similar company before?
Are there high calibre advisors and Board members with knowledge and contacts needed to execute the business plan?

Business Strategy risk:
Is the size of a success in this market sufficiently exciting?
Have a pragmatic business plan and strategy been developed for success in this market?
What is the risk that one or several competitors will get an unassailable lead, or dominate the market early, or take some action to create a barrier to entry (e.g. securing a business process patent which prevents the company from operating)?

Technical/product risk:
Are the planned technical advances achievable?
Is the technical improvement “disruptive” (i.e. a 3x or more improvement)?
Can the improvement be protected?
What is the risk that the technology will not work, is irrelevant, or will be surpassed soon in a significant way?
Does the plan require significant technological advances before the product can be finalized?
Is the product development effort (or customer purchase decision) contingent on outsiders’ advances/success?

Market risk:
Has the market need been conclusively demonstrated?
How large is the market and how fast is it growing?
Can the characteristics of the market (e.g. customers, end-users, key influencers, channel members, competitors) be readily assessed?
Is the market accessibility and sales cycle known?
What is the likelihood that the market will not accept the product on a significant scale, or that the market need will change?

Financial risk:
How much capital will it take to fund this business to cash flow breakeven?
Will it be able to raise that capital?
How valuable will this venture be if it achieves its business plan?
How long will it take?
How will investors exit the investment with liquid returns?

Operations risk:
Will this be a complex and difficult business to run and control?
Does the team have the necessary skills to operate this business?

Phase II Due Diligence – Assessing Value Drivers

The concept of assessing a company’s “value drivers” reflects that, due to the relative immaturity of the company, one of the most important determinants of success can be whether the company can attract the next round of financing. That concept in itself incorporates a myriad of other assessments as to business risks. It also helps focus the due diligence effort on a relatively few key areas.

One suggestion as to a company’s value drivers is incorporated into the pre-money valuation model developed by Dave Berkus, an active Angel investor since 1993. Recognizing the necessity for simplicity at the Seed Stage, he developed a pre-money valuation methodology that focuses on the primary drivers for value increases between the Seed Stage and the Series A Stage.

His suggestions of value drivers offer one view as to important value drivers at the Seed Stage. Those drivers are:

• sound idea;
• prototype;
• Quality management team;
• Quality board; and,
• Product rollout or sales.

Research conducted by TA Associates, wherein they describe the characteristics of success, offers a similar view. In that research, they found that, in the big winners (i.e. >10x return of capital), the success was mostly due to good market timing and strong market growth. The success had less to do with strengths in the CEO or Board. For the medium winners, management strength was the most significant determinant. Their losers were most noted for having “missed” the market.

TA Associates concluded that their ability to assess and control success had most to do with the strength of the management team. There was not much one could do to influence market success or failure.

Table 1: Factors Affecting Venture Success

Note: Scale is 1 to 5; Worst =1 and Best = 5
Source: TA Associates

One Party’s View

In the book “Winning Angels” by Amos and Stevenson, an Angel investor offers the following list of what he looks for in a Seed Stage deal:

Must have:

• Match of interest and experience;
• Management team is A++;
• A big market opportunity, rapid growth to >US$1 billion;
• Scaleable concept, yielding revenues of US$100 million by Year 5;
• A compelling business model; and,
• Concise and convincing differentiation.

Ought to have:

• Two customers already identified;
• Draft business plan;
• Demo version of the product;
• Two to four people already involved; and,
• Entrepreneurs that know how to use advisors.

Nice to have:

• Revenue;
• Track record in this kind of deal; and,
  Good advisors.

Must avoid:

• Dishonest entrepreneur;
• Self-destructive ego; and,
  Lifestyle entrepreneur.

Ought to avoid:

• Empire builders

Nice to avoid:

• Inexperienced CEO