Sunday, December 22, 2013

New Year Resolution: Think Out of the Standard Exit Box!

Think Out of the Standard Exit Box!

New Year Resolution: I am going to try and be more lateral in 2014 when it comes to thinking about exits with the companies I am invested in and advising. So thinking out of the standard exit box!

The Thesis:

From pretty much day one startups that raise money from "strangers" (ie non Friends and Family investors, so people who want their money back ++) they need to be focused on "exit". (Well, Friends and Family want their money back too, they might not be quit so focused on it however!)

I find the way CEOs/Founder think about exit opportunities to be pretty informative. First with +/- 200 or so IPOs across the US each year (in all sectors) vs c60,000 Angel and c3,000 VC financings monetization through an IPO is really pretty unlikely. The realist thinks M&A. Second looking into the future for potential buyers means looking at the present from a market landscape point of view. 

Having a good handle on exits is important of itself, but it also tells me how thoughtful the entrepreneur is about her/his competitive environment. And crucially who has a product gap that their business might address ie fit in to/add value to. This perspective can and should also drive strategic decisions too. Simply put, with the M&A exit in mind startups need to think "acquirer value" not "shareholder value". ie what maximizes the value of the entity as seen from the perspective of a potential acquirer. In the tech space the current industry giants have been the dominant M&A players - but increasingly there are opportunities for more creative "non standard" routes to exit.

An interesting recent post highlighted that an increasingly broad range of companies is acquiring tech start ups. In her Techcrunch article Lena Rao argues that "As software eats the world, non tech corporations are eating start ups". She makes a key point that I think founders and investors should take note of. (For the record the top 5 acquirers in 2012 were Facebook, Google, Groupon, Twitter and Cisco.)

Lena provides several big data related examples. And of course mobile will continue to be a key area. A recent example - Snapette. I caught up with Sarah Paiji Co-Founder and CEO of NYC based Snapette recently and she was pleased to have closed the sale of her company to PriceGrabber in August. Snapette is a mobile app and in its own words is: "the perfect shopping tool to help you find designer fashion currently in stores near you". Acquirer PriceGrabber is a leader in online shopping discovery/ecommerce with 26mn uniques driving over $1bn in annual retail sales for its partners. BUT like many established players in most any business, even online in this case, it was lagging in mobile. So Snapette addressed that gap making the point that its not just about the big players but companies in your ecosystem for whom you provide a solution to a pressing strategic problem.

Non standard might include financial buyers. In talking about this topic with Cynthia Schames we agreed that the majority of Private Equity (PE) acquisitions are of more mature businesses with assets and cash flow that can support leverage. Still there are some that focus on the tech space ... the most significant recent example by far is Silver Lake Partners who played a key role in the Dell going private transaction. For those not familiar with them take a look at Silverlake's portfolio. Can't recall anyone having them on an Exit table, but they have big fire power for later stage acquisitions.

So a useful year end entrepreneur exercise might be to: 
A. List all the obvious buyers for your company and then 
B. Brainstorm some non obvious ones too!

The Execution: Getting it Done

Never mind posts, whole books are needed to cover the nuances of getting to and managing exits in practice. However a recently exited entrepreneur just gave me this great one paragraph summary based on their experience:

"... it's all about relationships - doing an acquisition is even more of a marriage than hiring an employee, and people need to trust the people they're allying themselves with and investing in. So I would say to cultivate these relationships early, build trust, get insights into how your product can help these potential acquirers, and possibly even do strategic partnerships with them earlier than anticipated (when it makes sense)."

And if you do want to read "The Book" on the subject then, as David Rose pointed out to me, you need to add Early Exits by Basil Peters to you Holiday gift wish list.



























Tuesday, November 26, 2013

Investing in Women Entrepreneurs ... with help from Isaiah Berlin, Hedgehogs and Foxes

While catching up with Laura Sachar, one of the cofounders of Starvest, last week I was asked: "So, why do you invest in women entrepreneurs?" and I answered:

1. I want to exploit the power of diversity 
Early stage investing is partly a numbers game. So anything that can tilt the odds in your favor seems to me worth pursuing and diversity is one such factor. The a priori chances of success in any individual angel investment are very low ... the vast majority of returns come from no more than 10% of your investments. Of course the most fundamental numbers game point that angels need to grasp is that volume/diversification are essential as pointed out in "Angel Investing by the Numbers" for example. But for me the compelling evidence that gender diverse teams make better decisions is an additional and important one of those tilt factors. (See for example the 2011 HBR Article: "What Makes Teams Smarter?") 

2. I want to invest in an under appreciated opportunity
Women entrepreneurs, and specifically women CEOs, are under appreciated when it comes to the investment process, specifically when pitching in my view. ie there is what economists could call a "market failure". So a situation where capital is not appropriately allocated to set of investment opportunities based on non rational criteria, in the sense that the level of interest in those opportunities is not appropriately correlated with the chances and degree of success. There are (sadly) plenty of examples of women CEOs describing the differentially tougher challenges they faced when raising early stage capital. See for example the stories of Erika Trautman, Kathryn Minshew, Jules Pieri and Elizabeth Yin. The male dominated nature (80% of angels, 89% of VCs, c95% of the most senior VCs) of early stage capital providers is the obvious issue here and, as I recently noted, likely means the VC community is not as innovative as it likes to think it is.

Reflecting on Laura's question some more afterwards it stuck me I could have elaborated on the reasons for this under appreciation in the following two ways:

1. Pattern recognition
StartUp land loves to talk about "pattern recognition". Summarizing how this impacts diverse (aka not young straight white male techies) founders Dave McClure succinctly put the issue as follows: 
“There’s a soft bias toward doing things that are familiar. That's white male nerds.”

At a deeper level, and in the context of women entrepreneurs, the gendered nature of behaviors (which can encompass all of verbal and non verbal communication as well as appearance) come in to play in my view. Characteristics gendered masculine  ("assertive", "decisive" etc) are more commonly associated by both men and women ... with leadership. In their HBR article and book: "Women and the Labyrinth of Leadership" Alice Eagely and Linda Carli summarize this finding, and the so called "double bind", as follows:


Study after study has affirmed that people associate women and men with different traits and link men with more of the traits that connote leadership. Kim Campbell, who briefly served as the prime minister of Canada in 1993, described the tension that results:
I don’t have a traditionally female way of speaking….I’m quite assertive. If I didn’t speak the way I do, I wouldn’t have been seen as a leader. But my way of speaking may have grated on people who were not used to hearing it from a woman. It was the right way for a leader to speak, but it wasn’t the right way for a woman to speak. It goes against type.
2. Another framing: Hedgehogs vs Foxes
When it comes to the specifics of women start up CEOs pitching their companies evidence is more anecdotal but I have repeatedly heard "the way we pitch" cited as an issue. While individual comments aren't a good basis for generalization common observations I have personally come across can be bucketed as follows: 

a) The scale of vision 
So ... just not as bold as the guys. Many women CEOs I have spoken say that they feel were disadvantaged by the way they made the case for their company. ie not emphatically calling out the inevitability of their soon to be $1bn business. Exhibit A: On the guy side of the ledger one of the founders of Rap Genius summarized the secrets to their success in the great post "How RapGenius Raised $1.8mn In Seed Funding Without Knowing What We Were Doing" stating:

"So fundraising is a psychologically trying experience that depends very little on any sober analysis of the quality of your product and much more on how you can project confidence and manage your own psychology."

One women CEO I know reported being dumb struck by some of the unsubstantiated over the top (or so she felt) claims her (male) co-founder made in their first pitch meetings together. After some discussion and reflection she said she learnt to mimic at least some of his bravado!

b) Leading with more problems and giving detailed answers
Women entrepreneurs (again some not all) report that they feel they tend to balance positives with more negatives and, perhaps as a result, feel they can give too detailed answers in a pitch context. Result: they deemed less compelling (and hence less likely to get the second meeting) compared to the other six guys the investor saw that day who were all oozing conviction and who hit any question succinctly out of the park! As one CEO put it to me:

"The detail, no matter how thought-out or on point, can often hurt you because in the vagueness it's easier to sell a dream."

Hence ... maybe another case of Hedgehogs and Foxes?
While I might be connecting too many dots here, these issues reminded me of the decision making paradigms laid out by Philip Tetlock in his brilliant book: "Expert Political Judgement". He classifies thinking styles using Isaiah Berlin's prototypes of the fox and the hedgehog with his years of study indicating that the fox (the thinker who knows many things) is more successful at predicting the future than the hedgehog (who knows one big thing). In what seems to me to be a parallel with the world of what "works" when pitching vs what works for pundits and the media he noted the perverse inverse relationship between the best indicators of good judgment and the qualities that the media most prize in pundits. ie the media loves hedgehogs for their conviction ... but they are actually the worst people to have making a prediction! So maybe women CEOs are the foxes of the pitching world and men disproportionately the hedgehogs!? Hence, just as you are more likely to get an accurate prediction in most any domain from a fox as opposed to a hedgehog, seems to me that CEO foxes are worth extra consideration too!

PS #1: Just over a year ago RapGenius raised $15mn from Andreessen Horowitz. See: "Are Rap Genius's Founders Insane, or is it just a gimmick?"

PS #2: Note that in answer to Laura I did not say either: a) because with women making 80% of purchasing decisions in the economy having a woman on the founding team ups the chances of bringing relevant expertise/experiences to bear that will enhance product development and sales/market decisions (which it will!) or b) because it's an issue of "fairness" (which it is). The point being, this investment thesis makes sense enough just framed in clinical investment process and organizational decision making terms. Add these further two considerations and the case is even more powerful.





Thursday, November 21, 2013

VC has a gender gap problem, perhaps an innovation problem too!?


I recently wrote about the NVCA/DeSantis Breindel survey that looked at the claimed and desired attributes of VCs vs entrepreneurs. (The Brand Influence Guide For The Venture Capital Industry). This intriguing study showed that there was a brand "gap" and graphically represented it through a forced ranking of entrepreneur favored characteristics vs a VC derived ranking for the same characteristics. (e.g. hands-on, supportive, trustworthy etc).

An additional important "gap" was gender based. Specifically in answer to the question: "Does the gender make-up of a VC's partner base matter to CEOs?" 1 in 4 of CEOs surveys said "Yes" ... but only 1 in 10 of the VCs gave the same answer. And2 of 3 women CEOs said the gender make of a VC's partner base mattered!

What I didn't state at the time, was that this particular result (I think it's safe to say) is a reflection of the underlying gender diversity "gap" of the Venture Capital Industry. Namely that women make up just 1 in 10 (11% to be exact) of investment professionals at Venture Capital firms as reported by the NVCA. And in terms of senior decision makers its much worse ... for example the number of women VCs listed in the most recent Forbes Midas List fell to just 3 of 100 ranked.

Perhaps this lack of diversity (and it's not just gender) is one reason VCs in aggregate do a poor job for their LPs? As I noted end last month, VCs collectively haven't beaten the S&P 500 for a decade. To be exact the data shows 1, 3 and 5 year net to LP returns lag the public markets while the 10 year record is roughly a wash.

I sit on the Board of the Center for Talent Innovation which has just done some impressive work showing the way that workforce diversity unlocks innovation - and sets out in some detail what "diversity" actually is, well beyond gender. The analysis makes the case against homogenous organizations and in favor of those where leadership demonstrates "2D Diversity".

The CTI conclusion is as follows (my highlights):

But what drives serial innovation? CTI’s ground-breaking research reveals the engine to be a diverse workforce that’s managed by leaders who cherish difference, embrace disruption, and foster a speak-up culture. Inclusive leader behaviors effectively “unlock” the innovative potential of an inherently diverse workforce, enabling companies to increase their share of existing markets and lever open brand new ones. By encouraging a proliferation of perspectives, leaders who foster a speak-up culture also enable companies to realize greater efficiencies and trim costs—another way that innovation drives bottom-line value.

You can see more about the research findings here:
Executive Summary
Infographic

You can follow CTI's work at:
@talentinnovate
and its founding President Sylvia Ann Hewlett at:
@sahewlett

Saturday, November 9, 2013

VCs pitching to entrepreneurs - how well do they connect?

What do entrepreneurs want from a VC vs what VCs think they want!?

There is just so much noise in the start up world. So many people giving so many other people advice, solicited or otherwise. So many blogs to read. So many forums, panels etc where investors explain how entrepreneurs should most effectively do this, that or the other. Some of this is well informed, some not. Being a small part of this noise generating equation myself I do my best to add value where I can, or shut up! But when it comes to what entrepreneurs value and what VC investors think they want are "they" and "we" aligned?

In answer to this question a recent National Venture Capital Association (NVCA) commissioned survey provides some hard data, which I discuss below. And I supplement this with some more anecdotal observations from the recent Capital on Stage event in New York.


FIRST THE HARD DATA: The "Brand Gap"

In a piece this past summer Russ Garland at the Wall Street Journal dissected a NVCA/DeSantis Breindel survey that looked at the claimed and desired attributes of VCs vs entrepreneurs with a view to identifying and quantifying any "brand gap" - hence the title: The Brand Influence Guide For The Venture Capital Industry

Russ noted:

"Venture capitalists like to describe themselves as “hands-on” when it comes to portfolio companies, but that’s not what entrepreneurs want to hear. While 22% of venture firm representatives said “hands-on” is a phrase that best described their firm, only 1% of entrepreneurs thought that was an important quality when evaluating a VC firm ..."


and

“Entrepreneur-friendly” was the top quality for entrepreneurs, selected by 58% of those surveyed, followed closely by “trustworthy.”


Here is the detail from this intriguing study framed in terms of a forced ranking of entrepreneur favored characteristics with the VC derived ranking view overlaid on that:



Gender: A big disconnect

In terms of other brand gap issues the survey revealed, an important one was gender based. Specifically in answer to the question: 

"Does the gender make-up of a VC's partner base matter to CEOs?" 

1 in 4 of CEOs surveys said "Yes" ... but only 1 in 10 of the VCs gave the same answer. And, urgent memo to non diverse VC teams (i.e. most of them, see some of the data in my post on VC Backed Boards), 2 of 3 women CEOs said the gender make of a VC's partner base mattered.

The survey also found that by far the most important channel cited by CEOs in terms of influencing their perception of VCs was ... word of mouth from other entrepreneurs. So if you don't get the reality of the adverse perception of your partnership gender mix with women CEOs then look out, because it's on their agenda.


SECOND SOME MORE SUBJECTIVE DATA: Capital on Stage New York

On Thursday 11/7 Capital on Stage (CoS) held their 2nd NYC conference, hosted by Goodwin Proctor ... where VCs are literally put "on stage" presenting to a room of entrepreneurs. Credit and thanks to Arjen Strijker for bringing this great event to NYC for the second year. 

At CoS, rather than just filling in a survey, here were some 20 VCs face to face with potential investees and having to present their wares one in rapid fire format. How did this face to face experience compare to the DeSantis Breindel survey? What did the VCs say they had to offer? 

Five observations

My totally personal assessment was as follows: 

1. Just because you see and opine on a lot of pitches doesn’t make you any good at pitching yourself. Many of the pitches would not have got beyond the first round of most investor pitch competitions I have been to or judged based on delivery style and content. But I guess that is another version of the "golden rule." (ie he/she who has the gold makes the rules.)

2. For those who provided some substantive rationale around their value added (beyond money), which was not much more than half, the most often mentioned items were:

  • Network/support: "we help with intros, recruiting etc.; we connect you with other investees to share experiences around challenges, successes" etc.
  • Expertise/focus: relevant domain expertise, geography, stage, diverse founders, mobile consumer vs. B2B etc.
  • Level of engagement: some talked about being “very hands on” … others stressed being hands off esp. those which, as a matter of policy, do not seek Board seats.
  • Financing advice/strategic: getting you to the next round and working the exit.

3. About a third cited some version of the “We understand your pain” talking point. ie highlighting the extent to which senior team VC members are former entrepreneurs/operators and can thus relate to the experience of their investees based on personal experience.

4. In my view only one of VCs fully spoke to the "examination question". So really focused on WHY entrepreneurs might want to work with his fund. As such he (my personal plaudit goes to Rob Go of NextView Ventures) explicitly framed his pitch in the context of “know your customer”. So laying out how his fund processes are all about his team's assessment of what entrepreneurs actually need, then ensuring relevant expertise is thus brought to bear and that there is both strong alignment and empathy along the way. 

5. One other VC, although less heavy on the empathy, also had (or more to the point actually communicated) a thoughtful analytical approach to how they invest in resources that de-risk parts of their investees’ execution challenges, thus allowing the portfolio companies to focus on business specific risk. 


Some Conclusions

Yes, having sat through CoS and discussed this issue with eight CEOs afterwards, the DeSantis Breindel data does seem to make directional sense to me. So ...

More: 
Empathy, trust, collaboration and support needed from VCs. Definitely some vision and influence too. (Neither of those last two items got a clear mention in any of the Capital on Stage reverse pitches.) 

Less: 
"Hands-on" thank you very much! (Well, a balance anyway.) 
As one CEO at the event put it to me afterwards: "I don’t want to hear “hands-on,” because it implies that a lot more work is in store for the CEO just to keep the meddling investor tightly in the loop." And explaining why the issue of trust ranked so high in their own thinking another CEO noted: "You want to trust somebody before you want him/her to get involved hands-on, which could potentially mean that they really mess things up. So trust and trustworthiness are for sure more important than activism." A third CEO set out the tension nicely with this assessment: "The "hands-on" vs "hands-off" is hard. On one hand you do not want a VC micromanaging you, especially if they are not experienced in the space you are in. On the other hand as a first time entrepreneur you want feedback and guidance. So like most anything, its all about balance." Yep: younger first time founder? Most likely hands-on!; older serial founder? Most likely hands-off!










Wednesday, October 30, 2013

VC vs S&P 500? The public markets continue to win!

The Cambridge Associates Benchmarks provide a regular health check on the overall Venture Capital industry - it doesn't make for a great story! (In recent years anyway.) My optimistic conclusion continues to be that Angel Investors, being devoid of VC level fees, have a better chance of capturing additional returns to risk ... the data seems to bear that hypothesis out on the average, although with the winners being asymmetrically distributed to those with great skill, more likely a lot of luck and certainly a well diversified portfolio!


The 2Q VC 2013 data provides a reminder that, at least for LPs and in aggregate, investors in venture capital funds are not compensated for the additional risk they assume be it operational or liquidity related.

My three high level take on this latest data is as follows:

1. VCs collectively haven't beaten the S&P 500 for a decade:
The data shows 1, 3 and 5 year net to LP returns lag the public markets while the 10 year record is roughly a wash.

2. The glory days are decades back:
For any early VC investor lucky enough to be reviewing 15-30 year returns the picture is dramatically better with substantial out performance by VC vs the public markets over that much longer time frame. This likely reflects a period when these early stage markets were considerably less "efficient" then they are now.

3. Late/expansion stage funds have delivered better results than early stage funds of late:
Over the last decade to a modest or greater degree late/expansion stage funds have continued to outperform early stage funds and indeed over 5 and 10 year time horizons the S&P. (This is an inversion of the early years of VC as revealed in this data ... looking back over all of the 15/20/25/30 horizons early stage trounced late/expansion stage and indeed crushed the performance of the broader public market indicies!)

As I noted in two prior posts:
1. Gross VC returns are better than the Cambridge Associates net of fees numbers:
Obviously this is because of the 2/20% feee structure which, on the face of its, has eaten up all VC excess returns in recent years.
2. As a set of pooled investment vehicles VC has some similar disappointing return characteristics to Hedge Funds and Mutual Funds:
The point being that all in aggregate have struggled to beat public benchmarks in recent years, keeping at least Nobel prize winner Eugene Fama happy. 

PS VC size does matter, smaller is better: As an important footnote to the aggregate VC returns discussion, John Frankel of ff Venture Capital reminded me of the Kauffman findings pointing to the concentration of higher returns amongst smaller VC funds. Again this parallels the Hedge Fund experience. ie the larger asset under management funds are holding the overall averages "down" and you are more likely to find VC funds that deliver returns that look respectable, after fees, that are sub $500mn or so.

















Tuesday, October 22, 2013

Early Stage Investor Due Diligence: A More Detailed Take On What Matters


After "Due Diligence - The Philosophy Part" and "Early Stage Investor Due Diligence: A High Level Take on What Matters" here is a a more detailed take early stage investor due diligence based on my Big Three and Then Three More breakdown:


THE BIG THREE


1) THE PEOPLE
As you research an investment opportunity it seems to me that it is essential to put a lot of weight on the people, more so than I ever did in my public equity investment research career. Startups are by definition doing something no one has done before, or certainly doing it differently. Hence predicting success is hard - and is highly dependent on the vision, energy, determination, flexibility, creativity, persistence and down right crazy obsession to succeed of the founders.

Qualitative factors matter including:
- How do they present?  
- Why are they doing this?
- What is the genesis of their idea? 
- Are they the right people to be doing this?  
- Are they persistent and passionate?  
As you explore these things one thing will become clear ... do you "like" the entrepreneur. (And vice versa.) I don't mean that you are set to be buddies, rather that you have the basis for a good (long term) working relationship.

Getting a handle on the people stuff also involves some combination of factual/accessible stuff like:

-       Resumes (and social profile) 
-       References, talk to a few if you can since these add important color to the resume - especially prior employees if they ran a start up before
-       Assess team chemistry – visit the office, do they get on
-       If it’s a co-founded team are the roles clear or could there be friction
-       Is there a CEO, you need clarity
-       Do they have a strong understanding of their business and market opportunity
-       Are they well organized and responsive
-       Do they have a grip on their numbers – crucially costs
-       Does their compensation (if any) make sense
-       Has anyone left for less than friendly reasons
-       Credentials and contribution of the BoA/BoD, if any

And you need based on your dialog and reference to judge a crucial intangible - integrity:

-       Have they met prior obligations
-       Do they have unpaid bills
-    Are they candid

Final point here is something my friend Elizabeth Crowell described to me as "observation mode". How does an entrepreneur handle a request? How enthusiastic are they when they respond? ie it's not just the answers that matter. Form is important too - observe the way an entrepreneur conducts her/himself. Elizabeth's point rightly being, this is an important human capital due diligence data point of itself.

2) THE PRODUCT
You need to assess:

-       Is there a convincing pain point/need ... making for something that it a "must have", not just a "nice to have" solution. The point being Enterprises usually have too many other priorities for nice to have and Consumers are faced with so much noise that your prospective investee really does need to have a solid product/market fit to have a chance of success.
-       Do they have a technology platform/MVP that delivers a solution to the pain point - so ideally spend time with the engineering team too
-     What more needs to be done to commercialize the product
-    Is it truly differentiated from competitors and is there some kind of advantage that will prevent other people entering market and dominating it.

3) THE MARKET & CUSTOMERS

The Market is the opportunity in the long term, customers are the reality in the here and now.  More customers in the here and now, aka traction, validates the longer term opportunity. 

So for the here and now if relevant:

- Review the customer list and customer pipeline
- Interview some actual customers – does the product deliver real value
- Do the contract terms make sense
- What does it cost to acquire customers


And for the future market opportunity:

- What is the size of the market – it really needs to be $1bn +
- Is the go to market strategy credible. This is a major stumbling block for many start ups in my experience
- How does the sales strategy scale over time and what needs to be done to achieve that
- Crucially can the CEO sell the company and the product ... because she/he initially is sales person #1, #2 and #3!


THEN THREE MORE

1) Financials


As a former financial analyst you might be surprised to hear me argue that these are not a first order decision criteria – not ahead of People, Product and Market anyway. Let's face it, any start up can hire a decent outsourced CFO to make its models better and what the excel shows in Y5 may look nice but is still ... a work of fiction! My experience is that multi year projections are so hard to make that they just aren’t worth spending a lot of time on. 


Still, the financial model is valuable as a window on the business model as opposed to the specific numbers. i.e. how do the people and product create value from the market they are address. 

As an aside here I note that some people get this from a formal Business Plan. Personally I don't ask for them and don't expect to see them. A good deck with supporting materials, yes. But a full on business plan, no. It's just not a good use of the entrepreneur's time in my view. Although, back to the point about conveying the sense of the business model ... a business model canvas can be helpful. 

On the numbers, it is important in my view to reality check the balance sheet and historic figures. This means assessing these issues:

- Does the company have basic book keeping disciplines in place aka quickbooks in most cases.

- Is there any debt or other bad stuff outstanding (look at payables and aging if possible)

- Do they have a good handle on cash (ie what is in the bank end of each and every day) and cash levers (what can be quickly dialed up or down as conditions change)

Key Question: Why do startups die?
Answer: They run out of money!’

So I think you need to be comfortable that the CEO has a handle on cash flow and can flex things as necessary as stuff happens - it always does.

2) Exit

As Brian Cohen of the New York Angels likes to say, Angels are in the Exit Business, not the Investing Business. Without the exit your illiquid private equity investment has no realizable value.

Question: What is by far the most likely exit for a start up?

Answer: M&A ie an acquisition by a larger entity usually for cash.

So as part of your due diligence it is important to establish that the entrepreneurs who you are going to have a relationship with for quite some time have "an exit mentality". That does not mean, are they building to flip. As the driving purpose that is not healthy. You want to be supporting entrepreneurs with vision and drive to create a big business ... it's just that if they make it clear they will "never sell" then that's fine. Just don't give them your money ... because you won't get it back.


I like to assess whether the CEO have a good handle on acquirers. Partly for the obvious reason but also because I see it as a corollary of thoughtful competitive analysis. Combining those two means that the CEO can build towards "acquirer value". Again since the most likely exit is M&A value maximization comes from making you business optimally attractive to specific acquirers which can involve different strategic choices than might otherwise be the case in a standalone case.


3)  IP/Patents
In life sciences the patent behind a new molecule is crucial to value. But in most mainstream tech startups patentable ideas tend to be limited and where they do exist are not a meaningful source of protection because in a software context work arounds are all too easy.

That said IP is worth getting right for future value protection, it's just not for the here and now. Some Big Tech Co infringes your patent ... but let's face it ... you don’t have the resources to defend the patent infringement anyway. I think Paul Singh at 500 StartUps has it right when he says: “Traction is the new Intellectual Property” (See p12 of his presentation.)

Unless you are a patent attorney yourself, or have a friend who is, you need will need to engage one to review existing  patents. A no cost proxy, although hardly as robust, is making sure your potential investee's patents have been filed by a well qualified person at a reputable law firm.

Early Stage Investor Due Diligence: A High Level Take on What Matters


As I described in my recent post, Due Diligence - The Philosophy Part, I  recently gave a talk to Empire Angels on the subject of early stage investor due diligence, courtesy of Graham Gullans and Christina Bechhold. I followed up with another at The Hatchery on the invitation of Yao Huang. (And will be on a panel focused on this topic next month hosted by Angela Lee for 37 Angels.)

I spent a fair amount of time at the two past sessions framing the issue of "what to do" rather than getting straight into a "traditional" check list of steps to things "to do". My key line was:

"You need to recognize who is taking the real risk here and treat them [the entrepreneurs] with commensurate respect."


High Level Process Thoughts for Investors

Respect, and to be honest good use of your own time, translate into these three high level process guidelines:

1) Be sensitive to the context and the risks the entrepreneurs are taking and protect their time
- What can you do via desk research, talking to 3rd parties, not to them!?
- Don’t keep going back again and again for stuff. Have a few focused meetings, know what you want, and keep it to that
- Be aware that there is an 80:20 rule in most things … you will likely get 80% of the answer from 20% of the due diligence effort. Gathering the remaining 20% of the info but taking a lot more time ... will likely not change your answer!

2) Focus on the key issues for the given company

- What the biggest risks? 
- Biggest opportunities? 
ie Don't get lost in the weeds.

3) Try and set a deadline and stick to it
In the end know that this is decision making under extreme uncertainty. You need to make an informed but largely gut decision. For example Charlie O'Donnell recently spoke to the fact that he makes a decision in three weeks.


Getting to the detail: The Big Three, Then Three more ...

I break the due diligence to dos into what I called the three big categories and then three more. However there are many different approaches so what follows is just a personal perspective. By way of example Brian Cohen (read more at "What Every Angel Investor Wants You to Know") separates his "do diligence" into what he calls traditional build a better mousetrap and gee wiz "lottery" plays. He focuses on identifying viable innovation and disruption. And he says his "spidey sense" is key for lottery play. i.e. gut feel on steroids!

Anyway, back to my three own plus three more. These are:

The Big Three


1) The people


2) The product (or service)

3) The market & customers


Then Three More

1) Financials – which might surprise you but I will explain in due course

2) The Exit

3) Intellectual Property (IP)
I will dive into detail on all of these in my next post.