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.