the due diligence process

7/27/2019 The Due Diligence Process

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THE DUE DILIGENCE PROCESS

Nelson Gray, experienced angel investor, catches the essence of the time-consuming, detail-oriented

due diligence process in three simple questions:

So what?

Who cares?

Why you?

Be forthright because experienced investors have a sixth sense about matters, and when they find

inconsistencies and loose ends, their radar goes off and tells them that you are not giving them the full

story.

No two angels will conduct exactly the same level or intensity of due diligence, so prepare for the most

diligent angel investor. If you cannot adequately prepare for someone as important as an investor, what

will you do with customers, suppliers, or strategic partners? So get your act together and present

yourself as a capable, experienced, prepared entrepreneur.

Be open about interactions between your angel investor and your employees. One deal killer for angels

is a founder who feels able to do it all; no one is that talented nor has forty hours a day to handle every

task necessary to grow a successful company.

Many angels consider references one of the most important aspects of due diligence. Some angels will

run a background check on you and your team, so dont be surprised if they ask for your drivers license

number.

Example:

These are the main characteristics Mr. Collins will be looking for in your team:

High-quality, experienced people covering key functional areas with complementary skills. A full-time commitment to the company either now or at the time of funding. Team compatibility and fit, often resulting from team members past experience in working

together.

Agreed-to and respected systems, controls, and reporting structure. A stake in the outcome through ownership. Interests aligned with those of investors to build a great company that is highly profitable with a

strong potential exit strategy.

Coachable, willing to listen and hear input, and then integrate that information into their work. Passion.


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Mr. Collins will ask for references, possibly from a number of different sources including other investors,

customers, suppliers, bankers, previous employers, and even competitors.

Market and Technology Validation

Be willing to provide market analyst reports on your product and your marketboth must be validated.

In conducting his market and technology analysis to validate your claims, Mr. Collins will look at several

sources, particularly third-party market analyst reports. Be sure to have a complete and accurate section

on competition in your business plan.

Intellectual PropertyOwnership and Protection

Make sure you take all necessary stepsmaintaining confidentiality, filing provisional applications,

proper recordation, limiting commercialization, and so onEmployee proprietary information and

inventions agreements are a must even if you plan to patent, trademark, or copyright all protectable

intellectual property. These license agreements must be clear, clean, complete, and uncompromising.A red flag for investors is an arrangement in which the founder only licenses technology to the company

rather than assigning ownership.

Financial Analysis

Investors want to see things like these:

Financial projections that include a diversified customer base with multiple products off a broad-platform technology.

Markets being entered in a thoughtful, calculated manner, with strong support for your choiceof the first market.

A well-mapped-out process for introduction of products. Enough flexibility in your numbers and your mind to adjust your projections should an

unanticipated market show strong interest.

Board of Directors and Board of Advisers

Just as important as having outside directors and advisers is having them add value rather than just

contribute names and rsums to your documentation.

Due Diligence Red Flags

The following list does give an idea of potential red flags that can turn into deal killers:

No investment by founders: Investors read this as, I do not really believe in my idea. Numerous small investors, especially friends and family: Professional investors recognize the

need for pre-seed funding and know that friends and family are among the few potential


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sources. However, having dozens of very small investors, particularly ones who are

unsophisticated, spells a potential headache and distraction for the entrepreneur.

One-trick ponies: If your company has only one product or a single-application technology, theavailable markets are very limited and the investor is essentially betting on acceptance in a

single market.

Claims of no competition: Every company has competition. Saying you have no competitionwill cause angels to run, not just walk away.

Any portion of funds being used to cash out earlier investors or pay liabilities: Angels want everypenny of their investment used togrow the company.

Lack of participation by earlier investors (if relevant): If none of your prior investors step up toreinvest, it shows a possible lack of confidence in your company.

Prior financings have greater protection and more favorable terms: The last gold rules. Inother words, the most recent moneyin the door will expect the most favorable termsand will

notenter without them.

A history of failure by the management team: Though experience often comes in the form of afailure, investors are not interested in supporting someone who does not learn from past

mistakes.

Family business: Most angels refuse to invest in family businesses because nepotism and familydrama can create unfavorable dynamics and cause the retention of marginal performers, which

prevents real growth.

Multiple licenses required for practicing technology: Licensing involves many different possiblescenarios, from a concern that the field is already flooded to the chances of being sued for

patent infringement, making the value of your technology or product questionable. It can also

result in low realizable margins due to the license fees impact on the cost of goods.

Heavy debt: If a young company is already carrying a disproportionate amount of debt, investorswill interpret this as poor financial management skills, overspending, poor business judgment, or

some other unfavorable sign about the companys worth.

Hockey-stick growth projections: It is just not realistic to project a sudden, explosive rise invalue. That kind of success would require every assumption to be 110 percent true, the market

to react perfectly, no technical glitches to occur, and almost limitless funding to be at hand. You

need exceptional proof for exceptional projections.


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Key assumptions missing in financials: Not having considered many of the basics in developingfinancial documents can mean many thingsstarting with inexperience, poor business

judgment, and a failure to retain skilled advisers. In general, incomplete financials will cause

angels to seriously question your abilities and their interest in your company.

No board of advisers or board of directors, or only internal parties on either board: If you donthave boards with external participation, it suggests that you do not seek advice beyond your

team, creating a question of your coach ability. Remember, external board members and

advisers validate your ideas.

An entrepreneur who wants total control: In a start-up, the entrepreneur typically doeseverything from five-year strategy to answering customer support calls. One of the reasons for

raising investment funds is to hire smart people to take over various responsibilities; people

who have years of experience in their area of expertise. An entrepreneur who wants to be theultimate Renaissance businessperson will ultimately fail to meet investors expectations, either

keeping a small and interesting (but exit-proof) company or burning out and leaving the

company and investors high and dry.

Unrealistic valuation: If you are asking for a $20 million valuation on a seed/start-up and yourprospective angel is coming in thinking around $2 million, you are unlikely to have a meeting of

the minds. No matter how much you love your idea, it is still only worth what the market will

pay for it.

FINAL TERM SHEET AND RESULTING DOCUMENTS

The final terms should be a win-win. Also think about these questions:

Who is driving the investment terms?Angels generally expect you to draft the term sheet andhave your legal counsel create the underlying documents. Therefore, you will bear most legal

costs. Venture capitalists almost exclusively require that the company cover their legal costs as

well, but angels typically foot their own legal bills.

How many angel investors do you want?Mr. Collins may be quite interested in providing all thefunding you need for this round, but are you really interested in just one angel investor? One of

the many advantages of angel groups is the access to many angels and the likelihood of multiple

investors from the same groups or a couple of different groups.

What are your long-term funding needs and how does this affect decisions on early investors?Asdiscussed elsewhere, if your pro-formas call for subsequent funding rounds, particularly


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venture-capital-level funding, keep the terms relatively simple and straightforward with your

early angel rounds. Sophisticated angels will understand yourneed for creating incentives rather

than disincentives for follow-onfunding. At the same time, you need to understand that angels

areentitled to protect themselvesthey are taking a great risk on you.

In negotiating the deal, understand each of your angel investors as an individual and let them get to

know you, because angel investing is a personal decision. After all the negotiations, Make sure your

lawyer is experienced in early-stage funding and able to guide you through the document creation

process.

Shareholder and Buy-Out Agreements

Control of ownership is important in any company, and this is particularly true for professional private

equity investors. Buy-out agreements are particularly useful for companies that forecast high margins

and strong cash flow but have limited ability to realize the traditional exit strategies, an acquisition orIPO.

Deal Closing

After having gone through this entire process, one key lesson should be to plan ahead so you do not run

out of money before investors are ready to invest.

SUMMARY THOUGHTS

If you have learned anything from all this discussion, it should at least include these maxims:

Be prepared; stay two steps ahead of your prospective investors. Act professional; be professional. Recognize that investors enter due diligence with the thought of doing a deal and are looking for

deal killers.

Make sure you have a rough term sheet done before entering due diligence to avoid wastingyour time and that of the investors.

Discuss mutual expectations sooner rather than later. Dont think you can make an ill-fittedrelationship work.

Be open and honest at all times. Do not hide bad news; better you say something than the angelfind out through other means.

Angels dont expect a fully staffed company, but you should know what else you need to cover. Have the best advisory board you can assemble. Remember, angels put more stock in third-

party opinions of your company than in your own self-praise. You are supposed to be


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enthusiastic and totally committedthats passion, and essential, but it means angels will take

what you say with a substantial grain of salt.

the due diligence process

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