Tuesday, April 11, 2017
Stones Unturned: An Investor’s Guide to Due Diligence in Early Stage CompaniesBy: Ham Lord, Managing Director of Launchpad Venture Group and Co-Founder of Seraf-investor.com This post originally appeared on Seraf-investor.com This article is the first in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com. Some investors will tell you after spending 60 minutes with an entrepreneur they know in their gut whether to make an investment. They rely on their instincts and sometimes their ability to “pattern match” with successful opportunities and entrepreneurs they worked with in their past. At the other end of the spectrum, there are investors who will spend countless hours digging into every aspect of a startup company. They want to feel 100% confident in their investment decision before they sign the check. Comprehensive due diligence efforts like this usually drag on for months and may do relatively little to actually de-risk the deal. What is challenging to explain is that both types of investors meet with some success, and both types meet with some failure. Because so much judgment is involved in investing, it can be very hard to know what the right amount of diligence is, and how to go about it. It turns out that picking the right level of diligence is achievable: due diligence is really nothing more than the gathering of additional facts which you can consider before making a decision. If you need to make a decision, it will generally be easier if you have some data. There is no specific amount necessary, and not all data will be directly helpful with the decision. The amount will vary by stage of company. But good data, timely and efficiently gathered, will never hurt. Our Approach to Due DiligenceAccordingly, in our roles as Managing Directors at Launchpad Venture Group, we believe in a balanced approach to due diligence. As my partner, Christopher likes to say: “We major on the majors.” Over the years and after making investments in nearly 100 companies, we designed a process that is intended to be quick, efficient and focused on the key issues which underpin the key risks. Executed properly our process can be completed in under 40 aggregate person hours of effort. Split this effort across a team of investors and you have a very fast and manageable project. Before we dig into how our process is structured, it’s important to describe the stage of company we are typically examining. We invest very early in a company’s lifespan. Usually, the company is pre-revenue, though in some cases they might have up to $1M in annual revenue. So to be clear, we aren’t talking about businesses with substantial operating histories, multiple divisions, multiple geographies, large teams or complex product portfolios. In the parlance of early stage investors, we are looking at companies during their Series Seed or Series A rounds of investment. 3 Guiding Principles of Due DiligenceOur process is driven by three guiding principles:
Let’s dig a bit deeper into each of these guiding principles so we can demonstrate how we focus our efforts and come to an investment decision in such a short period of time. Identify Key RisksAfter listening to the entrepreneur’s presentation, we caucus to discuss first impressions and immediate top of mind questions and concerns. From that we are able to distill it down and pull together a list of 3 or 4 critical areas that need further examination. These areas are usually covered to one degree or another in the investor pitch deck (e.g. customer problem, market opportunity, management team, competition, financials, etc.). Each topic area is naturally going to have a few important questions that we need to further research. For the sake of completeness, we cross-check against our due diligence checklist when forming these questions. But, to keep the process efficient and focused, our diligence team members work together to distill the list of key questions we are really trying to answer and disregard questions which will not add value in a given situation. The answers to the key questions help us identify the areas of solid ground as well as the key risks that will need to be addressed for the company to achieve a successful exit for the investors. Develop the Investment ThesisUltimately when you are forming an investment thesis, you are building a model or likely scenario in your head. An important filter that can help when assessing potential investment opportunities is sometimes defined as the Three P’s: Potential, Probability and Period. Formulating the Three P’s into questions, we have the following:
Acknowledge What Needs to Be BelievedOnce we have a handle on the key risks, and we have built an investment thesis, we need to synthesize them into a workable company hypothesis. The best way to keep yourself honest when doing this is to take the trouble to acknowledge and actually list “what needs to be believed” for the investment to make sense. Thus, when we get to the final stage of our due diligence effort, and we write up our very brief report, we make sure we know and prominently document right at the beginning “What Needs to Be Believed” or WNTBB. If an investor just cannot get comfortable that something on the WNTTB will come true, then maybe this deal is not for them. The core of the WNTBB exercise is really a test to make sure we are not fooling ourselves. It forces us to ask:
14 Key Factors of Due DiligenceNow you have a very high level conceptual overview of our Due Diligence Process. To make it fully understandable, and more importantly, something you can actually practice, we need to delve into more detail. With this series of articles our goal is for you to better understand the types of questions we ask, major risks that concern us, and how we structure our deals to work well for founders and investors. Over a series of articles, we will take an in depth look at the following:
This is a lot of material to discuss... and to master. I am sure many of you are wondering how it’s possible to cover all these questions in a short, concise due diligence effort. Trust us… we’ve executed this process dozens of times over the past few years and it works! Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com. Tags: |