Due Diligence and Early Stage Companies

“Surprise, surprise, surprise” – from Gomer Pyle USMC – played by Jim Nabors

I have had the privilege of being involved in due diligence activities (both buy side and sell side) for dozens of companies of all sizes. I had the chance to blog (November 2013) about being prepared for due diligence citing one of my favorite Monty Python sketches, “No one expects the Spanish Inquisition.”  That wasn’t just some pithy quote – a number of my clients used that analogy when describing the diligence process they were going through. However most were established companies with some history for a buyer to digest.

We have now been through quite a few due diligence exercises with very early stage companies. Many think it is a quick process; just answer a couple of questions and then wait for the check to clear. But surprise, surprise, surprise it is a bit more intense than you would expect. Compound this with how off point many of the diligence requests are and the process really gets convoluted.  I recently became involved with one startup that was being acquired and had been in business a little over two years. The potential purchaser’s diligence team requested the last 5 years’ tax returns and the entrepreneurs (taking the request literally) were in the process of getting together their personal tax returns for the earliest three years.

So, what do (or should) investors focus on when doing diligence on an early stage company? I would highlight five areas:

Management team – we always suggest looking at the team both current and future. Do the key leaders know what they have and what they need to get to the next level?

Dashboard report – what has the team laid out in terms of what they are focused on? Burn rates, the competition, a detailed plan to get from MVP to sustainable product and KPI’s are all key aspects to assess.

Traction – I do not just mean unique visitors to a site but customers or near term prospects who will buy your product or service. If you are selling to end users, it’s easy – how many swipes do you get and what is the trend. If you are selling enterprise level software, the sales cycle is longer and the question is how well do you know the status of each pursuit?

Equity – a complete cap table including options, promises and any “winks and nods” for future equity. If there is no equity plans covering employees or future key team members, that is also a red flag

Owners’ mindset – just like mature businesses I often see deals crater over sellers’ remorse. While subordinated notes have allowed all parties to “kick this can down the road” are owners ready for partners or to sell outright?

CPA’s are often retained to complete due diligence but for accountants used to financial data analysis, this type of diligence is not comfortable.  Other than tying down revenue, there is little they feel they can do. So, if you are in a potential deal and sense the acquisition deal team has the wrong focus, don’t be afraid to let the purchaser/investor know.  For many, this is still somewhat virgin territory.  Be prepared.

Teamwork – No Successful Entrepreneur Should Leave Home Without It

“We got the tools; we got the talent.” – Winston Zeddemore from Ghostbusters

I am often asked what makes one company more successful than another.  Many think it is the uniqueness of the product or the ability to obtain financing that results in success.  I am going to draw upon three decades of comments and discussions with Venture Capitalists to help form my point of view.

It was the early 1980’s and I was at Arthur Young.  We had started to focus on high technology startups and, in fact, our San Jose office had been formed to focus solely on this market (Apple and Genentech were early clients.)  We had a national meeting of about 70 people – including a group that probably represented a majority the Venture Capitalists in the country.  One of the partners from Welsh Carson was doing a presentation and we were all anxious to learn how this very successful firm selected the best technology prospects in the world.  The Partner said that was easy.  The first 5 things they looked at were management, management, management, management and management.  Pretty clear message.

In the 1990’s I had a chance to attend some sessions with the brilliant strategist, Brian Quinn, from Dartmouth as part of the Tuck Executive Program.  We were discussing successful strategies in what was (and always is) an ever-changing world.  Brian consulted with many VC’s and, based upon his experience, had one key piece of advice; without a successful management team, most strategies were doomed to execution failure.

A few weeks ago, I was at one of our favorite spots, the ER Accelerator in New York.  I was talking with the team there regarding their selection of participants for the upcoming session they sponsor.  So, what was their focus?  It was simple; a solid team and a fair product trumps a good product and a fair team every time.

Growing and maintaining a successful company requires a good team; that is obvious.  As the leader, the burden is on you to recruit the right people and, more importantly, to not allow a true non-performer to remain because it is too difficult to part with a friend.  So, a few ideas to consider:

  1. Never be afraid to hire someone onto the team who is smarter than you (or the other team members.) There is something to be said for having the best athlete on your side.
  2. Chemistry rules but conformity is destructive.  Don’t avoid having someone on the team just because they may not be like the rest of you.  I counsel with a number of very talented individuals who, at times, do not maximize their contribution because they feel they are left-handed people in a right-handed world.
  3. Get input from junior team members on selection.  I have had the chance to be the one in charge and have rarely hired a person when my administrative assistant or a junior staff member felt it was not a good fit.  That unfiltered view can be extremely valuable.

Recruiting the right team members is one of the most important contributions a leader makes.  Keeping the team motivated and working as one unit (once they join) is probably a close second.  Spend the time on these important tasks and have the patience to develop your team so you can help ensure your company will be a success.