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.

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