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Keys to Successful Venture Capital Investing: Due Diligence

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This chapter is from the book
This chapter starts the beginning of what venture capitalists (VCs) call the due diligence process. That is, it describes the steps that an investor should take in researching an investment opportunity. This is a detailed process that takes weeks—sometimes months—of work. It begins when an investor is confronted with a business proposal and must decide whether the idea warrants further investigation.

We are all presented with numerous opportunities to invest in businesses. If you are a professional working for a venture capital or leveraged buyout firm, you are being bombarded with “opportunities” from professional money raisers known as investment bankers. If you are an “angel” investor, you are being flooded with new business plans from friends and business associates. In the introduction, we discussed how we all have biases toward everything, including what we like to invest in. Now we move from biases to gathering hard facts about the business, the industry, and the team running the business. This part of the investing process is know as due diligence.

This chapter starts the beginning of what venture capitalists (VCs) call the due diligence process. That is, it describes the steps that an investor should take in researching an investment opportunity. This is a detailed process that takes weeks—sometimes months—of work. It begins when an investor is confronted with a business proposal and must decide whether the idea warrants further investigation. If the investment does make it past this initial decision process (explained in this chapter), Chapters 2–8 go into further detail of the extent the due diligence process must take.

What are the Basic Items to Look for in a Business Proposition?

There are six critical components to look for in this first stage of evaluation.

1. The Numbers Should Be Properly Presented

Everybody in the investment business lives and dies by “the numbers.” This means that the investor cannot proceed without accurate figures on a company’s past performance. Anything less than accurate and detailed (and in most cases, certified financial statements) will lead the investor into a business risk that is probably not worth the business opportunity. To repeat—no investor should make an investment without accurate historical figures.

In addition, current financial statements are an absolute must. All too often, investors are given financial statements that are ancient history. The older numbers do not reflect how the company is doing at that current moment. You should not accept any statements older than two months. Make sure the entrepreneur gives you current (either monthly or quarterly) interim financial statements, or don’t invest. Any entrepreneur who sends you poorly prepared or stale financial statements does not deserve financing.

Another thing to look for is the entrepreneur’s knowledge of the financials. You must make sure that your entrepreneur is able to explain the numbers in detail. If that cannot be done, it is a sure sign that the entrepreneur does not live and die by the numbers and, therefore, will be a poor match for you. As an investor, you must live and die by the numbers.

If an entrepreneur cannot produce accurate financial projections, he or she should hire an accountant to prepare them. However, even if hiring an accountant, the entrepreneur should still know most of the numbers by memory if he or she intends to live and die by the numbers. If you ask the entrepreneur about the financials and the answer is, “These financials were put together by my accountant and I cannot tell you why certain projections do certain things,” the small business person does not understand the numbers. This is a clear sign that you will have problems in the future unless a new member of the team is brought in to handle that side of the business.

In addition, the entrepreneur must provide accurate and detailed projections for at least five years. As an investor, you cannot assess how much money you can make without good projections. An engineer was once asked for some projections on his small business, and the VC was told that he couldn’t supply them because this involved “sheer speculation” and that engineers don’t guess about things; they only report what is known. Needless to say, the VC did not invest in his company. Projections are important because they reflect the company’s financial plan. A company without a financial plan is a company without direction.

Another point is that if the company has not reached the point where cash from sales is equal to expenses—the “breakeven”—the entrepreneur should provide you with a month-by-month financial analysis indicating when the company will reach breakeven. An investor needs to know when a company will finally reach cash flow breakeven and no longer require more investor money.

As investors, we prefer not to deal with entrepreneurs who do not understand the financial projections for their companies. A good entrepreneur must know the operating plan and the financial plan. A good manager has a deep appreciation of accounting. Managers know that, without accurate and timely information, a manager cannot manage a company. This sounds obvious, but many entrepreneurs are “concept people.” An entrepreneur who lives by the numbers is the one you want to back.

2. The Deal Must Make Lots of Money

Usually, no one has to tell an entrepreneur that the projections must go up. Every set of projections that we have ever received from entrepreneurs has the infamous “bell curve,” with everything on the income statement and balance sheet improving. If they didn’t show improvement, no one would be interested in investing. Unless the projections go up significantly, no VC is going to be interested in investing. VCs look for a return on investment of at least 25 percent, and in many situations they expect to see as high as 50–100 percent return on investment per year.

When you look at the company’s projections, you should be asking the question, What will the company be worth in three to five years? Using that projection and the earnings and cash flow of the business, one can put a value on the business at the end of that time period. Using that expected value of the company in the future, you can as the potential investor calculate how much of the company you will have to own in order to receive a return on investment that will compensate you for the risk. If the projections don’t go up significantly, the investor will have to own a very large share of the small business in order to make a significant return. Years ago, a VC did this calculation on a potential investment, and it was determined that, to make the type of return that was commensurate with the risk, an investor would need to own 150 percent of the company. It was a nice little business on a slow growth pattern, but there was little possibility of a high return for an investor. Obviously, no one can own 150 percent of anything!

3. The Acid Test of a Deal Is Management

Recently, there was an industry seminar in which some very well known VCs were asked what attributes of a potential investment opportunity would indicate that the investment was going to be successful. There were ten slots on the blackboard, and within a minute, the first six slots were filled with some phrase that had the word management in it. Over and over again, VCs say that the acid test of any deal is its management. You may have heard a real estate executive say that a good real estate investment is based on the three attributes of good real estate: location, location, location. Well, in the venture capital world, the three attributes of a good venture capital deal are management, management, management.

But what exactly does good management mean? It is very easy for an investor to blame poor management for a loss, but the reverse is also true. You can make a lot of money when management is good. Well then, what management qualities should an investor look for? Here are a few.

Honesty and Integrity

One criterion that every investor uses to test management is honesty. If the entrepreneurial team is not honest, almost “honest to a fault,” it is unlikely that the lender or VC will invest. One VC tells about touring a plant with a group of VCs and stopping for a moment to watch a lady at a drill press. He happened to ask her what she was making. She replied, “Oh, nothing. I was hired just for the day. I was told there were some big shots coming through and that I should look real busy.” At that moment, management’s credibility (and that of others in the plant) was gone. As a result of that one incident, the company never raised the money it needed. The news of its actions went flying through the venture capital community and killed all hopes of raising cash.

Experience

Every VC wants to back an entrepreneur who has extensive experience in the industry in which the business is operating. If the entrepreneur is a white-collar government worker who is going to buy a meat-packing plant, for example, the investor should have serious reservations about that person’s qualifications for work in the industry. Would the entrepreneur know how to run a meat-packing plant? We remember one of the questions that a VC asked a man who owned a meat-packing plant when the VC was fresh out of business school and filled with a new concept called management by objective (MBO). The VC asked the owner whether he used MBO to run his plant. He was a fairly burly fellow, puffing on a big cigar, and he quickly informed the young VC, “No, I don’t use MBO in my plant. I use MBI.” “Oh,” asked said the VC, “What is MBI?” This husky fellow replied, “management by intimidation.” This gruff entrepreneur knew how to work in his business. He knew that objectives were best left in the office and that MBO would not work inside his meat-packing plant. He had the experience necessary to operate the plant.

Achievement

Solid achievements in the entrepreneur’s background are a big plus. Every investor should look for achievements. The chances of success increase when the entrepreneur is an achiever. Look at the entrepreneur’s background. What did the entrepreneur achieve in college or in business? Achievers are what make the world go ’round.

During the 1950s, a social scientist studying achievers and nonachievers made some interesting discoveries about their backgrounds. The background factor having the highest correlation with the achievers was Eagle Scouts. The lowest correlation was between achievers and pipe smokers. There is a lesson here for anyone looking at an entrepreneur trying to raise money: Bet on high achievers. They have the spark that will light the fire. They want to win. They have achieved in the past and most likely will continue to achieve.

High Energy Level

What most investors look for in a management team is a high level of energy. Being an entrepreneur is tough. Every VC has the greatest respect for all entrepreneurs. Entrepreneurs work long hours. Most of us have worked only a few 70-hour weeks, and there are few people who like them. Your entrepreneur will have to be one who can accept the long hours and the grinding pace. Creating a great business is 1 percent inspiration and 99 percent perspiration.

Your entrepreneur must, therefore, be in good health and of sound mind. The entrepreneur’s health will be put to the test as the daily stress and physical exhaustion mount. Make sure your entrepreneur is a strong person with plenty of energy. The entrepreneur must have the energy to be successful. Good management will not only possess the strength to work long hours, but also will actually put in the long hours to make the business successful.

Motivation

Many entrepreneurs work long hours, week in and week out. So some of the questions a VC should ask an entrepreneur are, Why do you want to do all of this, knowing it is going to take time out of your life? Why is it you want to get involved in this difficult situation?

The wrong answer to this question is, “I want to be my own boss. My current boss doesn’t understand me. I just want to get out on my own.” Investors should not be solving the personal or psychological problems of entrepreneurs. The right answer to this question is, “It is a great opportunity for us both. If you will invest in the company, we can make a lot of money.”

Of course, there are plenty of greedy people in the world who want to make money. But it is our experience that the winners are rarely just plain greedy! Business profits are a way of measuring one’s success. Every achiever selects some standard to be measured by. A doctor measures success by the lives saved or the diseases cured, a clergyman measures success by the souls saved, and an inventor measures success by the useful inventions created. When one selects a business career, one accepts as the ultimate measure of success: a very strong, going concern with strong profitability for all parties at stake. You want to back an entrepreneur who measures success by profits.

4. The Situation Should Be Unique

One basic question every VC asks is, Why is this situation special? Every investor knows that in the business world, big businesses “beat up” little businesses. Therefore, if a small business is to survive, it must have something special, such as a patent, a proprietary process, a two-year lead time on the competition, or a good location (for example, in the case of a restaurant). What does the small business bring to the marketplace that will make people want to buy its product or service? The business must have something unique if it wants to win in the competitive environment.

At the same time, most VCs have an aversion to products that are too unique. The product or service should not be revolutionary; rather, it should be evolutionary. We suspect that most VCs would not have backed Edison’s new invention, the electric light bulb, because it was too revolutionary. Revolutionary products change the way human beings live on Earth. As a result, they take many years to gain public acceptance, and the return on investment is stretched out over such a long period of time that the annualized return on investment is too low for most investors. VCs don’t want to wait 20–25 years. Their normal time horizon is five to seven years. So the product cannot be revolutionary; it should be a follow-on product.

5. The Proposed Venture Should Be Oriented Toward the Market

Every successful business must take its direction from the marketplace it addresses. Emerson wrote, “If a man can...make a better mousetrap than his neighbor...the world will make a beaten path to his door.” Obviously Emerson was not a venture capitalist! Good entrepreneurs do not introduce a product because it is a nifty product. They introduce a product because their analysis of the marketplace shows that a new product will sell and that there is a demand for the product.

Some people praise Henry Ford for creating mass production. He should be given more credit for his market analysis. He believed that the average person would purchase a cheap, stripped-down car if it were available. Instead, most cars were like the high-priced and beautifully made Stanley Steamer or Pierce Arrow. His market analysis concluded that people would buy a low-cost, shaking, rattling, “tin lizzie.” That contraption made marketing history. It changed the way we live.

A good entrepreneur starts not with a product idea but with a vision of what the marketplace needs and wants. A market division entrepreneur loves the action of making sales. He or she is not in the lab to create a new product but to find a solution to a problem or to develop a product that people will want. Make sure you back a market-oriented company.

6. The Deal Must Have an Exit

The final element of a business proposition that every investor should look for is the exit. This refers to the way to get one’s money back, or how to cash in on the investment. All VCs look at cash flow (sometimes known as EBITDA) and how the money will come back. VCs spend a great deal of time reviewing a business situation to make sure that they will get their money back, as well as turn a good profit. The event when a VC gets the investment back with a big capital gain is called a liquidity event.

There are only three basic ways to get your money out of a small business:

  1. It can go public (this is one of the most common ways VCs reach liquidity).

  2. A business in the same industry (a strategic buyer) or another investor group (a financial buyer) may want to buy the entire business, pay off its debts, and give the existing stockholders a good return on investment.

  3. The company can simply buy out the VC by refinancing the company out of cash flow.

Although this last exit is an unusual way for VCs to make money, it happens more often than most VCs will tell you. The point here is this: Make sure there is a way out of the deal (a liquidity event) before you get into an investment.

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