Due Diligence: The Litmus Test for Angel Investors

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Due Diligence The Litmus Test for Angel
Investors
Presented By W. Daniel MothersillPresident,
National Angel Organization
In conjunction with NOEG and Ontario Centre of
Excellence
September 2006
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Why Due Diligence?

• The net sum value of a killer idea, product,
  service, science or technology is zero unless it
  can be translated into a profitable scalable
  business.
• W. Daniel Mothersill
• Thats the function of the due diligence process.
• Can the great idea be successfully
  commercialized?
• Can the management team deliver?
• Is the innovation sustainable, scalable, and
  potentially profitable?
• Can it return at least 3X on the Angel investment?

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Horror Story

• Founder was a shady operator, stuck other
  investors
• Did not totally own the technology to chain of
  title
• Market demand had passed for browser technology
• Lots of name-brand technologies
• Morphed the investment to another company
• No safeguards in place

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Where it fits in the Angel Investment Cycle

• Application submitted
• Forms available on website

• Investment managed
• Further rounds negotiated
• Successful exit

• Working committee screens
• Picks to 2 or 3
• Communicates deficiencies

Angel Group Deal Process

• Term sheet developed
• Negotiations undertaken
• Investment made

• Content template provided
• Presentation coaching (mandatory)

• Potential syndicate formed
• Site visit concluded
• Value proposition discovered

• Working committee reviews
• Find presentation
• Suggests changes

• Critique by the group
• Expressions of interest
• Due diligence team formed

• Companies present
• 3-4 dinner meetings
• 2 breakfast meetings

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Due Diligence a four-part decision process

• 1) Gut check do I want to do business with the
  founder(s)?
• 2) Do they have the ability to build a
  team/advisory board?
• 3) Do they have a scalable business that can be
  translated into a profitable business within the
  next three-to-five years?
• 4) Can the company get to commercialization
  without being squashed by the competition?

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People First

• Bet on the people before the product, technology
  or service.
• A disruptive technology will die a short and
  monetarily painful death unless it has the right
  people to commercialize it.
• A first rate management team with a second rate
  technology or product always prospers over a
  disruptive technology and a couple of geeks in
  the lab.
• Sony VS Beta.
• 60 percent of your financing decision is based
  on the team

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Team Components

• Business Acumen
• Domain Knowledge
• Operational Expertise
• Financial Savvy

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Team Components (cont.)

• Business Acumen
• Who on the team has run a successful
  entrepreneurial business?
• Have they only managed in large corporations?
• What business-related education do they bring to
  the venture?
• What proven business success do they offer?
• How do they propose to build the team? What
  resources do they believe are required?
• Can they supply references?

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Team Components (cont.)

• Domain Knowledge
• What experience have they had in the industry
  sector?
• What is the depth of knowledge re that vertical?
• In what capacity did they function?
• Did they have significant responsibilities?
• How well do they know the competition and can
  they list them without hesitation?
• Can they supply references?

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Team Components (cont.)

• Operational Expertise
• Do they know how to get product out the door?
• Are they big picture or practical?
• What experience do they have putting processes
  and systems in place?
• What industry-related experience do they possess?
• What is the level of their sales management
  expertise direct VS channel?

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Team Components (cont.)

• Financial Savvy
• Can they set up and maintain solid financial
  records?
• Do they advise management on such financial
  matters as DSOs?
• Are they capable of putting together detailed
  financial projections?
• Can they manage the process or are they just
  bookkeepers?
• How familiar are they with GAAP?
• What is the level of their formal training?

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And Theres More

• The Angel or Angel group is dealing with immature
  companies.
• Fully scoped out management teams are seldom in
  place.
• However, from the advisory board, can the
  business plug holes in the team until revenues
  will allow for an appropriate level of staffing?
• What is the role that the Angel investor can play
  in mentoring the company to profitability?
• A good test is to determine if the company wants
  more than money from the Angel investor.

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The Deal Killer Founderitis

• The Angel group must determine immediately if the
  founder(s) suffer from this affliction.
• Will the founder relinquish control to a more
  experienced individual if required?
• Or will the founder hang on to the title and
  drive the enterprise into the ground?
• What participation will the founder tolerate from
  Angels or the board?
• Is this a group effort or a one-person show?
• If the enterprise suffers from Founderitis run
  from it

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Personal Checks

• Check out the founders and senior management
  teams for
• 1) Criminal records
• 2) Past bankruptcies/business failures
• 3) Credit score/trade references
• 3) Supplier references
• 4) Past employer references
• 5) Third-party references
• 6) Educational references (often overstated)

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And finally

• Do they have skin in the game or is it all just
  sweat equity?
• Have they mortgaged their homes, exhausted their
  savings, maxed their credit cards, and sold their
  children for medical experiments?
• Are they assuming that the Angel investor will
  assume all the risk?
• Remember the value of sweat equity is zero.
  Thats what entrepreneurs are expected to
  contribute.

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Now to the Product/Technology/Service

• Is the company focused on providing a solution to
  a large pain in the market?
• Is the market timing right for this solution?
• Can they readily state the pain and solution in
  laymans terms in a few short sentences?
• Can they state from recognized third-party
  sources what the size of this market is in dollar
  terms?
• Is this market a local play or does it have at
  least North American applications?
• Does the company want to go offshore before the
  application is proved out locally?
• Is their solution technology push or market pull
  -- a great idea or something for which there is
  demonstrable demand?
• Is there any expertise or appetite within the
  Angel group for the business the founder is
  proposing?

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Product Development

• At what stage of development is the solution
  bright idea, research development, Alpha, Beta,
  commercialized, growth?
• Does the company have the potential to be a 50
  million operation within the next five years?
• Is there enough market demand for it to be a 100
  million organization?
• Will it achieve profitability within the next
  12-to-18 months?

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Funding

• How much money in total is the company seeking to
  achieve profitability?
• Will the founders accept tranched/milestone
  deliverable funding?
• What additional funding requirements does it
  foresee?
• Will the Angel have to cope with successive
  rounds of follow-on financing with VCs.
• Does the organization have enough public market
  appeal to become a CPC traded on the TSX Venture
  Exchange?

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The Business Plan What to Look For(the devil is
in the details)

• An executive summary of no more than 4 pages
• The body of the business plan that is 20 pages
  maximum
• All references are supported by recognized third
  parties lots of footnotes and appendices
• The plan is written in English not in acronyms

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The Business Plan Major Elements

• Pain/Solution statement the elevator pitch
• Mission statement that outlines the vision of the
  company
• The market
• The business strategy dynamics of how the
  company will grow, the kinds of people it will
  attract the types of strategic alliances it is
  seeking
• Product/technology/services description what it
  does or briefly how it does it. This should paint
  a picture of what the world looked like before
  the introduction of the solution and what it
  would look like with the product introduction.
• Management team/board of advisors short bios
• Go-to-Market strategy Market size direct or
  channel or both
• Competitive analysis
• Risk assessment market, technical, financial
• Five-year pro forma financials
• Exit strategy does management plan to grow the
  company to a size that will provide the Angel
  with an adequate return or is a quick flip
  planned?

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Pain/Solution Statement

• Anyone can tell you what they do in a five-minute
  monologue.
• What an Angel investor wants to know is whether
  the entrepreneur is focused and can position the
  company in four or five key sentences.
• The founder should be encouraged to start with
  the pain that the enterprise addresses and why
  there is real demand in dollar terms for his
  solution.
• Then, and only then, should they tell you what
  the solution is and why it proposed to be the
  best.
• Push the entrepreneur until they can articulate
  in this format

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Mission Statement

• This statement goes beyond telling you what the
  company does, it outlines what the enterprise
  wants to be.
• It allows to Angel to understand if there is
  passion and commitment to build a substantial and
  meaningful organization.
• To be the number two in the beer industry by the
  end of the 1990s. Coors
• To establish Merck as the preeminent drug-maker
  worldwide. Merck
• To gain technological sovereignty in digital
  telecommunications switching. -- Nortel

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The Market

• This section must provide a detailed discussion
  of the market that the company is addressing.
  The Angel must be convinced that the company has
  an in-depth understanding of who it selling to.
• Topics that must be covered
• Target market and who within that market are
  there buyers
• Market segmentation demographics, regions,
  trends
• Total size of the addressable market and the
  companys projected market share
• Barriers to entry
• Market influencers technology, economy,
  government regulation.

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The Business Strategy

• What is the current and potential size and scope
  of the business organization?
• What are the detailed mechanisms in place to
  track milestone accomplishments?
• What is the role of business alliances in growing
  the business?
• What functions are key to success in the short
  term?
• What resources will have to be added as the
  company grows?
• What are the levels of monetary compensation
  anticipated?
• What other forms of compensation/benefits are
  planned?

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Management Team Organization

• What are the key positions in the company, their
  responsibilities, and how they relate to each
  other? (An org chart should also be provided.)
• Has the company covered all the vital roles
  leadership, sales marketing, technology
  (product development implementation), finance,
  human resources, administration support?
• Is there a formal plan in place to develop and
  strengthen the management team?
• What is the formal role of the board of
  advisors/directors and consultants?

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Technology/Product/Services

• What is the product how does it work what does
  it do?
• What are the key advantages technological,
  service, other?
• Is this a platform technology with a number of
  vertical applications?
• What is the primary application, and for what
  market?
• What are the other products and verticals, and
  the timing of introductions?
• Where is the product or service in the RD cycle?
• What are the key product delivery milestones?

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Go-to-Market Strategy

• Lack of an executable sales and marketing
  strategy is the principal weakness for startups.
• The technology and products are often well
  thought out, but targeting the right customers
  and capturing profitable revenues often fall
  short of expectations.

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Go-to-Market Strategy (cont.)

• The Go-to-Market portion of the business plan
  must include
• The operational expertise on the team
  responsible for execution
• A review of the sales cycle
• Outline of target customers
• Sales approach direct/channel
• Sales tools
• Marketing the vehicles employed to raise
  awareness and stimulate buying
• Trade shows, direct mail, promotions,
  presentations, brochures
• Sales breakout of sales staff/channel partners
• Customer support resources and tactics to keep
  customers onside
• Budget what percentage of revenues/funding are
  allocated to sales/marketing

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Go-to-Market Strategy (cont.)

• Are concrete sales and marketing objectives laid
  out for the next three-to-five years?
• What are the key marketing messages that provide
  differentiation from the competition?
• What are the principal attributes of the product
  or services?
• Is price the main differentiator? What is the
  pricing of the offering?
• Where do the sales team need to be place
  geographically?
• Who will handle contract negotiations?
• What is the billing and payment model?
• Are there product line extensions to the existing
  customer base?

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Competitive Analysis

• Who are the competition direct, indirect, and
  status quo?
• What does the company do that is better, faster,
  more technology rich, etc? What are the main
  competitive features?
• What are the main characteristics of each
  competitor?
• What are the advantages and disadvantages of the
  company compared with each competitor? Consider
  not only features but benefits, distribution
  methods, and price.
• Is there an 800-pound gorilla?
• In examining status quo, what will take the
  customer to move from business as usual to buying
  the companys solution?

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Risk Assessment(the acid test for the business
plan)

• What are the major risks?
• Are they listed in priority? High, medium, low.
• What can be done to minimize these risks?
• What is the impact of these risks on the future
  of the company?
• What is the mechanism of process that will
  provide an early warning?
• What is being done in the planning to lessen the
  impact of the risks?

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Risk Assessment (cont.)

• Market Risk
• Human Risk
• Technical Product Risk
• Business Strategy Risk

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Five-year Pro Forma Financials

• Are there detailed spreadsheets, covering all
  aspects of the operation? Balance sheet, income
  statement, cash-flow statements.
• On the expense side, has the company included
  such items as sales people, new sales, recurring
  revenues, human resources, AR/AP, administration?
• Are the financials broken out month-by-month for
  the first years and then year-by-year for the
  next four years?
• In this section, has the company indicated the
  amount of money they are raising and provided a
  detailed outline of the use of proceeds?
• Has the financing structure been set out common
  shares, prefs, debenture with conversion features
  and warrants?

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Exit Strategy

• What are the planned exit strategies?
• Will this work to the advantage of the Angel
  investor?
• Note that lots of Angel money gets stalled in a
  company because there is no plan of action for an
  exit. Exits could be provided through such
  mechanisms as a CPC, RTO, merger, buyout.

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Appendices

• Resumes of key people
• Professional references
• Product or technology specifications of
  descriptions. These should include such things
  as photos and brochures.
• Articles on the company of the industry
• Industry analyst reports
• Customer LOIs
• Market analysis date and market studies
• Current shareholder agreements
• Abstract of patents
• Product/technology reviews

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Research

• Research conducted by TA Associates found that ,
  in the big winners (i.e. .10x return of capital),
  the success was mostly due to good market timing
  and strong market growth. The success had less
  to do with strengths in the CEO or Board. For
  the medium winners, management strength was the
  most significant determinant. Their losers were
  most noted for having missed the market
• TA Associates concluded that their ability to
  assess and control success had most to do with
  the strength of the management team. There was
  not much one could do to influence market success
  or failure.

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Factors Affecting Angel Success
Note Scale is 1 to 5 Worst 1 and Best
5 Source TA Associates
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Ongoing Financial Needs

• Most companies will require another round of
  financing.
• The role of the Angel is to keep this out of the
  hands of VCs.
• First-in Angels need to keep some powder dry for
  the next round.
• Angels from other groups can assist with the next
  round.
• If a VC round is necessary, this could affect
  downward the Angel valuation.
• Be sure to understand the total financing needs
  of the company to build it to profitability and
  to allow for growth.
• Ensure that a board seat is obtained to protect
  the Angel investment

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A Due Diligence Summary Checklist
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Thank You Questions
W. Daniel Mothersill 416 368 8770
x222 dan_at_ciris.biz