Finding the Cash in Due Diligence
Before you can land a loan, an investment, an acquisition offer, or an agreement with an investment banker to take you public, you'll need to prove you have a solid business. This is where the due diligence (DD) process comes in. Despite being ridiculously time-consuming, you have to use it to demonstrate your worthiness—it's simply required if you want to raise cash. But good DD prep enables a company to extract more cash with less dilution. Here's how to make the process work for you.
The DD Mind Game
You are on one side of the table, eager to close the deal. Across from you is the funding source, who has at least as many reasons to nix the deal as to ink it. This is why DD is key. With adequate preparation, you'll be able to simultaneously reduce your source's fear and increase their greed for gain.
First, be open and cooperative, as the funding source will note your reactions—both what you say and your body language (see BusinessWeek.com, 2/7/07, "It's Not Your Mouth That Speaks Volumes")—to their requests for information. Assign one person to be the contact during the DD process. Choose a detail-oriented staffer, such as someone in finance or operations. Do not assign someone from sales or marketing.
Some funding sources will obsess over every area of your business; others will focus only on the potential deal breakers. The entire DD process generally will take three to 12 weeks, depending on the transaction, with the least amount of time for a loan and the most for an acquisition. The process for investments from venture capitalists or angel investors usually lands in the middle of this time frame.
Phase I: Pre-Due Diligence Prep
Before you formally begin the process, the funding source will need the basics: executive summary, business plan, financing pitch (see BusinessWeek.com, 2/20/07, "Make Your Financing Pitch Sizzle"), financial model, and current balance sheet. Next they'll want résumés and contact information for your founding team and key executives, an organizational chart, and customer references. They'll need Social Security numbers because they'll be doing background checks, looking for criminal records, bankruptcies, foreclosures, and any personal or financial trouble patterns that might predict a problem in the future.
Now it's time to understand ownership, so pull out the capitalization table and shareholder roster (Are your shareholders investors? If so, are they accredited or qualified? If the majority are neither, funding sources will be concerned); stock-option grants and vesting schedule (a red flag flies if the source sees that the stock of key executives or founders has mostly been vested—the thinking goes they won't stick around without another grant, which will likely dilute everyone involved); and contact information for directors, shareholders, your attorney, and your accountant. If you're outsourcing Web development, engineering, manufacturing, or any significant aspect of product or service creation, funding sources will want to make sure your company owns all the intellectual property before they dive in further.
Phase II: Scrutinizing Your Business
Let's say you've made it through the preliminary due diligence above. You're developing trust and rapport with the funding source, and the process is moving along nicely. Now it's time for further business details. Have the answers to the following questions handy. Yes, they are in your executive summary and business plan. No, the source may not have read it or retained the info.
1. Who is the customer? Where is the pain or problem? How severe is it? (If your company is a "pleasure play," what is the pain beneath the pleasure? For example, the pain beneath social networking plays is isolation, feeling invisible, not feeling connected to others.)
How does the customer make a decision to buy your product or service? How long does the decision-making process take? Why would they pick you over a competitor?
3. How is the product sold? Direct? Indirect? What is the likelihood of significant market adoption? How would you achieve this? In what period of time?
4. How is the product or service priced? What are the cost of goods sold (COGS)? How healthy are the margins?
5. How will the business reach the identified customer segments? (Please don't say "It'll be viral!" because it's unclear what that means. A while back, I met a CEO who said his social networking site would have 5 million registered users within its first year. But he had no plan for how he'd achieve this. Hey, I'm all for "virality," but let's be real. Maybe you'll be like one startup I worked with who signed up several dozen "community builders" by giving each one 200 shares of fully vested stock and a list of performance expectations. The community builders were chartered with bringing both content and friends to the site over the first year (or longer, if they wanted). They were recruited because they were influencers, connectors, mavens, enthusiasts. It worked—the startup hit its first million registered users in the first year of this program. And for a few thousand shares—such a deal.
6. How much will it cost in time and resources to acquire a customer? How much does it cost to support a customer? How easy is it to retain a customer?
7. How are you with milestones? Show us your past performance and specify future milestones. Then tell us when you'll achieve them and boost our confidence with your track record.
8. What's your exit strategy? We'll be paying attention to see if the executive team agrees on this.
Phase III: Searching for Show Stoppers
Right on! You've made it through Phase II. Everyone's feeling good, but now is not the time to get cocky. This is precisely when the naysayers try to kill the deal. Prevent this from happening by eliminating the following risks:
1. Harmful pre-existing agreements. The funding source needs to know what has been promised to whom, as they'll have to help deliver it. Be straight with them. If they're on board, they may be able to untangle some messy contracts.
2. Unsettled management team issues. Nothing kills a deal faster. If the team isn't cohesive, the funding source won't want to clean up the mess. Handle this before you seek out a source.
3. Disruptive or complex shareholder issues: I recently looked at a deal ("Company X") for about five minutes—then I ran screaming. The problem: 73% of ownership was in the hands of a silent foreign investor. Silent? Maybe. Able to sway any stock class vote? Absolutely. The company wanted VC or angel funding to clean up their capital structure—but a VC or angel wouldn't invest in it as is—it's too messy.
4. Inadequate intellectual-property protection or ownership issues: Back to the Company X example above: The IP (which would comprise the entire product line) was set to be acquired via the anticipated financing round. But would the financing happen, only to have the still silent and the majority shareholder nix the IP acquisition? Wait a sec—what exactly was a financier supposed to invest in? A shell company that had big dreams? Yep. The startup needed to hire a boutique investment bank to do the initial fundraising (which really was a leveraged buyout), clean up the shareholder and IP issues, then seek VCs or angels.
5. Excessive current liabilities. Been spending too much? Funding sources will be gone. They want to finance the future, not pay for your past.
6. Inappropriate use of proceeds: Be realistic about where you'll spend the money. Tell your investor, then stick to the plan, or seek out advice if the plan changes.
7. Regulatory issues: Anything scary or requiring excessive bureaucracy? Does your company require FDA approval? Special licenses to operate? How hard are these to get?
If you get through the above, you'll be well on your way to securing a fabulous financing. I'll dive into the heads of financiers in future columns, where I'll talk about the key people, finance, sales/marketing, and technology risks of funding a company.