Investors due diligence and pre-investment audits

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Investor due diligence and pre-investment audits.

Whether you deal with Angels, Venture Capital investors or your local banker as a small business owner you need to understand the documentation requirements of fund raising as well as the due diligence and pre-investment audit process. While the process is cumbersome and awkward the primary issue with small business owners is preparation, generating the required information and presenting it in the right format to the investor and financer. Part of the process is answering difficult questions and sometimes the same question asked in different ways. The following guide walks through the terminology and process behind the due diligence and pre-investment audit.

Managing the Due Diligence Process

Due diligence refers to the caution and prudence that one would show in managing one’s own money or the money of someone else. This step entails comprehensive investigation and analysis. What is also important is the investor’s own judgment because the information usually available for these early stage investments tends to be limited as well as unreliable. Generally investors are cautious of investing in businesses they have very little or no knowledge about.

In order to make an informed judgment about an investment the investor would need to carry out extensive research to identify the potential risk and reward opportunities of the ventured. This includes

  • having a number of face-to-face meetings with the entrepreneur,
  • making a thorough review of business plans
  • having interviews with management, customers, suppliers and competitors,
  • receiving advice and counsel from industry experts
  • carrying out reference checks of the entrepreneur including speaking with former superiors, peers, subordinates and business associates
  • carrying out legal and financial audits, including an analysis of financial projections and capital requirement (must consider investor’s own fears and concerns regarding the financial assessment of the company when evaluating the projections and capital requirement as this may not be accounted for by the entrepreneur. The investor must consider ways in which the venture company may be reporting inflated revenues and hiding costs)
  • assessing market potential

Questions raised during the process relate to:

  • Quality of the management team
  • Performance to date
  • How management has previously addressed and overcome business hurdles
  • The venture’s effort to identify and quantify potential markets
  • The competition (existing or potential) that the venture faces

Things to keep in mind when evaluating a prospective entrepreneur:

  • They can be overly optimistic
  • They can minimize true capital requirements

Reasons to perform due diligence include:

  • Having capital tied up for a long time without any return during this period
  • Expenses that they would incur on top of the initial investment that they would make for various fees and costs associated with due diligence
  • Possibility that projections are not met and that more capital would need to be invested at a later stage to keep the operation running or to protect from excess dilution of the investor’s position
  • Legal and ethical misconduct by entrepreneurs

Screening investment opportunities

The first stage of the due diligence process is to quickly screen through the opportunities to ensure that they meet the investors criteria. This is done by asking the venture’s entrepreneurs to submit an investor oriented executive summary based on a pre-specified format that the investor provides. The information provided in the summary should be well organized, concise, clear and readable.

The summary allows for a preliminary evaluation of the venture. If the venture passes this evaluation they are asked to submit a more complete business plan and documentation package. Besides company particulars, the summary should include the following elements:

  1. A description of the type of business, the industry category, stage of development, key goals of management
  2. Details of the product and/ or service
  3. Whether proprietary, patented , etc
  4. Details of the company’s founder/ CEO
  5. The target market- market size, growth rate, competition
  6. Operations
  7. Channels of Distribution
  8. Financial results
  9. Current financing status
  10. Level of active/ passive investment sought
  11. Investor appeal
  12. Valuation
  13. Exit strategy for returning investors capital
  14. Potential return on investment

Business Plan Outline

A business plan must contain the following elements:

  1. Summary of the company’s proposed activity, management, and performance
  2. Present stage of development (time line of formation, product choices , description of early problems and setbacks and solutions)
  3. Product/ service description (features, advantages and disadvantages, target market and purchase cost justification)
  4. Venture objectives (sales and profitability goes, solution that the product brings to the market)
  5. Nature and current condition of target industry and industry trends
  6. Business strategy (implementation methodology and how it will create a competitive edge)
  7. Competitors
  8. Existing and potential customers
  9. Summary of function specifications of the product
  10. Key technologies and skills needed reach development and manufacture
  11. Sales channels and distribution modes and alternatives
  12. Aftermarket service operations
  13. Cost volume and development cost break down
  14. Manufacturing process (facilities and equipment needed, associated cost purchase/ lease, labor and place space)
  15. Summary of the proposed deal
  16. Market place (target market, size, growth rate, market analysis, buyers profile)
  17. Management team
  18. Sources and uses of funds
  19. Financial statements and projections

Before reviewing the business plan and the other venture documents the investor would need to investigate the entrepreneur and the management team.

This is done through a soft evaluation through face-to-face meetings as well as a formal back ground check by engaging a professional corporate investigation firm. This latter check would encompasses checking up on criminal records, if any, court proceedings and litigations if any, credit and debt checks, education and credential checks etc.

The purpose of such evaluations is to assess:

  • The level of skills and experience of the management team including the CEO/ Founder
  • The need for additions or replacements to the management team
  • The stage at which further additions to the team would be needed
  • The stage at which investors would need to become involved to resolve problems, provide direction, consult, take an operational role, etc

The investor should be a good and objective judge of people. Studies show that the following psychological characteristics are present in entrepreneurs of successful ventures:

  • They have vision, the foresight to handled unexpected events and take advantage of opportunities
  • They are leaders. They are enthusiastic and passionate about their product, are charismatic and professionally competent
  • They have courage to take on risks
  • They are optimistic
  • They are reliable and hard workers
  • They have patience and a long term view
  • They are creative, resourceful and independent thinkers
  • They have integrity, are trustworthy and ethical

The Pre-investment Audit

The handbook suggests a six step analytical research approach to the pre-investment audit process for early stage ventures as follows:

  1. Collection of data from the company including documents and notes taken during interviews
  2. Using the reference check list provided by the company that includes information on people outside the company such as the company’s investors, directors, advisers, financial intermediaries, appraisers, landlord, bankers, competitors, etc to contact and get their perspectives regarding the company
  3. Compare and analyze the data collected from 1 and 2 above
  4. Identify gaps in the data that would suggest that the management’s lack of integrity, poor judgment or other weakness. Identify strengths and weaknesses in the business plan, the financial data and the deal itself. Weigh these strengths and weaknesses and compare results
  5. Evaluate the results of this analysis against own assessment of the company based on intuition for each of the following, the management, the company, the plan, the deal. Consider the advice of advisers. Identify what you like and dislike about the investment
  6. List all the gaps identified and assess the risk/ reward potential against personal risk tolerance to evaluate the fit of the venture with personal investment strategy.

Data collected includes data on:

  • Management
  • Products and Services
  • Industry
  • Market, Sales, Distribution
  • Competition
  • Human Resources
  • Suppliers
  • Production
  • Research and Development
  • Financial analysis of projections including
    • Capital requirement
    • Balance sheet
    • Income statement
    • Cash flow forecast (most important projection- examines the changes in cash due to business activities. It will be indicative for future additional funding requirements).
    • Use of proceeds
    • Financial plan assumptions
    • Risk/ Return Analysis
  • List for reference checks
  • Other documents for analysis such as organization chart, resumes of key personnel, capitalization table, marketing plan, job descriptions, business licenses, list of suppliers, noncompete agreements, lease, insurance policies, appraisals, director and broker fee agreements, bylaws, certificate of incorporation, etc.

While analyzing financial data:

Investors assess:

  • how accurately the venture company has quantified the qualitative aspects of the business proposal, i.e. the funding requirements and the future performance
  • Attainability of the profit projections of the venture
  • If the projections can be used to convince other investors and advisers of whether the projections are attainable

For a company already in business the investor should be guided by past financial data, for a new start-up he should be guided by industry standards.

Evaluate the projections based on soundness, validity and consistency of the underlying assumptions.

Begin analysis of financial projections by reviewing the operating budgets (including forecasted revenue and expense projections). Next review the cash budgets that project how sales turn into cash which in turn is used to pay the cost of doing business and return profit. It reviews the sources and uses of the cash and helps the investor assess the company’s credit and debt collection policies, trade credit and other financing activities, etc including identifying when cash would be required to avert a potential liquidity crisis. The final stage is to review the pro-forma statements such as the historical and projected profit and loss statements and balance sheets.

The management of the company must be able to assess the company’s potential break-even point in terms of the sales volume required and the ability or likelihood of that materializing

An analysis of the financial data would help the investor to evaluate:

  • The amount of funds management is requesting over the time period under question
  • The date when this funding would be needed
  • The most appropriate types of funding
  • The equity that the management is willing to concede to the investor
  • The uses for the funding

(From the book “The Angel Investor’s Handbook: How to Profit from Early-Stage Investing by Gerald A. Benjamin, Joel Margulis)

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