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Entrepreneurship: Due Diligence

Continuing on with my occasional writings on entrepreneurship, let’s move on to due diligence.

As mentioned in an earlier blog entry, I’m opting for entries regarding my forays into entrepreneurship by focusing on subject matter as opposed to chronological order. Perhaps at a later date and if it makes sense I’ll place these into a logical or chronological order, but for now I’m going to do them as I feel. Hope you like it!

Due Diligence is that aspect of starting a high-tech venture whereby a series of investors get to examine every aspect of your organization and, to a certain extent, you. The outcome of a due diligence review is usually a set of reps and warrants (representations and warranties) that you sign off on saying that what was discovered is the whole truth and nothing but the truth, as far as you know. And God help you if you lied during this phase as it will come back to haunt you ñ big time!

The due diligence is typically broken down into a series of requirements:

  • Sales & Marketing
  • Financial
  • Engineering & Manufacturing
  • Materials Management

I will endeavor to go into each in some level of detail. However, no matter how much detail I may go into your investor may want more, or less, than what I present here. But if you cover all of the requirements Iím about to lay out youíre pretty much guaranteed not to be caught with your pants down. Youíll have the necessary answers that the investors want, and youíll find out a lot about whatís going to go on in the future since this is pretty much a roadmap to where youíll be expected to take the company and a set of requirements to which youíll be held forever more.

Sales & Marketing

This is, of course, assuming you have sales and marketing divisions. If not, this won’t be applicable. However, you will be required to get sales and marketing departments before too long. How do you expect to sell anything without ones? My belief is that you can’t wait too long at all, and need to get into sales mode as quickly as possible. You need to find folks interested in what you’re doing, so much so they’ll either buy your idea as is — before you’ve started coding — or will tell you what they’re really looking for, which you should take as sound advice since the customers are what you’re attempting to attract, not nods of attestation to your intellect. Similarly, it’s crucial to find a good product manager. They’re worth their weight in gold — just don’t tell them that, or they’ll expect to be compensated accordingly. More on this in a later blog.

Also, you should be doing marketing. And by “marketing” I don’t mean brochures and the like. I mean finding out what the market wants and how close your vision of that market is in reality. The two should coincide to a certain extent so that what you want to build actually has people wanting it. You want a “pull” from the market. Pushing a product into the market is a very bad idea and probably a guarantee of failure.

Now, if you do happen to have sales and marketing people on staff — or you have an idea of where you want to take the product youíre developing (have developed) the following must be answered:

  1. For each key sales and marketing person, describe their backgrounds. You must describe why they are key individuals and what they bring to the table. Who do they know that will advance your product? What is their past experience? How will that experience help you get name recognition and that all important first sale? And, how will that first sale be repeatable?!
  2. What is the state of the industry you’re targeting? For example, you need to consider economic factors, technological advances, anticipated trends and events, customer involvement (i.e., early adopters — are there going to be any?), competitors (i.e., are there any?, is this a new area?, etc.), and especially what will the future hold for the company’s product? Ultimately, you must figure out  how you will translate what you’re building into a competitive advantage?
  3. Is there any research currently done by an outside group on the company? Although this might sound strange, some companies get write-ups because of who is in the company. Think of companies like Groove. Because of the founder they had write-ups well before they got funding because of Ray Ozzie. However, most companies won’t have anything written about them. But, they will have stuff written about their target market! And that’s crucial. It shows the investors that the area is hot, or at least likely to become hot. Look at it another way, someone other than you thought it was a cool enough area to write about so it probably has some legs in terms of an area to invest capital in to build a product to address the perceived need of the market. It will also indicate who the key players currently are and whether or not it’s worth the investors while to place capital into that market. For example, if Microsoft or Google or Apple are already playing in your market you should probably just abandon it. If they’re in there, they’ll most likely win. They’re just too big to fight. And if you try, the investors will lose confidence in your equilibrium. There is an exception, and that’s if you intend to stay small and go after business not worth the while of the big boys. A lot of successful “lifestyle companies” exist that do this. Of course, you (probably) won’t get investment cash. These types of startups are getting a lot of interest from techies because they don’t require a lot of capital to start, resolve an immediate problem, and usually offer superior support. It’s one of those ironies that a small firm is better situated to offer focused support for a niche while large firms can’t. This leaves a lot of niches out there that need filling and often the big boys will help you get into customer shops because the product the big boy sold doesn’t solve some annoying little thing that you do, so it’s a win-win. And, really, how much cash do you need? Not much when you think about it. So, if you have a nice idea for a $5M business, go for it. You won’t be Bill Gates rich, but money isn’t everything.
  4. Background literature. This is an interesting one. This is stuff you’ve accumulated on your market and product, especially stuff over the past three years or so. It usually consists of articles on the market, what analysts are saying, stuff from the Internet, news feeds, etc. Don’t ignore what slashdot or some other source might be saying as they usually predict cool areas to be involved in. Hence if slashdot’s been on about something for a while you know it’s getting close to hitting the radar of people with serious money. Here I’m obviously talking about stuff that’s new, not stuff that’s been in the market for a while.
  5. Who are your major customers? This assumes you have customers. You only need to include those that provide appreciable revenue. And if you have a lot, the top five or ten should suffice. For each you should include units and revenue totals. And if you have more than a single product, then break it down by product as well.
  6. Who are the competitors? This one techies always love, but the investors need to know who the competitors are. They want to know they’ll be getting in fairly early and that none of the big boys are around yet. The reason? Simple. They want the big boys to buy you out. That’s one of the liquidation scenarios that investors are always talking about.
  7. Do you have a backlog? This one usually doesn’t apply, but if you’re a fairly well established company you may have more orders than you can fill at the present time. If so, how do you plan to fill those orders? Is this a regular occurrence? For example, are you always backlogged? If so, this is a good thing. If it’s seasonal, explain why. Etc.
  8. What new businesses are you contemplating? This is actually only applicable to established firms that may be opting to go into a new market. If, however, you mention more than a single product you’ll have the investors turn tail and run like hell! They’re investing money and for that they want your undivided attention on a single product. I know this sounds boring but that’s what they want. And, guess what? They’re right. As a little guy you can’t possibly run multiple product lines and be successful. If you try, you’ll die. If you get asked this question either answer with a “not applicable” or with the fact you have but a single product line and that will be your focus for the foreseeable future.
  9. Do you have third party agreements with anyone? This one just wants you to tell the investors if you have any outstanding agreements to service one thing or another, or if you have an agreement with a software vendor, for example, for their software and services. This usually isn’t complicated. They do want to know if you’re using open source, though. And if you are, what rights do you have with respect to that open source? If you have to publish your source then the likelihood of getting funded diminishes, as you won’t be able to show any intellectual property that won’t quickly become available to the general community. In this way it’s best to know what your rights are with respect to your code base, etc. if you’re utilizing tools. This holds for royalties against binaries as created by a given compiler.
  10. Do you have any distribution channels for your product? Another great question that’s hard to answer. If you’re just starting out, the answer is no. But if you’re established you must have some form of distribution channel. The usual answer here is direct or channel. The former requires a lot of sales people. The latter requires really good product within a niche where the product sells itself — don’t expect the channel to sell for you. Either way, you better have a good grasp as to how you’re going to sell this thing you’ve built. It’s why it’s usually best to have some sales before talking to investors. Know who your customers are and what they want. The type of customer you’re currently appealing to will usually indicate what type of market you’re in, as well as the size. It will also provide you with insights into who you should go after next.


The company must have financials, even if those are no more than the incorporation papers. What the investors are looking for is a clean set of books. They don’t want to get into the company only to find out there’s all kinds of outstanding debt or preferential shares that will have to be immediately paid off against the incoming capital. The money the investors are putting into your company should stay in there. If it’ll be flowing out somehow, the investors will be very, very unhappy. Not a good thing.

Again, there’s a series of requirements. Ironically, these are some of the easiest to satisfy if you’re just starting out. If you’re established its a bit more of a problem but nothing onerous. The investors may ask to have your books reviewed or even audited prior to investing. But usually this isn’t necessary. If you do have revenue then a review by one of the big accounting firms will be in order.

  1. Corporate legal structure. Just what it sounds like: what is the legal structure of the corporation? Is it a corporation or a limited partnership? Microsoft, when it was founded, was a limited partnership. You want a proper corporation. Federal, state, provincial? Up to you. You will have to provide the articles of incorporation and the minute book from the annual shareholders meetings, etc.
  2. Employee information. Investors actually invest in people. The mantra of a good many investors is People, Product, Plan. In other words, they invest in people first, they assume the product will be reasonable and will determine that after due diligence. The plan, well, it can be written up later and usually is as the plan you currently have — unless youíve done this time and again ñ is wrong and needs to be corrected to reflect reality. What needs to be provided here is a set of organization charts, including who reports to whom, titles, etc. Don’t be surprised if the investors decide some people wont be vice presidents or chief gurus.
  3. Go-forward employee information. This is quite simple, really: how many employees will you need to get this product to market and get the company to profitability? This is usually assumed to be for the next three years. Include budgets figuring out salaries for the various employees as well as assumptions as to their qualifications, etc.
  4. Historical financial information. These are the details from your financial records. They need to be in good order and clean. If you’ve been around for a while, they’ll need five years worth. If you’ve not been around that long, then whatever you have. They want to ensure nothing is hiding in those documents.
  5. Projected financials. Here you’re writing a bit of hopeful fiction as to what you hope your company will do in the future. Investors will usually want to have this broken down by month for the next year and then quarterly for the next two years and finally yearly estimates for the final two years (for a total of five). Although this is silly, in my opinion, it gives the investors an idea of what you’re thinking about and how grounded in reality you are. For example, if you state you’ll be doing $100M in revenue in five years they surely will want to have you examined. Furthermore, assuming you’ll capture a substantial part of the market you’ll be in is also a sure sign you’re not sitting in the investors’ reality. That’s one of the reasons investors shoot for companies that may own a substantial part of a market — but here were talking 10 ñ 20%. And then, if that market isn’t going to be huge they wont be playing with you anyway. 10% of a $100M market just isn’t exciting. 10% of a billion, now you’re talking. Yeah, I know, 10% of a billion is $100M and they wont believe those revenue numbers. Don’t argue logic here. Just make sure that market is sufficiently large enough to let you survive in it. Whether or not it gets to a billion in the five years the investors are looking at is another matter entirely. As one investor told me, spreadsheets produce the world’s best fiction.
  6. General ledger and balances. This is just a copy of your books. You do have properly maintained books, right?
  7. Auditor’s reviews and/or letters for the past 3 years. This is another check to ensure you a) have auditors and b) have kept your books up-to-date.
  8. Accounting policies and bases for expense allocations. They’re looking to see how expenses are paid out, etc. Are the founders getting paid dividends? Are they’re expenses extravagant? Do they get a corporate car? Etc. Whatever’s there right now will either have to be changed or accepted by the investors. Similarly, what are the accounting practices in terms of:
    1. Product development costs.
    2. Other capitalized costs.
    3. Depreciation.
    4. Revenue recognition.
    5. Reserves and provisions.
    6. Deferred charges.
  9. Assets and liabilities. What are the corporations assets and liabilities?
  10. Capitalization tables. Which shareholders hold more than 5% of the company. How much did they put into the company to get that percentage? The table must include a history of past offering prices, share options outstanding, etc.
  11. Previous stock issuances. Here you’ll need to provide the documents on how you valued the company. When you issued shares to the various individuals you must have valued the company at some preset value. What was that value and how did you come to it? If you’ve revalued the company a number of times, show the reasons behind the valuations and what those valuations were.
  12. Unrecorded or contingent liabilities and outstanding litigation. Is there anything that the investors should know about possible liabilities or litigation that may cause them to lose their money? You have to be perfectly honest here. Better to mention the trivial than have the investor pull out of the deal at the last minute because of the liability associated with the corporate car, for example. Or an outstanding lease on equipment that requires specific payments.
  13. Soft assets and liabilities. You may have R&D commitments or capital expenditures that are liabilities. For example, you’ve promised specific aspects of your research to another firm as they’ve paid you in kind with equipment or with services contracts. The investors want to ensure the IP is free and clear.
  14. Material agreements. If there are any material agreements not mentioned elsewhere in the financials they should be mentioned here. This includes customer contracts, management contracts, supply arrangements, strategic alliances, software subscriptions, etc.
  15. Computers and computer systems. What computers and computer systems do you currently have? These include ones for accounting, R&D, sales, the Web, etc. What is the current status for these systems? You should point out what the budget is for these systems, what you determine to be the ongoing liability for these systems, the annual budget, maintenance, etc.

Engineering & Manufacturing

This set of requirements is broken down into a series of targeted requirements. This is the messiest of all the requirements of a due diligence and is brutal as the investors will come back time and again to ensure that you know what’s required to get your vision to market. Screw up here and you can kiss any chances of running the company, or of even being a senior player, good-bye. They may still invest but you won’t be running any part of the organization; and rightly so.

Project Management & Manufacturing Processes

If you’re going to be manufacturing something, as you inevitably are if investors are interested in you — it’s rare the investor that invests in a services company. Hence, you need to provide the following information:

  1. Equipment details. You need to provide the net book value for your major pieces of equipment. Don’t worry about your cell phones, but do worry about your servers, etc. If you’re into chip manufacturing you need to include all that expensive hardware. If into fibre, all the associated hardware that you require in order to get your product development must be listed. You should also include the age of the equipment, repair and maintenance history, etc. If you’re dealing with PCs, don’t worry about it as they’re pretty much a commodity so just list what you have. At well below $1000 a pop nowadays no one cares about its maintenance history. They know you’ll just get another one. Hell, you can buy used PCs for $200 and they’ll work wonders for your labs.
  2. Capital spending. If you’ve had capital expenditures over the past five years, what were they. Is that equipment capable of delivering expected sales volume over the next couple of years? If not, how do you plan to address that issue?
  3. Manufacturing process. This is a description of your manufacturing process. For software houses this is pretty straightforward. However, you should include details on who will assist you in getting the product out, how you plan to distribute it, other engineering/support requirements, etc.
  4. Standards. If there are standards you must adhere to — or simply choose to adhere to — what are they?
  5. Production technology. Here you’ll need to describe what technology you’ll be using to create that final, salable product.

Product Design + Project Management & Quality Assurance

If you don’t have a design process, you’ll be getting one. So you should start thinking of both product and project managers now.  You’ll need to explain to the investors what methodologies you utilize, how you develop the product, how you manage internal versus release versions, etc. You’ll also need to define the process associated with designing the product in terms of product verification, functional specification, detailed design, life-cycle management, etc. Any third party relationships that will impact the development process must be described.

If you’re utilizing tools to develop the product what are they? These tools may automatically maintain and track bugs and documentation. But if not, how are you going to handle the documents and the document stream for the product.

How well versed are you and your staff in the tools you need to utilize to get the product to market? Furthermore, are you truly familiar with the development process? Don’t be surprised if the investors bring in techies to probe your knowledge to see if you know your stuff or not. God help you if you don’t.

Finally, the investors will want to know what was the biggest design issue surrounding your product. What was it that kept you up nights during its design and development? If it hasn’t been developed yet, what do you think will keep you up nights? Is the product portable across a variety of platforms? If so, which ones. If not, which platform are you initially targeting and why.

There may well be more questions to answer, but this is a good sampling.

Quality Control, Versioning, Release Management

What are the quality control programs you have in place? For this market is there a requirement for an ISO certification or some other certification? What testing, process, or metrics requirements are there?

How are versions handled? What are you going to do when you have one version in the field and another in development? How are you going to handle patches and updates to those versions in the field and how are you going to ensure those fixes appear properly in the next version? What approval process is in place from quality assurance to ensure that bugs that have been fixed are noted as such.

The version and release management systems that you’ve opted to utilize — and these can be paper-based initially but must be able to handle multiple product versions. Do note that today with so many free version control systems just opt for one and get on with it, preferably with an embedded Wiki. It’ll save days of trouble later and provide a history now.

And who’s going to run quality assurance? What is that person’s qualifications? Why do you feel that that person will be able to stay independent and ensure delivery of quality product to the customer? Remember, you have but a single chance to impress the customer. A bad first impression will probably be your last impression.

The quality assurance manager will have to interact with the Program/Project Manager and the Product Manager. Who fills these positions at the moment? Whats their history and what do they bring to the company? Are they process driven or process aware?

Materials Management

This is closely tied into the accounting aspect of the due diligence. For a new company it’ll be fairly straightforward, for those that have existed for a while it will depend on how the manufacturing process is done and what the various depreciations, etc. will be on equipment and assets. Furthermore, you’ll need to examine the costs associated with inventory and the maintenance of older equipment and products. For example, if you change the manufacturing of a particular product are you going to have to maintain the old equipment that manufactured the older equipment as well as the newer equipment?

The following describe the typical questions that must be answered during this aspect of the due diligence.

  1. Costing process. What is the company’s costing process (i.e., standard or actual)? Does this include the full cost, including overhead for all goods sold including inventory?
  2. Inventory. If you’re an established company, whats your inventory been like the past quarter? Here you’ll need to include every product you sell, how much resided in inventory during that past period, the financial burden of keeping said inventory, etc. You will also have to include how you track inventory, deal with quality issues (i.e., returns), shortages of inventory, and seasonal supply and demand.
  3. Demand profile. If you’re an existing company, what is the demand profile for the product(s)? What is the profile one month out? Two months? Three months? Six months? A year? And why do you believe these profiles are accurate? Is there history to back up these numbers?
  4. Backlog. List all the products that have a backlog. How big is the backlog? Are there any products that you sell that have no backlog — i.e., you’re sitting on a huge inventory of product? For each you should include the cost of the product, the cost to inventory the product, etc.
  5. Assembly. If there’s a requirement to assemble the product, what is the actual cost behind this? Sometimes this is trivial, for example the simple manufacture of a CD or the use of the Internet and a Web site for sale of a product. The more complex situation is large computer or network systems.
  6. Purchase orders. Provide a list of outstanding purchase orders, potential revenue, and the time it will take to fill the purchase orders.
  7. Warranty returns. What ratio of sales to returns exists? Is there a particular component that fails more often than others, and if so what is it? Are warranty concerns being addressed to limit the amount of cost these returns are taking on the company?
  8. Inventory obsolescence. New versions come out all the time, what type of inventory obsolescence has the company experienced over the past number of years — typically five? The reason for this is to see if you’ve been building way more than you can sell. If you historically build more than you can sell and then have to have fire sales, the investors will determine that you cant manage your supply side and that this mismanagement will lower your revenue potential as you’ll always end up with customers willing to wait until the next model of the product so they can get a good deal on last year’s mode. Obviously this is more of a hardware problem than software. CDs are cheap, you can always just toss them and today you can manufacture them on demand or utilize the Web to permit download to customers thereby eliminating the need for inventory.

As you can see, the number of questions the investors ask is enormous. And this is just a base list of questions, they can ask a lot more if they don’t get a warm fuzzy for a particular question or requirement. If they figure you’re pulling the wool over their eyes, they’ll delve deeper or ask for more onerous reps and warrants. Honesty is your best policy here as it’ll make your life easier as time goes by.

And as you’re going through the due diligence process you’ll also be dealing with lawyers and accountants ensuring the company is ready to accept external investments. That alone is a series of blogs I will get to sometime soon.

Until then.

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November 2010
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