[Guest article by Pavan Krishnamurthy, Partner at Ojas Venture Partners. This article is a must read for entrepreneurs who wants to understand the due diligence process.]
Many first time entrepreneurs may not fully understand about the due diligence process followed by VC’s or what to expect during the diligence phase. This post makes an attempt to demystify the VC due diligence process and provide a list of typical questions for which VC’s would be seeking answers during the due diligence process.
Before we get into what actually happens in a due diligence phase, it would be good to understand the investment decision making process followed within a VC fund. Depending on the size/focus of the fund, a typical fund on an average receives anywhere from 50 to 75 business plans per month. All the plans received are logged into a deal database. In most funds, deals logged into the deal database are discussed in the weekly deal-flow meetings. Typically, deals go through the phases of preliminary meeting, preliminary diligence, internal discussion, detailed diligence and final decision.
Once an investment reaches a final investment decision stage, the deal team related to the specific opportunity is required to prepare an investment memorandum on the opportunity and present it to the “Investment Committee” (IC). IC typically consists of senior partners of the firm along with independent experts and in many funds also includes representatives of Limited Partners ( LP’s). Members of the IC normally meet once in a month or in any other agreed time-frame. IC members review the investment memorandum prepared by the deal team and provide their feedback/approval/follow-up points. In Global funds, an India deal may be competing with a China deal of US deal and typically in such a scenario, IC would be comparing and contrasting the deals from a risk/return perspective across geographies before finally approving.
The Investment memorandum prepared by the deal team typically talks about the investment rationale, valuation, deal structure, key risk factors and projected exist scenarios/returns. In fact the findings/learning from the due diligence is captured in this document. The size of this document varies from fund to fund and can be anywhere from 5 pages to 25 Pages (depending on the specific deal facts)
In an early stage investing, the basic objective of a VC diligence is to independently validate the business opportunity and qualify the risk/return profile. In later stage or private equity investing, financial and legal diligence becomes very important and therefore becomes the primary objective of the diligence (This is a separate topic and is not covered here). In contrast, early stage diligence is primarily an opportunity or business diligence. This diligence is carried out through a combination of internal research, talking to potential customers, industry experts, vendors and other relevant eco-system players.
As stated above, the output from the diligence phase is captured in the “investment memorandum” and therefore the deal team needs to find answers to a number of questions related to the founding team, market, competition etc. In early stage, this is easier said than done. One may not be able to find answers to many market related questions. In such a scenario, the deal team would use their best judgement to come up with close approximations and reflect the same in the risk profile of the deal.
While there is no one size fits all approach for diligence (each fund is different and each deal is different), generally speaking most investors would be looking to get an understanding of the following questions.
- Does the founding team/management team have the necessary and relevant expertise, experience, team dynamics, competencies and skill sets to architect, model, build, enhance, sell, service products/solutions proposed to be offered by them? Are there gaps in the team and if yes how easy or difficult is to fill the management gaps/expertise gaps?
- Does the opportunity fit in with fund’s engagement model, investment stage, investment focus, value add, valuation ranges, exit horizon and quantum of investment?
- Is the timing right? Are macro trends and customer confidence positive?
- Are there are a large number of identifiable, reachable, ready and able customers who are willing to buy the offerings of the Company? Are there any large, established and well funded companies playing in this market? If yes, is there a competitive vacuum that the start-up can leverage on?
- Is the solution well differentiated from the competition? Can the competitive advantage be maintained for at least 18 to 24 months? If yes, what is the Net Purchase Value (NPV) to the customers from purchasing the solution offered by the Company, net of switching costs if any, disruptions/ changes required at the business if any, workflow and process levels if any and factoring in the availability of alternate or substitute solutions in the market?
- If there is significant NPV to the buyers, what specific attributes, variables, functionality etc of the solution is giving raise to the same as compared to existing and available solutions in the market place? How sustainable is the value provided to the customer? What is the window of opportunity?
- If the solution requires enabling mechanism or ecosystem in place before the sale can happen, are the required enabling mechanism /ecosystem in place? Does the product require multiple influencers for adoption? Are there multiple path dependencies for the product to take-off?
- If the company’s product is solving a well defined problem in a mature industry, does it have significant cost/performance benefits? Why is it that other established players have not attempted to solve this problem? Is it due to lack of market size or ability to sell at a profit or customer inertia? What trends are favouring the start-up to solve this problem now?
- If the product is very easy to build and technically not challenging and the business is a pure execution play, then has the team demonstrated execution capabilities and does it have the right ecosystem relationships in place?
- What factors, events, trends and developments could impair/displace the value attributed to the solution at the customer’s level? What scenarios would minimize or negate the NPV derived by customers from the solution provided by the Company?
- What is the nature and extent of competition in terms of size, maturity, and geography and solutions portfolio?
- Degree of demand (DOD): What demand patterns are attributed to the solution segment? Are the demand patterns sustainable? What factors, events, trends and developments would drive demand? What scenarios would displace the predicted demand or move the customers away from the solution provided by the company?
- Degree of Uncertainty: What are the known unknowns in the market place? What is the extent of uncertainty/risk with respect to demand, consumer behaviour, availability of assumed talent, customer adoption rates, extent of market readiness, consumer needs evolution, technological changes, market disruptions etc?
- Market realities: What has been the experience of similar companies in the market place? What have been the historical failure rates in this industry? What kind of companies have succeeded and failed in this industry and why? What has been the experience of investors if any in this space from an exit perspective? How have similar companies fared in the financial markets? What is the strategic rationale behind acquisitions in this space? How are these kinds of companies perceived by the financial community such as other VC’s or financial market players?
- Are the price levels, margins, time to develop, time to acquire/ costs to acquire customers, etc estimated by the company realistic? Are the time frames estimated to turn profitable and the investment assumed to be required/valuation expected realistic? Is it possible to benchmark or provide an example about the same? Is data about comparable companies available? (In terms of funds raised, time taken to reach profitability, steady state margins etc)
- What kinds of ecosystem/relationships/critical resources are required for the business to succeed? How easy or difficult to build this ecosystem/develop relationships/critical resources?
- Given the risk profile of the opportunity, are the returns attractive? Can the business scale in a rapid manner? Does it meet the funds return threshold?
To conclude, the objective of the VC diligence process is to validate the opportunity and qualify the risk/return profile of the opportunity. As can be seen from above, this is a time consuming process and consumes significant time on both sides. Hopefully, the list of questions outlined above provides start-ups a framework to approach their diligence in a more prepared way.