The 12 step due diligence framework that any Investment Pro should know

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VC & the finance of innovation — A must read

VC and the finance of innovation

I learnt one of my favorite business analysis framework to this date in school back in 2012. I was a happy student back then, being a fall semester exchange master student at Tulane in New Orleans (very fond memories…) and between two jazz festivals, Mardi Gras party, a getaway in the swamp and meeting heaps of amazing people, it turns out that I did learn a few things about finance and investment that still serve me well today.

In particular, to this day I still regularly reference and go back the book “Venture Capital and the finance of Innovation” from Andrew Metrick & Ayako Yasuda. No lies, I’ve read that entire book at least three times and still enjoy reading extracts from time to time.

Back in 2012 my interest for Venture Capital and Private Equity investment was only blooming. Truth is, I liked the general concept but only had a blurry understanding of the industry and how it worked.

Reading “VC and the finance of Innovation” book and attending the MBA class on VC investment at Tulane offered me the confirmation I was looking for and played a big part in my decision to pursue a career in private equity investment and to be involved in the startup ecosystem.

A framework suitable to a wide array of applications

That VC framework offered by Andrew Metrick and Ayako Yasuda is not only useful from a Venture Capitalist perspective but can also help anyone working in Strategy Consulting, general investment, due diligence, building a startup, growing a business or overall business analysis.

I like it because it is simple, fairly straightforward and help quickly frame and focus your questions and analyses on the most important areas.

If you’re looking to seriously learn financial due diligence, you can check out the exhaustive Financial Due Diligence course that I’ve put together based on my experience at PwC.

Founders, if you are contemplating the idea to raise from VC, this can also be an helpful way to understand better how VCs will look at your company, what type of questions they will ask and how to best prepare your pitch presentation.

The analysis framework broken down for you

That VC analysis framework is summarised as The 3C, 3M, 3P, 3T or 3CMPT

1- Customers, Competition, Channels

2- Management, Market, Money

3- Product, Projections, Partners

4 -Technology, Transaction terms, Terrible things

I will go through each points and summarize in bullet points some key areas of diligence or questions to ask yourself and ask the Target.

1 — Customers

Regarding customers, you want to make sure you understand

  • Who are existing customers, how are they segmented?
  • Who are the target demographics / preferred buyer personae?
  • How concentrated revenue is (ie. is a large % of revenue generated through a handful of customers)?
  • Do customers generate recurring purchases vs. one-off?
  • How loyal are they (ie. what is the historical level of retention / churn)?
  • Do key, large customers have personal relationship with owner (especially important if current owner is looking to exit the business)?
  • What is customer’s purchase pattern / seasonality in sales?
  • What is the current traction / revenue or user growth ?
  • How much was the company able to upsell historical customers?
  • Has the average revenue / purchase per customer improved over time?

2 — Competition

  • How fierce is competition?
  • How fragmented is competition?
  • What is the Company’s positioning vs. competition?
  • What is the size of the Company relative to competition?
  • What is the competitive advantage of the Company?
  • Are there any barriers to entry for new comers?
  • Are competitors competing on price vs. competing on value (entering a market where a price war is raging may be quite risky
  • Who are considered as direct competitors vs indirect competitors

3 — Channels

  • Where and how is the product sold?
  • How dependent is the Company on its individual distribution channels (and what leverage / power does the Company has)?
  • How easy is it to get access to the different distribution channels?
  • What are the different levels of profitability of each different distribution channels / what mark-up or fee is charged by intermediaries
  • How scalable is the distribution channel network
  • What is the level of complexity and costs associated with the distribution channels
  • What is the risk of the distribution channel declining (eg. for filmmakers, the DVD channel is a on clear declined with the growth of steaming platforms)

4 — Management

Management is one of the most important factors (with Market) in VC investment decision.

  • Fit with investor’s culture
  • Adequate background / track record
  • Managerial skill / ability to delegate
  • Background check / skeleton in the closet?
  • Ability to pivot
  • Competency ceiling

5 — Market

  • Is the target market accurately defined
  • How large is the market
  • Is it easily addressable
  • How fragmented is the market
  • Is total market shrinking / growing
  • What are the possibilities to expand to other markets (either other verticals or other geographies)
  • How mature is the market (ie. new tech adoption vs. existing demand)

6 — Money

  • What were previous sources of financing?
  • What is the current and expected Cash burn of the business?
  • How Management plans to use the new cash injection?
  • How well has cash been managed so far?
  • How has cash been used in the past?
  • What return / success has been achieved on cash spent so far (eg. helped drive free users, drastically reduced response time, expended the features of the platform etc.)?
  • How good is budget process / financial reporting / financial management?
  • When does management expect the business to be profitable and what are expected levels of profitability?

7 — Product

  • In what phase is the product (beta? MVP? Fully functional?)
  • How good is the Design, user experience?
  • How easy is it to use?
  • How viral is the product?
  • What’s the pricing and how does it compare to other similar products?
  • What’s the Product Roadmap?
  • Disadvantages vs advantages of the product?
  • What problem does it solve?
  • Alternatives / substitutes?
  • Potential liabilities related to selling this product?
  • Positioning (cheap / luxury)?
  • What kind of mark-up do the company charge?

8 — Projections

Investors don’t take management’s projections as source of truth. However Management’s projections should help you tell how well management understand their own business and what it would take to achieve projected revenue numbers and whether they understand cash generation (ie. Net Working Capital impact for instance).

You can also review and challenge assumptions behind the projection and if the business has historical numbers, check that KPIs make sense over the forecast vs. historical period. Some ratios that are easy to use include Revenue / Sales FTE and marketing costs as a % of revenue.

9 — Partners

Ie, every organisation that the Company relies on to do business. The key here is to understand the nature, dependency and strength of the relationship with suppliers, distributors, affiliates, communication / PR partners.

Also, reviewing different business partnerships can be a good indication of how strong Management was to create meaningful, profitable relationships that positively impacted the business.

10 — Technology

  • How advanced is the tech?
  • Is the technology patent protected?
  • Does the technology infringes any existing patent?
  • Are there competing technologies with a risk of market / regulators deciding on one technology rather than the other? (think Blu-ray vs HD DVD)
  • Availability & cost of expert tech staff in the job market?
  • Risk of obsolescence?
  • How reliable, clean and documented is the technology (eg. Code clarity)?

11 — Transaction Terms

Or in other words, how to structure a Transaction and word agreement to protect investors against risks uncovered during DD while offering motivating incentives to Management.

  • Understand terms
  • Have clear conversation with Management to ensure everyone is on the same page and understand the terms correctly.
  • Think about covering upfront the “worst case” scenarios. What happens if XXX happens?
  • Get a skilled lawyer to review and advise

12 — Terrible Things

Any other areas of potential risk that you can think of. And do not be afraid to think about the box on this one.

  • Ongoing lawsuits
  • Regulatory risks
  • Environmental risks
  • Is the company tax-compliant
  • Are every legal documents in good order
  • Are there any dodgy accounting practice being done (fraud even maybe?)?
  • Does the company conduct business with blacklisted organizations / countries?

Contemplating joining a startup? This framework can be useful to you as well

If you are considering joining a new promising company don’t be afraid to do your own diligence and to use the framework above.

Remember that when you accept employment, especially in a startup, when you agree to dedicate all of your professional time to one company, you’re effectively making a bet on the firm as well. And you are putting all your eggs in the same basket.

Better hedge your risk by asking the right questions !

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Investment & M&A Director at HoriZen Capital. Creator of FDD course @ https://fddcourse.horizencapital.com/p/financial-due-diligence.

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Pierre-Alexandre HEURTEBIZE

Pierre-Alexandre HEURTEBIZE

Investment & M&A Director at HoriZen Capital. Creator of FDD course @ https://fddcourse.horizencapital.com/p/financial-due-diligence.

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