The 4 Martial Arts of a Startup Due Diligence
As a part of the investment team, the major challenge is to support a detailed, timely and comprehensive due diligence (DD). The DD is not only essential for the investor but should also be understood by every startup. So, this article is a — non-exhaustive — summary of practical aspects regarding Commercial, Technical, Financial and Legal parts of a DD (see also the graph below)!
Commercial
The master exercise in a DD is to properly capture a highly innovative product with its potential to capture a huge market, which yields profitable economics and attractive exit scenarios. To kick-off, understanding the product is key, i.e. that the actual use-cases are crystal clear. Following this, market research should validate that (1) the market is not too small (e.g. >Xbn annual revenue), (2) there is little, but not an overly superior competition and (3) that a growing number of customers actually demands the product as of today. In addition, the business economics have to be understood: revenue and cost metrics for the company as a whole and for individual units (Unit Economics) should yield long-term profitability (e.g. upselling potential). Finally, after combining product, market, and economics you should be able to (4) define multiple exit scenarios which result in appropriate returns based on your/your firm’s potential share on the cap table.
Technology
The assessment of a company’s technology should reflect (1) the value of the underlying innovation — thus the technical asset (or intellectual property (IP) which ties tech to legal) the company has developed. As we talk about high-growth cases, (2) the degree of automation should also be measured as well as the robustness of the „engine“ powering the company through massive growth. Moreover, (3) the IP should even deter mighty competitors from copying the competitive edge. Finally, (4) the overall quality of the technology regarding infrastructure, architecture, code-base, testing as well as the technical roadmap & processes should be evaluated as competitive and doable. Note: Many technology cases require an external review.
Finance
The financial evaluation of an investment case could be described as the quantitative conversion of the shiny commercial part into the dusty accounting part. So, the financial DD requires (1) a detailed analysis of a company’s book-keeping (accounts, invoicing, deposits, balance sheet, cash flow, P&L, etc.) and (2) should validate that official business assessments (positively) correlate with the presented business plan plus the accuracy of past figures. For example, what is the amount of gross revenues recognized by tax authorities vs. the gross revenue in the business plan? Moreover, the DD should show the company’s ability to qualitatively and quantitatively assess financial and operative KPIs. As an investor invests cash, he wants to see what cash is actually generated. This is why (3) the analysis of liquidity, hence cash in- and outflows (cash collection, payment policy, etc.) is crucial. Finally, (4) previous audit and tax reports complement this DD part and tie up accounting, controlling and cash status.
Legal
Starting-off, you (1) analyze the legal base, meaning the legal body, articles of association and entity structure (e.g. existence of subsidiaries or parent companies). This again can be seen as the conversion of the shiny commercial part into the dusty legal one. Additionally, (2) the evaluation of previous or current legal cases and reports should reflect challenges the company faces because these could indeed influence commercial success (e.g. incorrect terms and conditions triggering customer churn). Directly related to this, (3) a detailed look at the company’s legal relationships is undertaken: employees, customers, partners, suppliers, banks, shareholders and so on. Ultimately, (4) negotiated investment terms have to be implemented (into new and) existing agreements with respect to acquiring and future selling of shares. These legal statements and updates require the support of specialized lawyers.
As stated in a previous post, to do well as VC requires a lot of craftsmanship which is quite a challenge and comes with loads of information, references, research and external help. However, each and every finding will sharpen or dilute the investment decision. Therefore, in terms of speed and effectiveness both, VC and startup, should team up to be ready for a good DD!
