Due diligence for startups

START-UP

a practical guide for after term sheets

DUE DILIGENCE

https://www.flickr.com/photos/paurian/

This deck hopes to scope out the process of due diligence for 1st-time

buyers & sellers in a start-up acquisition

This is not legal advice

I’m not a lawyer

And yes.

If you are selling or buying a company, you should get a lawyer.

Also…

though I have been a seller, I am writing this as a buyer

So sellers, be aware of my biases as you read this

With that said, let’s go!

BIG IDEA 1MIND SET MATTERS

Due Diligence is not an us-versus-them activity

DO NOT

1) Approach it as an opportunity to catch someone lying

2) Tell little white lies

You are conducting an external audit, but you are not doing it as enemies

This is the first project between partners

partners that need a positive, trusting working relationship throughout the execution of the acquisition and for

many months or years after

So, your mindset, attitude, and words matter

They determine what you will see and how others will see you

The focus should be on collaboratively validating the business value of the

acquisition

And by business value, I mean the synergy value.

Not just the value of the selling business on its own.

PS: Don’t rely on the Warranties Agreement to ensure that the deal is

driven with ethics

Just be ethical and positive

BIG IDEA 2COMMUNICATE AGGRESSIVELY

The people performing the due diligence may be different from the

ones doing the deal

For example the buyer may appoint a lawyer or an accounting firm, and the

seller may appoint a business management team or an outsourced

accountant

Whatever the case, much of the work will not be CEO to CEO

So CEOs must ensure that the project team is driven by the business value of

the deal, or they will investigate the wrong things

And this means communication at the start and throughout the process

CEOs are not allowed to disengage just because it is detail

At the same time, it can be useful to keep the deal makers at arms length as

we don’t want them spoiling relationship as we iron out the tough

bits

Also, don’t allow a due diligence to get sidetracked on aspects of the review that have no real impact on the value

of the deal

For example, if the valuation is primarily about IP that will eventually be driven through the buyer’s

distribution network rather than the seller’s, other than making sure that there are no legal or debt-related skeletons in the closet, I wouldn’t go too

deeply into the seller’s distribution network.

It’s going to be deprecated anyway, so it doesn’t matter in the big picture.

Instead, I’d focus on validating the IP and making sure the buyer’s distribution network will be able to

integrate the new IP seamlessly.

Finally, because the buyer’s team is likely to do interviews, the Seller’s CEO

should ensure that everyone in the company, from CXOs to interns, are clear on the business plan, culture,

processes, etc.

Scripted answers, bad

Single story driving a clear vision, good

That said, you should already have strategic clarity in place regardless of

an acquisition!

BIG IDEA 3MAKE IT THOROUGH, BUT

DON’T LET IT DRAG

How long should due diligence take?

I think between 6 weeks – 3 months

If it take longer than 3 months, the process may scuttle the deal

Either the management team will be distracted from running the business

and the numbers will free fall

or the buyer will find something more sexy (or get bored) – typical CEO!

Shorter than 6 weeks feels too cursory to me to deliver quality

The following schedule makes sense to me

WEEK 1Understand high level business, deal

terms, and deal valuation

(employee, management, and client interviews, market research,

competitive analysis)

WEEK 2Decide as a team what needs to be

reviewed, and develop a due diligence project plan

(hold workshops to do this with explicit action plans tied to specific people)

WEEK 3 – 4Management team collects collateral

WEEK 5 – X

Execute Due Diligence

WEEK X+1

Prepare due diligence report with executive team

WEEK X+2

Present report to deal team and discuss results and operational next

steps

BIG IDEA 4

BEWARE OF DUE DILIGENCE FORMULAS & CHECKLISTS

(like this one)

Like all business processes, recipes only get you so far

Before anything else ask, "Why am I conducting due diligence?"

You've got to be very clear about the deal terms that you are validating?

If you are buying customers, but you won't really leverage IP, then spend more time on client due diligence

Firms merge for synergy value

1 + 1 needs to equal 3

So, make sure you validate synergy value

This is not about checking boxes

That said, the goal of due diligence is to…

(1)

validate the valuation that underlies the deal

(2)

surface any post-deal risks that could undermine that value

BIG IDEA 5

VALIDATING VALUE

Valuation can be understood roughly as the Net Present Value (NPV) of future

forecasted profit.

The NPV formula has two key variables

1) the 5-year profit forecast

2) the discount rate (what is the risk that the forecast is wrong).

So, the first thing you need to do in a due diligence is to make sure to

validate the profit forecast

Since

Profit = Revenue – Cost

your job is to dig through both Revenue and Cost and make sure that you

believe the assumptions that underlie the forecast

Are salary costs scaling in proportion to Revenue in the plan, and do they flow in a way that makes sense from

the previous 3 years?

The basic business ratios should be consistent through growth.

COST VALIDATIONREVENUE VALIDATION

Are salary costs above, below, or at market rates.

For example, is profitability being artificially subsidized by reduced salaries or government grants?


What other costs drive the business in a meaningful way, and do they make

sense?


How sensitive are profit forecasts to inflation in costs (higher salaries,

rents, value chain, etc)?


To what degree are costs under the control of the company?

For example, are costs highly relative to supplier prices?


If segment or geographic growth underlies the revenue strategy, are the investment costs of opening up a new

segment calculated in?


Are costs dependent on supply, manufacturing or logistics partners, and are those relationships and cost

structures locked-in?


How will operations be integrated after the acquisition? Are they

integratable and can you impact the cost base?


Note here that my assumption has been that salary is the number one

cost, so I focus on that first.

However, this is dependent on the type of business.

Whatever the case, focus on where the dial can be moved (or not) first.


With regards to Revenue, we are going to look at two variables:

Price x Volume

So you'll have additional questions to validate

Given average sales lifespan and closure % rate, are there a sufficient number of deals in the funnel, at the

right stages, to hit the revenue forecasts?


Does the growth in sales make sense, given historicals and the plan? Does it look like comparables in the industry?


Are the "% likely to close" estimates fair, or are they being too optimistic?


Given # of accounts that can be managed by 1 sales person times the

number of sales people in the headcount growth forecast, is the

sales team physically large enough to fill the funnel given the sales targets or

do they need to scale up more?


Do you think that the company can find the right people forecasted to

support revenue growth in the labour market


Are customer's comfortable buying at the proposed price? Does the price

make sense vis-à-vis competition (especially as they grow into new

segments)


Is volume dependent on distribution or retail partners and are those

relationships locked-in?


Is this a one-trick pony, or is the company extending a proper product

platform?


Can revenue synergies post-merger be realized?


Everything I just said for revenue, but for all revenue streams in the product

halo (support & maintenance, peripherals, training, advertising, etc)


Once you have validated the assumptions around Profitability, you need to validate whether you and the

founders of the firm being bought agree on the likelihood that the

forecasts will be wrong.

This is the Discount rate.

BIG IDEA 6

SPOTTING POTENTIAL POST-DEAL RISK

After you validate the valuation, you should make sure that there are no bugbears that might crop up in the

future to undermine the realization of the valuation

There are a bunch of good ones to look at, but remember from above, the goal

is not that you are sneaking around trying to catch someone out in a lie.

Also, this should be a cooperative process and it is totally acceptable that the selling company may not have all

these risks covered.

Business is risk

The key is,

1) are the risks understood 2) is there a good process to prioritize

& control the right risks.

Go through the Org Chart and get bios for the Board of Directors,

Advisory Board and key members of the operational team.

Some buyers will do reference checks off the CVs.

RISK

PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING

Go through salaries and bonus payments for the last 3 years

RISK


Make sure you understand Key-man Risk and that there are succession plans in place and being executed

for critical roles.

RISK


Is there a defined and explicitly managed culture (vision, values,

events/activities, CSR, etc) and do employees have a unified focus?

RISK


Are employees committed with high morale (interview them)?

Is there Insurance / Pension / Employee Stock Option Plan

exposure?

RISK


Are key people incentivized correctly (too little or too much

ownership)?

RISK


Do you personally get along with the key people? Do they get along with each other? How significant is

politics?

RISK


Review the Employee Handbook (including benefits, holiday, vacation, sick leave policies)

RISK


Get a copy of all employee problems for the last 3 years like

alleged wrongful termination, harassment, or discrimination or

other labour disputes

RISK


Minutes and material for statutory meetings (like AGMs, Board meetings, resolutions, etc)

RISK


Key corporate secretarial documents (Articles of Incorporation and Bylaws,

minute book, shareholder agreements, etc) and any

amendments. You might even check with the relevant authorities to make

sure Incorporation is in good standing.

RISK


Shareholding structures/ownerships – a Capitalization Table “cap table” is

best and Shareholder AgreementsInformation about subsidiaries if

relevant

RISK


Does the company's corporate structure allow for a liquidity event and ROI? Is it too complex and do

you understand which parts you are buying and dependencies on other

parts?

RISK


Determine if there are too many shareholders or too few?

RISK


Review all agreements related to options, voting rights, warrants, puts, calls, subscriptions, and convertible

securities

RISK


RISK


Shareholder, or any other, loans, credit, lines of credit, contingent

liabilities, and leases

RISK


A copy of the General Ledger and Bank Statements up to 3-years back

RISK


Accounts Payable

• How much is owed• To whom and how many creditors• How long has it been owed

Look at these metrics as a trend over 3 years. For example, what is the average number of days over a 3-year period that it takes to settle a

debt? What is the standard deviation of that metric

RISK


Accounts Receivable

• Who owes us and how much do they owe us?• Is our receivables risk

concentrated in specific debtors?• How many days does it take to

collect?• What % of debtors never pay at all

and what do we do in those cases?• Any outstanding invoice factoring

And as with Accounts Payable, do the analysis metrics

RISK


Property & Equipment (deeds, leases, mortgages, surveys, zoning

approvals or other permits, financing/Sale & Purchase)

RISK


Audited financial statements (and any adjustments) for previous 3

years, and unaudited statements for this year

RISK


Any letters from auditors.

RISK


A description of depreciation/amortization/restructuring methods and any changes to the accounting methods over the last 3

years

RISK


A description of internal financial controls

RISK


What is their financial year end and does it integrate with yours

RISK


Credit report (if possible and relevant)

RISK


Budget (next year) and strategic plan (5-year)

RISK


Tax returns for all relevant jurisdictions (3-years back) for

withholding, corporate and employee

RISK


Inventory schedule

RISK


Get a schedule of the companies that make up 50% of the revenue with a breakdown of age, volume, account management plans, etc.

RISK


A list of customers lost or fired over the past 3 years with explanations

RISK


Get a schedule of unfilled orders

RISK


Everything I just said, but also for subsidiaries

Make sure every employee is covered by an employment / consulting contracts (esp with regards to Confidentiality, non-

compete, non –solicitation, and IP). If there is diversity in contractual terms, make sure you understand

the diversity and that there is a plan to simplify.

RISK


Are employee benefits documented, understood, included in the financial model and are there

any open-ended exposures

RISK


Go through all inward & outward

• Non-Disclosure Agreements • Non-Compete Agreements• Letters of Intent• Outsourcing Agreements• License Agreements • Client contracts (past & present)• Marketing agreements• Supplier Agreements• Subsidiary agreements• Partnership / JV agreements

RISK


Make sure you understand any litigation claims, documentation,

and proceedings, settled or threatened/pending (esp.

employee non-compete or IP-infringement risk with previous

firms)

RISK


Make sure you understand any government investigations,

citations, permits, licenses and agreements and that you have

copies of any communications with regulators

RISK


Make sure you see all Patents, Trademarks, Copyright registrations or any claims or threatened claims

of infringement (inward or outward)

RISK


Make sure you understand how the company protects its IP and Trade

Secrets

RISK


Make sure you reviewed any dividend policies or restrictions that could affect your liquidity

RISK


Review escrow agreements (money or software source code)

RISK


Go through all guarantees in which the seller is a party

RISK


Make sure all 3rd party software used in production is properly

licensed

RISK


Is the engineering/product documentation in place?

RISK


Is BCP in place if required?

RISK


Can the platform scale with expected revenue/volume growth

RISK


Is the product platform old (needs rewrite soon)?

RISK


Are the business requirements / function requirements documented?

RISK


Is the R&D plan in place for the next 3 years?

RISK


Does the firm employ the right people for platform management & Development? Is the technology so specialized that you will not be able

to hire people in the future?

RISK


What is the Quality Assurance process like?

RISK


Is there a sufficient product support infrastructure in place to support

forecasted revenue growth?

RISK


Are there proper SOPs in place for Product Development &

Management

RISK


Is there warranty risk?

RISK


Is there product recall risk?

RISK


For software companies:

• Have an independent review of source code quality and extensibility

• Ensure source code is in a source control environment

• Review production incidents for the last 12 months

• Review outstanding bug tracker and find out how long it takes on average to resolve bugs

• Review all security incidents for the last 12 months

• Understand any sub-component licensing dependencies (dependencies on Open Source Licenses for example)

• Ensure that basic IT Controls are in place (Controlled access to production, data confidentiality, network security, etc)

• Understand Software Development Life Cycle culture (waterfall or agile) and ensure that your existing teams can integrate with processes

RISK


Review Advertising/sales material & Press clippings (material) / analyst

reports

RISK


Review Social Media image

RISK


Review forward-looking marketing plan & budgets

RISK


Any negative correspondence from clients over the last 3 years?

RISK


Is there a process to manage operational & emerging risk?

RISK


How mature are operations? Are they documented? What is the CMM

level?

RISK


Prepare a schedule of all law firms, accounting firms, consulting firms, or similar companies engaged with the

seller in the last 3 years

RISK


Is there a clearly defined and executable exit plan?

RISK


If the exit is dependent on aspects not including Revenue and Cost (such as proprietary data in the underlying user and usage base), validate those

assets too

RISK


Will follow-on funding be required to execute 5-year plan and how does

that impact valuation?

RISK


That’s it

Have fun with it and stay positive

BIG IDEA 7

DUE DILIGENCE HAS NOTHING TO DO WITH WHY YOU DO THINGS

RIGHT

OK, so we just spent 100+ slides reviewing what things should be in

place for a due diligence

But why were we looking for those answers

Because only the leaders of a tight run ship have the answers ready

Those leaders don’t have the answers because they are subjected

to due diligence

They have the answers because they are good at what they do and

the companies they run deserve their valuations

Don’t get your act together because of a due diligence exercise

Get your sh!t together now, because it is the right thing to do to make

your company stronger!

APPENDIX: If you really want to copy and paste the “checklist”

1. VALIDATION VALUEValuation can be understood roughly as the Net Present Value (NPV) of future forecasted profit. The NPV formula has two key variables – 1) the 5-year profit forecast and 2) the discount rate (what is the risk that the forecast is wrong). So, the first thing you need to do in a due diligence is to make sure to validate the profit forecast. Since Profit = Revenue – Cost, your job is to dig through both Revenue and Cost and make sure that you believe the assumptions that underlie the forecast. With regards to Cost, I'd look to understand the following:Are salary costs scaling in proportion to Revenue in the plan and do they flow in a way that makes sense from previous 3 years? The basic business ratios should be consistent through growth.Are salary costs above, below, or at market rates (is profitability being artificially subsidized by reduced salaries)?What other costs drive the business in a meaningful way and do they make sense?How sensitive are profit forecasts to inflation in costs (higher salaries, rents, value chain, etc)?If segment or geographic growth underlies the revenue strategy, are the investment costs of opening up a new segment calculated in?Are costs dependent on supply, manufacturing or logistics partners, and are those relationships and cost structures locked-in?How will operations be integrated after the acquisition? Are they integratable and can you impact the cost base?Note here that my guess is that salary is the number one cost, so I focus on that first. However, this is dependent on the type of business. Whatever the case, focus on where the dial can be moved (or not) first.With regards to Revenue, we are going to look at two variables, Price x Volume. So you'll have additional questions to validate:Given average sales lifespan and closure % rate, are there a sufficient number of deals in the funnel, at the right stages, to hit the revenue forecasts?Does the growth in sales make sense, given historicals and the plan? Does it look like comparables in the industry?Are the "% likely to close" estimates fair, or are they being too optimistic?Given # of accounts that can be managed by 1 sales person times the number of sales people in the headcount growth forecast, is the sales team physically large enough to fill the funnel given the sales targets or do they need to scale up more?Do you think that the company can find the right people forecasted to support revenue growth in the labour marketAre customer's comfortable buying at the proposed price? Does the price make sense vis-à-vis competition (especially as they grow into new segments)Is volume dependent on distribution or retail partners and are those relationships locked-in?Is this a one-trick pony, or is the company extending a proper product platform?Can revenue synergies post-merger be realized?Once you have validated the assumptions around Profitability, you need to validate whether you and the founders of the firm being bought agree on the likelihood that the forecasts will be wrong. This is the Discount rate.2. SPOTTING POTENTIAL POST-DEAL RISKSAfter you validate the valuation, you should make sure that there are no bugbears that might crop up in the future to undermine the realization of the valuation. There are a bunch of good ones to look at, but remember from above, the goal is not that you are sneaking around trying to catch someone out in a lie. This should be a cooperative process and it is totally acceptable that the selling company may not have all these risks covered. Business is risk. The key is, are the risks understood and is there a good process to prioritize and control the right risks. People RiskGo through the Org Chart and get bios for the Board of Directors, Advisory Board and key members of the operational team. Some buyers will do reference checks off the CVs.Go through salaries and bonus payments for the last 3 yearsMake sure you understand Key-man Risk and that there are succession plans in place and being executed for critical roles.Is there a defined and explicitly managed culture (vision, values, events/activities, CSR, etc) and do employees have a unified focus?Are employees committed with high morale (interview them)?Is there Insurance / Pension / Employee Stock Option Plan exposure?Are key people incentivized correctly (too little or too much ownership)?Do you personally get along with the key people? Do they get along with each other? How significant is politics?Review the Employee Handbook (including benefits, holiday, vacation, sick leave policies)Get a copy of all employee problems for the last 3 years like alleged wrongful termination, harassment, or discrimination or other labour disputesFunding Risk Is there a clearly defined and executable exit plan?Will follow-on funding be required to execute 5-year plan and how does that impact valuation?Contractual / Legal RiskMake sure every employee is covered by an employment / consulting contracts (esp with regards to Confidentiality, non-compete, non –solicitation, and IP). If there is diversity in contractual terms, make sure you understand the diversity and that there is a plan to simplify.Are employee benefits documented, understood, included in the financial model and are there any open-ended exposuresGo through all Non-Disclosure Agreements, Non-Compete Agreements, Letters of Intent, Outsourcing Agreements, License Agreements (inwards and outwards), Client contracts (past and present), Marketing agreements, Supplier Agreements, Subsidiary agreements, and Partnership / JV agreementsMake sure you understand any litigation claims, documentation, and proceedings, settled or threatened/pending (esp. employee non-compete or IP-infringement risk with previous firms)Make sure you understand any government investigations, citations, permits, licenses and agreements and that you have copies of any communications with regulators Make sure you see all Patents, Trademarks, Copyright registrations or any claims or threatened claims of infringement (inward or outward)Make sure you understand how the company protects its IP and Trade SecretsMake sure you reviewed any dividend policies or restrictions that could affect your liquidityReview escrow agreements (money or software source code)Go through all guarantees in which the seller is a partyMake sure all 3rd party software used in production is properly licensedProduct RiskIs the engineering/product documentation in place?Is BCP in place if required?Is the product platform old (needs rewrite soon)?Are the business requirements / function requirements documented?Is the R&D plan in place for the next 3 years?Does the firm employ the right people for platform management & Development? Is the technology so specialized that you will not be able to hire people in the future?What is the Quality Assurance process like?Is there a sufficient product support infrastructure in place to support forecasted revenue growth?Are there proper SOPs in place for Product Development & ManagementIs there warranty risk?Is there product recall risk?For software companies:

Have an independent review of source code quality and extensibilityEnsure source code is in a source control environmentalReview production incidents for the last 12 monthsReview outstanding bug tracker and find out how long it takes on average to resolve bugsReview all security incidents for the last 12 monthsUnderstand any sub-component licensing dependencies (dependencies on Open Source Licenses for example)Ensure that basic IT Controls are in place (Controlled access to production, data confidentiality, network security, etc)Understand Software Development Life Cycle culture (waterfall or agile) and ensure that your existing teams can integrate with processes

Brand riskReview Advertising/sales material & Press clippings (material) / analyst reportsReview Social Media imageReview forward-looking marketing plan & budgetsAny negative correspondence from clients over the last 3 yearsDelivery riskIs there a process to manage operational & emerging risk?How mature are operations? Documented? CMM level?A schedule of all law firms, accounting firms, consulting firms, or similar companies engaged with the seller in the last 3 yearsGovernance (Corporate Secretarial) RiskMinutes and material for statutory meetings (like AGMs, Board meetings, resolutions, etc)Key corporate secretarial documents (Articles of Incorporation and Bylaws, minute book, shareholder agreements, etc) and any amendments. You might even check with the relevant authorities to make sure Incorporation is in good standing.Shareholding structures/ownerships – a Capitalization Table “cap table” is best and Shareholder AgreementsInformation about subsidiaries if relevantDoes the company's corporate structure allow for a liquidity event and ROI? Is it too complex and do you understand which parts you are buying and dependencies on other parts?Determine if there are too many shareholders or too few?Review all agreements related to options, voting rights, warrants, puts, calls, subscriptions, and convertible securitiesFinancial RiskShareholder, or any other, loans, credit, lines of credit, contingent liabilities, and leasesA copy of the General Ledger and Bank Statements up to 3-years backAccounts payable (size, velocity)Accounts receivable (size, concentration, velocity, collectability, average collection time, any outstanding invoice factoring)Property & Equipment (deeds, leases, mortgages, surveys, zoning approvals or other permits, financing/Sale & Purchase)Audited financial statements (and any adjustments) for previous 3 years, and unaudited statements for this yearAny letters from auditors.A description of depreciation/amortization/restructuring methods and any changes to the accounting methods over the last 3 yearsA description of internal financial controlsWhat is their financial year end and does it integrate with yoursCredit report (if possible and relevant)Budget (next year) and strategic plan (5-year)Tax returns for all relevant jurisdictions (3-years back) for withholding, corporate and employeeInventory scheduleSame thing for subsidiariesGet a schedule of the companies that make up 50% of the revenue with a breakdown of age, volume, account management plans, etc.A list of customers lost or fired over the past 3 years with explanationsGet a schedule of unfilled orders.

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Due diligence for startups

Documents

alleged wrongful

extensibilityensure

outstanding

source code

3rd party

software source

spotting potential

sick leave