Social Icons

Tuesday, March 24, 2009

Aspects of Due Dilligence

Due diligence is the final stage in a long investment process, so it's unlikely much can go wrong at this point, right? Wrong - but there are steps you can take to tip the balance in your favour and using the latest business plan software technology will support you with this process.

It's an entrepreneur's worst nightmare. You've given countless presentations and sat through endless meetings with VCs before finally getting a terms document from an interested investor. Then, as due diligence is carried out, the VC's advisors find out a 'dirty little secret' about your company that throws the whole deal into jeopardy.

For many organisations, due diligence is seen as a difficult and time-consuming exercise that caps a stressful and exhausting investment process. But there are a number of steps you can take to help the process go more smoothly, and with the right preparation you can even short-circuit it. Preparation means just that - in many cases, the documentation you will need to present to investors will stretch back over years, so it's important to keep everything up to date as your business grows.

To begin with, keeping secrets of any kind is a singularly bad idea when you're dealing with current or potential investors. 'VCs hate surprises,' says Keith Arundale, author of the British Venture Capital Association's Guide to Private Equity. 'If there's something that's significant to the investment and you don't disclose it until the due diligence stage, that's going to be a problem.' Arundale advises entrepreneurs to outline anything they think might be of the slightest relevance up front and update investors on any new developments in a disclosure letter. Mike Bowman, investment executive at g2i partner company eSynergy, adds that holding back early on may come back to haunt you: 'What you may perceive as a problem may not be a problem to the investor. Problems aired early can be dealt with. Problems uncovered by the investor towards the end of due diligence may well halt the deal.'

Richard Anson, CEO of Reevoo, the on-line reviews service, is even more categorical. 'Honesty is not just the best policy, it's the only policy - there is no other way.'

Reevoo secured $5m from Eden Ventures towards the end of last year to expand its services and tackle new markets, both geographical and vertical. Anson found the due diligence process relatively painless precisely because of the way the company had prepared, beginning with its documentation. He points out that these documents include contracts with customers, suppliers and partners; details of intellectual property (IP) rights; the technology in use at the company, employee service agreements; compliance with relevant legislation; information about key processes; and insurance documents. While the company's advisors may be presenting this 'bundle', it's important to remember that it's the directors themselves who are signing off on it, including providing warrants. The most common example of a warrant required by a VC is to the fact that there's no outstanding litigation against the company, but an investor could ask for warrants about any verbal statement you might have made that if untrue, would affect its investment position.

Equally from the VC's perspective, due diligence is just the final stage in an investment process that starts with an initial application, runs through presentation meetings and deal assessment, includes negotiations over deal structure, and proceeds to approval, offer and completion. At each of these stages, the VC will be screening the prospective investee on different aspects of the deal - 'peeling the onion', as some due diligence experts refer to it - which minimises the formal work that needs doing at the final stage and reduces the risk of surprises.

Arundale, who is about to publish a more in-depth version of his private equity guide in book form called 'Raising Venture Capital Finance in Europe', says: 'Once they've seen business plans or an exec summary and met with the team, the VC will already be carrying out their own informal due diligence enquiries, and they'll do this to the point where they're interested in making the initial offer. It's only once that's in place that they go about the more formal due diligence.'

Questioning assumptions

So what exactly does due diligence cover? The areas entrepreneurs usually think about are the financial figures, including evidence supporting the assumptions that underpin the company's projected growth. But investors will also be looking hard at the business opportunity, the quality of the management team, the technology behind the product and various intangibles, such as the IP. Often external consultants will be brought in to examine these different areas.

eSynergy's Bowman says that as much as digging into the details of the product, due diligence is designed to test the responses of the management team. 'It's about getting to know the company they are investing in and how they deal with the issues raised. This is just as important as the details of the plans and markets, as the team is the most important aspect of any investment.'

One of the most difficult areas for potential investors to judge is market positioning, particularly in emerging technology sectors where it's tough to assess how large a slice of an emerging market you can take. Real customer references - or agreements in principle to make purchases - are the favoured evidence here. But VCs might also bring in technology experts - perhaps from a University department with a particular specialism - to examine the technology opportunity. 'It can be difficult assessing the size of the market, particularly if it's a new technology,' agrees Arundale. 'Maybe the VC will have to carry out new market research about whether people are actually going to buy the technology. There's no point in having fantastic new technology if no one's going to buy it.'

Given how exhausting that process is, you might assume that any unsavoury issues will have been eked out long before you get to the due diligence stage. But not necessarily so, says Arundale. Business changes fast, and during an investment process lasting six to nine months, much can happen. Typical problems include the day-to-day risks that every business faces, such as a big customer contract falling apart at the last minute - which is not unusual, and not necessarily a dealbreaker. More serious problems are rarer, but they can happen. One due diligence advisor, examining a company that had been approved for investment by a VC, found most of its R&D work going through a partner in Dubai. That breached the rules of the government-supported funds that the company was relying on, which require any investment to benefit the UK economy.

Finally, some entrepreneurs are concerned about giving away confidential information to investors, fearing they'll use the information to help their existing portfolio companies. It's difficult to say whether these fears are well grounded, but there are measures companies can take to allay them. Some VCs will refuse to sign non-disclosure agreements upfront, simply because too many ideas cross their desks, but many will do so as discussions progress - the BVCA, for example, provides a confidentiality letter template which its members should be willing to sign. An alternative approach, Arundale adds, is to ask to deal with a different investment executive at the VC firm to the one who's already made investments in your competitors. Ultimately, however, there has to be a certain amount of trust in any business relationship, particularly when you're dealing with reputable firms. 'Hopefully they are people of integrity and trustworthy, so it shouldn't be a major issue,' he says.

By David Longworth, Webster Buchanan Research