An Investors Due Diligence

Author: Dennis J. Gerschick, Esq., CPA, CFA

Introduction

This article will summarize part of the due diligence process that a venture capitalist, or a private
investor, may go through in evaluating whether to invest in a particular private company. The
due diligence process should include legal due diligence, however, this article will not focus on
the legal due diligence that is appropriate. Instead, it will focus on the business issues that are
often considered.

As a practical matter, the venture capitalists attention may be initially attracted by an executive
summary or business plan. The venture capitalist will then want to do some due diligence to
verify that the formation provided is correct, and may want to address other issues that were not
addressed in the business plan. In the venture capital community, a question often posted is,
What is more important, the horse or the jockey? The horse being the business and market
involved. The jockey being the management team involved. Many opine that the jockey is more
important, while others take the opposite position. As a practical matter, you need both.
Consequently, sophisticated investors will want to do due diligence regarding the people
involved, the product or service, and the market.

Investing in start-up and early-stage companies is part science, part art, and the decision
regarding whether to invest or not, is often very subjective. There are no formulas, so subliminal
perceptions are very important. Further more, different factors may be more important to some
investors than others. There is not one way to perform due diligence, and the process may vary
somewhat depending on the product and people involved. Some investors will look at the
product or service first. If it is attractive, they will then proceed to inquire further. Others will
look at issues such as valuation first, and if satisfied, will proceed. For example, if the company
indicates it will sell 1% of its stock for $1 million, the investor may believe it is overvalued and
there is no point in pursuing due diligence.

Evaluating the Key Players

Most successful companies have competent management in (1) operations, (2) marketing, and
(3) financial, tax, and legal. The great companies, like Microsoft and Intel, have it all three
areas, and they work closely together. An investor may evaluate the people involved in each
area. A company may have a great product, but it may be wasted if it is not marketed properly.
The third area of financial, tax and legal can help to ensure success.

The importance of having a qualified management team is emphasized because smaller

companies often cannot afford to make many mistakes. Large companies can miss a significant
change in the industry and still survive. For example, Chrysler missed the trend to smaller, more
gas-efficient cars, but got bailed out. Smaller companies do not normally get bailed out.
Consequently, small companies have pressure to utilize their assets, especially its cash, as
effectively as possible. As a practical matter, many small companies seeking capital simply do

2003 All Rights Reserved. Dennis J. Gerschick, Esq., CPA, CFA. Dennis J. Gerschick Manages VenCap Opportunities Fund, L. P. a venture
capital fund. Dennis wishes to acknowledge the suggestions made by Mike Vollmer and Ben Dyer, many of which were incorporated in this
article.
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not have the resources to engage competent management in all three areas. In such a case
outside investors may then consider the companys outside advisors including the companys
legal counsel, CPA, and whether the company has any independent directors. Venture capitalists
will want to verify that the management team is technically competent to manage the business.
Often, as a starting point, a venture capitalist will ask for resumes of the key players, and will
then take action to verify whether the information presented is accurate. While entrepreneurs are
often extremely positive and optimistic, they should be advised to be truthful in their dealings
with potential investors. Obviously, if an entrepreneur or key player is caught lying, their
credibility is damaged and the potential investor may lose interest.

A potential investor may also consider whether members of the management team possess
certain key character or personality traits that they find important. These traits may include the
following: honesty, integrity, determination, tenacity, creativity, energy level, willingness to
work hard, a willingness to do whatever it takes to be successful, ability to inspire and lead
others, ability to handle disappointments and set-backs, and others. The evaluation of these traits
and others is very subjective.

An investor may consider the work experience of each key player including their prior
experience with other start-ups, or whether they have any experience in bringing new products to
market. What was their level of involvement and what were the results? In short, have they
done it before, or will it be a new experience?

Many investors will not simply accept information provided to them at face value, but will want
to verify such information and get additional information from independent third parties. In
checking references, they may ask to speak to others who are not listed as references. Investors
may also engage private investigators and may ask many personal questions including whether
the entrepreneurs or key players have a drinking problem, use illicit drugs, or are engaging in
extra-marital affairs. In short, they want to know everything that may affect a key players
performance. Are the key players focused on the business, or are they distracted?

In evaluating the management team, the investor may assess their commitment to the company
and may consider how much money they have invested in the company. They may ask about
their current salary and benefits package, and ask what they could receive elsewhere. Investors
often do not like to see large salaries being paid, but would rather see stock options and stock
appreciation rights being used. Are the key players covered by restrictive covenants agreements?

Evaluating the Product or Service

An intelligent investor will also consider the particular product service that is being offered. Is it
a commodity, which is an indistinguishable product or service that competes on the basis of
price, or is it unique in some respect? How is it different from similar products or services? Will
it compete on the basis of price, convenience, image, or other factors? Is it something consumers
need or simply want? What need is met? Does the product work? Are there any kinks or
problems that need to be worked out? Can the product or service be sold over the Internet?
Does the company currently engage in e-commerce? If yes, what are the results?

2003 All Rights Reserved. Dennis J. Gerschick, Esq., CPA, CFA. Dennis J. Gerschick Manages VenCap Opportunities Fund, L. P. a venture
capital fund. Dennis wishes to acknowledge the suggestions made by Mike Vollmer and Ben Dyer, many of which were incorporated in this
article.
 3
Evaluating the Market

Having a great product or service is often not enough. One of the criteria often considered in
deciding whether to make an investment, is the size of the potential market. Accordingly, how
the market is defined becomes very important. Investors will want to know the size of the
potential market and the expected growth rate of the market. They will also consider trends in
the market and how expected economic, political, and demographic changes might affect the
market. Obviously, they are looking to see if the market will be growing, and how that will
affect the companys projected revenue stream. It is also clear that when dealing with new
products or services, the market may be very hard to define and it may be difficult, if not
impossible, to get accurate information to support the asserted size of the expected market.
Obviously, when dealing with the future, some guesswork is involved. Intelligent investors will
consider what factors affect that particular market, whether there are competitive products and
how such competitive products are priced. Investors may consider whether there are any signs
that the market has accepted the new product or service, or whether there is any demand for the
product or service at the expected price. Also, is the level of demand price sensitive? If prices
are raised, will demand fall sharply?

Evaluating the Marketing Strategy

A company may have a great product and competent management, but it would still fail if the
product is not marketed properly. What is the companys marketing strategy? This will involve
an analysis of the companys distribution channels, advertising, and pricing strategy. An
investor will consider the total market and will consider what percentage of the market the
company is expected to capture. This leads to a consideration of whether there are any barriers
to entry. In other words, if the product or service under review is attractive, what will prevent
or delay competition from offering the same or similar product or service? Does the company
have any patents, trademarks, copyrights, or trade secrets? If so, how strong are the companys
rights? Maybe lawyers really are necessary! How will the company get the product to market?
Will it sell directly? Will it use middlemen? How will it create awareness of the product? What
is the most cost-effective way to advertise? Will the company target a market niche? What
factors are important to the buyer in making their purchase decision?

Conclusion

Sophisticated investors generally ask a lot of questions before making their investment. They
want to feel comfortable by getting to know the management team and other "key players." Once
investors contribute money to a company, a relationship is then created. Unlike a marriage,
however, it may be very difficult, if not impossible, to get a divorce. Companies should do due
diligence on their potential investors, but that is a subject for another day.

2003 All Rights Reserved. Dennis J. Gerschick, Esq., CPA, CFA. Dennis J. Gerschick Manages VenCap Opportunities Fund, L. P. a venture
capital fund. Dennis wishes to acknowledge the suggestions made by Mike Vollmer and Ben Dyer, many of which were incorporated in this
article.