Monday, December 16, 2013

8 Key Questions To Expect In Investor Due Diligence

startup-employee-due-diligenceIf you really want to impress a startup founder as a potential employee, or you want to be a smart investor, you need to know the right questions to ask. These are the questions that get past the hype of a founder “vision to change the world,” and into the realm of real business strengths, weaknesses, and current health.

Some founders try to deflect these questions by talking incessantly, so you often need to be calm, patient, and persistent to get the answers. My advice to founders out there is to not volunteer too much, but be open and honest in the face of direct questions like the following:

  1. What is your burn rate and runway today? These are investor slang terms referring to how fast money is being spent, with an implicit question of how long the startup can survive before breakeven or another cash infusion is required. You need to know this as a future employee, since it probably gates how long your new job will last. If the runway is less than six months, with no new source signed, both you and the startup are at risk.

  2. How much “skin” is already in the game? The intent of this question is to determine the level of commitment of founders, both cash and “sweat equity,” and how much others have already invested into this plan. Implicit in the analysis of the answers is how much progress has been made for the investment, and how stable the business is now.

  3. What’s the total history of this company? Gaps in the history of a startup are big red flags, just like gaps in your resume. If the company was incorporated five years ago, and is still in early stages, with the same founding team, chances are slim that it will suddenly get back on track with you as an employee, or you as an investor.

  4. How well do the founders get along with each other, and with the team? The smartest people are often the most eccentric, so some conflict in the ranks is normal. Excessive conflict, lack of communication, or lack of mutual respect is indicative of a dysfunctional team, and eventual failure of the startup. You won’t get this answer from the founder, but it’s not hard to get it by talking to other team members.

  5. What’s in this deal for me? Investing in a startup, or joining a startup, is always a very big risk, so the potential return better be large. As an employee, you salary will likely be low, your job security low, so the job title better be large, and the stock options better be large. As an investor, look for an ROI that is 10x your initial investment, based on something more than a dream from the founder. What traction can be measured today?

  6. Who do you have as outside board members? The only true outside board or advisory members are not family members, not current investors, but are experienced entrepreneurs with deep knowledge and connections in the relevant business area. They should be asking to speak to you if you are a potential investor or a superstar hire. If you talk to them, they better know the answers to the previous questions.

  7. Who is a real customer that I can talk to? Real customers are ones who have paid full price for the product, have it installed and in use, and are still satisfied. Free trials don’t count, betas don’t count, and “excited about the potential” doesn’t count. If there are no customers yet, when will the product ship, and how many times has the date been set?

  8. How solid is the intellectual property? Provisional patents, or lawsuits pending, don’t add up to a strong sustainable competitive advantage. You need to know these things before you put your money on the table, or bet your career and your family’s future on this startup.

Again, I’m not suggesting that you go on the attack to get answers to these questions. But don’t let management divert you with comments on your failure to understand “the vision and the big picture.” If you are a potential employee, it probably makes sense to get the job offer first before you tackle some of these, always staying calm and assertive.

In the parlance of an investor, asking these questions and getting answers is the heart of that mysterious “due diligence” process. Now you know. If you are a potential employee, you need to do the same due diligence before you sign on. Every good founder will have done the same on you, before they make you an offer.

Marty Zwilling


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2 comments:

  1. From my own experience I should mention that the fact how well the founders get along with each other, and with the team is very important.
    Jull from NorthandLoans.ca

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  2. Good questions all, but nowhere near as "universal" as they might appear.

    The existence of answers to 6, 7 and 8 will depend strongly on the stage of the company. If at the seed stage (probably no "professional investors") a company, especially a physical product company (not service or software), may be trudging through 3-5 years to move from a provisional to an issued patent. They may have only proven that the technology is viable by creating working prototypes. They may not have recruited outside directors as defined in the article.

    So, the answers to the above questions will depend on the stage of the company. To judge the stage of the companies development, questions that I've found useful are: Can you prove that one of your product will work? Can you prove that one potential customer has validated the value? Can you prove that you can make many of the products? Can you prove that you can sell many of the products? Can you prove that the cost is less than the value to customers?. The answers to these questions will place the company on the line from start up to sustainable enterprise. The expected return will depend on where along this spectrum investment occurs. 10X is a nice number, though infrequently achievable if the company has strong answers to all 10 questions.

    One other tangential point related to very early stage investing. I have seen convertible debt work as a very nice option. The conversion occurs at the first round of "professional" investment. This avoids many pitfalls--VC's dealing with previously established prices that may unattractive (or having a "messy" cap table) and the founders trying to establish prices at different times with multiple investors, many of whom may be close friends or relatives. This also can prevent the founders from being forced into giving up too much equity at low entry prices. It's a method that seems to work well as companies move funding beyond self, family, and friends and into professional VC's.

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