Month: March 2023

Tom Koor

Due diligence questions for a startup. V3

Due diligence questions for a startup. V3

 What is the purpose of this article

  • Provide a framework for founders and investors to identify due diligence questions.

This article does not provide legal, tax, financial, or investment advice.

You can download a PDF of this article from: Due diligence questions for a startup V3

What are the critical learnings in this article?

  • Due diligence begins before a startup asks for funding. Due diligence is not a one-time event.
  • Due diligence is based on more than the information a startup provides.
  • Detailed due diligence questions depend upon where a startup is in the investors’ analysis and decision-making process. Due diligence increases the further along a startup is in the funding process.
  • Due diligence is done for every kind of startup, including investment funds and angel investment groups.
  • Three overarching due diligence questions apply to any company or fund at any stage: How many cash paying customers are there with urgent problems and needs they are willing and able to pay for? How does the company enable customers and users to achieve more value than the competition? How is the leadership team competitively differentiated?

What is a startup?

A startup is a temporary organization designed to search out a repeatable, scalable, and profitable business model with lots of potential customers who are willing and able to pay to solve their problems and needs.

Startups are not building a solution.  They are building a tool to learn what solution to build.1

A business model describes how a company creates more value for C&U (customers, users) than the status quo and competitors. Who are your target C&U (Customers and Users)? What C&U problems are your solving? What C&U needs are you addressing?  What benefits and value are you enabling C&U to achieve? What are the human and technology resources needed?  What are the channels and partnerships?

What are the startup stages?

  • You have some assumptions about an urgent problem or need that C&U have.
  • You meet with C&U to hear from their lips: that this is an urgent problem or need that they have, and the value to them of meeting this urgent problem or need.
  • Within a few months you have something in C&U hands which delights them. This is not the whole solution, but something which provides noticeable value.
  • You keep adding customers while enhancing your solution to provide more value to more customers. You may be changing direction several times during this phase.

A startup is no longer a startup when it has successfully searched out a repeatable, scalable, and profitable business model with lots of potential customers who are willing and able to pay to solve their problems and needs.  The startup has learned what solution to build.  The temporary organization structure must change to one that can grow rapidly.

What are the three key sets of questions an investor asks throughout the life of the startup?

  • How many cash paying customers are there with urgent problems and needs they are willing and able to pay for?
  • How does the company enable customers and users to achieve more value than the competition?
  • How is the leadership team competitively differentiated?

The number of detailed questions in each of the three sets increases as the startup progresses through the due diligence process.

Your due diligence supports a series of decision that you, as an investor, make.

  • Why should you open (rather than immediately delete) a cold call email or introductory email from someone you know?
  • Why should you read the content of the mail?
  • Why should you read any attachments?
  • Why should you have a brief call with the startup?
  • Why should they have a meeting with you?
  • Why should they start a due diligence process with you?
  • Why should they start to negotiate terms and conditions with you?
  • Why should they decide to give you cash?

Due diligence begins before there is a funding deal to consider.

  • Early-stage funds encourage startups to: enter information into the funds’ databases at the pre-revenue stage and before asking for funds; update the data regularly; provide month updates to the fund; etc. Software tools analyze the data to identify high potential startups.
  • Early-stage funds are using software to build large databases of startups based on existing third party databases and their own tools to scan the web. Analytic tools identify high potential startups.
  • Many funds are now using software to determine which startups to actually contact. InReach Ventures in Europe has built custom software which created a database of over 95,000 startups. The software identified 2,000 candidates for management contact.2 Framework Venture Partners (Toronto Canada) has a 20,000 startup database with about 100 datapoints per startup.  Startups from the pre-revenue stage on can submit information and receive benchmark feedback.3

Due diligence also occurs at the deal sourcing stage

Only 12% of deals arise from companies applying to VCs. Each of the deal sources does some degree of due diligence.

Where do VCs source early-stage deals?4

31% Generated through professional network

23% Proactively self generated

22% Referred by other investors

12% Inbound from company management

09% Referred by portfolio company

01% Quantitative sourcing

02% Other

Once there is a deal, each step of the deal process has due diligence.

Harvard Business Review published the findings from a survey of 885 venture capitalists at 681 firms.5

For each deal that closes, on average:

  • 101 deals are considered;
  • 28 deals proceed to a meeting with company management;
  • 10 deals are reviewed at partner meeting;
  • 8 deals have detailed due diligence;
  • 7 deals result in negotiation; and
  • 1 deal actually closes.

What is one example of the questions asked at the screening stage?

Going VC has pass/fail factors in their one-page screening test:6

  • Fit with the fund themes and areas of focus.
  • Addressing problems in the fund’s target industries/sectors.
  • Startup stage aligns with the fund’s target stages.
  • Startup target geography aligns with fund’s target geography.
  • Quality of the referral.
  • Strengths of the startup’s partnerships, customer traction and suppliers.
  • Startup’s market size aligned with fund’s target market size.

What are the most important factors for VC investment decision making?4

What do VC’s say is the most important factor when they make the final investment decision?

53% team

13% fit with the fund

12% product/technology

07% Business model

07% Market

06% industry

02% fund’s ability to add value

00% valuation (not a typo – 00%)

Why is the team the most important factor at investment decision time?  Capital is unlimited but the talent to search out a large market and supporting business model is very scarce.  The team must have demonstrated that: they can work together, learn a variety of skills very quickly, build relationships quickly, make fundamental changes in direction when required, have integrity and trust worthiness, maximize the results from careful cash management, etc.

Andreessen Horawitz looks for three things in a startup: huge market, differentiated technology, incredible people.7

 What are the three areas I assess when hearing someone making a pitch?

#1 What is the market risk and value proposition risk

How many potential customers have an urgent need or problem they are willing and able to pay to address?

Red flags for me are:

  • Focusing on customer and user “needs”. Everyone has lots of needs. Not every need is urgent enough to warrant spending money.
  • Market size is based on a chart from a consulting firm.
  • Market size is focused on users i.e. not the cash paying customers
  • Not knowing who the cash paying customer is.
  • Not having interviewed and surveyed potential customers to understand the problems and needs they are willing and able to pay to address.
  • Market size is based on the founders opinions and hopes rather than the understanding of potential customers.

#2 What is the technology/solution risk?

  • Can the founders explain the competitively differentiated technology/solution so that anyone can understand? Albert Einstein supposedly said “If you can’t explain it to a six-year-old, then you don’t understand it yourself.”
  • If I have current and relevant knowledge of the technology/solution, what is my assessment?
  • If there is someone who I trust, and who has current and relevant knowledge, what is their assessment?

#3 What is the talent risk?

  • Is the CEO presenting or some else?
  • Do I understand what the CEO is saying?
  • Does the CEO understand the customer and market place metrics?
  • Do I trust the CEOs answers to questions?
  • What does the CEO (and team) know what competitors do not know?

What are your next steps

If you’re an investor:

  • Ensure you have an investment thesis.
  • Define your due diligence process and questions. You’ll need several stages of due diligence to quickly screen out companies for which you’ll put in the time and resources for detailed due diligence.

If you’re a startup:

  • Write down your answers to the three overarching due diligence questions apply to any company or fund at any stage: How many cash paying customers are there with urgent problems and needs they are willing and able to pay for? How does your startup enable customers and users to achieve more value than the competition? How is your leadership team competitively differentiated?
  • Define how you communicate these answers to investors and your team: in person or video calls, in presentations, in seminars, in your newsletter, on your website.
  • Research your target investors to understand their due diligence process and detailed questions.

If you’re a company past the startup stage:

  • Follow the same steps as a startup, described above.

If you are a company that is not planning at any point to raise capital:

  • Follow the same steps as a startup, described above. Note that you need to communicate with any existing capital providers

 Footnotes

1 Alistair Croll, Benjamin Yoskovitz , Lean Analytics – Use data to build a better startup faster, (Sebastopol California: O’Reilly Media ,2013) Page 41

2 Maija Palmer, “Artificial Intelligence is guiding venture capital to websites”, Financial Times, https://www.ft.com/content/dd7fa798-bfcd-11e7-823b-ed31693349d3

3 Framework Venture Partners, “What is world class – how do we benchmark venture companies?”, https://www.framework.vc/blogs/what-is-world-class-how-do-we-benchmark-startup-companies/

4 Paul Compers, Harvard Business School, Will Gornall, University of British Columbia Saunder School of Business, Steven N. Kaplan, University of Chicago Booth School of Business, Ilya A. Strebulaev, Graduate School of Business Stanford, “How do venture capitalists make decisions”, Medium,  https://medium.com/vcdium/venture-capital-decision-making-c3258bc1b09c

5 Paul Compers, Will Gornall, Steven N. Kaplan, Ilya A. Strebulaev, “How do venture capitalists make decisions”, Harvard Business Review, https://hbr.org/2021/03/how-venture-capitalists-make-decisions

6 GoingVC Team, “Screening Scorecard”, GoingVC,  https://www.goingvc.com/post/venture-capital-due-diligence-the-scorecard

7 Corporate Finance Institute, “How VCs look at startups and founders”, Corporate Finance Institute, https://corporatefinanceinstitute.com/resources/knowledge/other/how-vcs-look-at-startups-and-founders/

What further reading should you do?

How do venture capitalists assess teams?

https://koorandassociates.org/selling-a-company-or-raising-capital/how-do-venture-capitalists-assess-teams

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Tom Koor

Traditional corporate governance dooms your company to failure. V2

Traditional corporate governance dooms your company to failure. V2

 What is the purpose of this article?

Help shareholders, investors, founders, the board of directors and C-Suite discuss and improve corporate governance.

You can download a PDF of this article from: Traditional corporate governance dooms your company to failure. V2

What are the critical learnings in this article?

  • You need to have a common understand about the purpose and value of governance.
  • You must focus governance on value creation and the ability to survive crisis.
  • You need talent that is qualified to make decisions which result in value creation and enable surviving a crisis. This talent must be supported by processes and technology.

What are some definitions of corporate governance?

#1 “Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company’s many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community.

Since corporate governance provides the framework for attaining a company’s objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure”1

#2 The Globe and Mail Board Games survey of corporate governance produces a score of a company’s governance based on 38 sets of criteria in 4 areas: 2

  • Board Composition
  • Shareholding and compensation
  • Shareholder rights
  • Disclosure

#3 OSFI (Office of the Superintendent of Financial Institutions), the Canadian Federal Government Regulator of Financial Institutions, has published its guidelines.  There are 4 major areas:3

  • The Board of Directors
  • Risk Governance
  • The role of the Audit Committee
  • Risk Appetite Framework

#4 Law firms often discuss corporate governance in terms of government laws, regulations, and court rulings.

What are the fatal flaws with many approaches to corporate governance?

  • The focus is on the processes and the degree to which processes are carried out. The impact on profitability and value creation for members of the company’s ecosystem has little or no consideration. Two examples; a) a company could score very highly on the Globe and Mail Board Games, while at the same time losing market share and shrinking profits. b) Facebook has transformed the world and generated enormous profits, while not being a great example of corporate governance.
  • Talent requirements often have little or no consideration in corporate governance. Competitively differentiated talent is the key to the company’s value creation for ecosystem members and for the company’s very survival.  The talent criteria and talent assessment of board directors and the C-Suite often have a limited role in corporate governance.
  • Following all the laws, regulations, and court filings do not result in large numbers of cash paying customers.  Many rapidly growing companies are in areas with limited laws etc.  Innovation often is far ahead of government regulation.
  • Corporate governance objectives and practices in a public company with no controlling shareholders are very different from those with a controlling shareholder or in private companies, especially those with unanimous shareholder agreements.
  • The traditional concept of a skills matrix for board directors is obsolete. Early-stage companies, Venture Capitalists, and Private Equity seek directors who are able to enable value creation.  g., I was in a meeting when a director asked if they were going to be nominated for another year.  The response was “what value are you going to provide next year?” A value creation matrix (formal or informal) is being used by companies focused on value creation.
  • Leaders get confused about their roles i.e. the degree to which they coach and mentor talent vs make decisions about talent. g., some board directors attempt to coach and mentor the CEO. It then become difficult to challenge the CEOs recommendations when the directors were involved in the creation of the recommendations.
  • Corporate governance is often focused only on the board of directors and C-Suite. Corporate governance is much broader than that.
  • The skills and experience necessary to make decisions is unclear. g. some governance advisors believe that no skills and experience are required when voting on whether to appoint a CEO or terminate a CEO.  The advisors cite the example of U.S. Congress or Canadian Parliament, where no skills or experience are required for any vote by any member.  Other advisors use the example of the Supreme Court, wh,ere every single justice must have the skill and experience to vote on every decision.
  • The competitive differentiation of the board of directors is often ignored. It is challenging to have a competitively differentiated company without a competitively differentiated board.
  • There is no clearly defined link, and common understanding, of how corporate governance specifically enables your company’s long-term value creation and ability to survive crisis.

 

What are your next steps?

  • Read “Is your company planning to fail?”4 I observe that most companies are successfully executing their plans to fail.
  • Agree upon the purpose of your company.
  • Agree upon your company’s definition of governance and the purpose of governance.
  • Assess your company components (talent, knowledge, processes, technology) relative to your definition of governance and the purpose of governance. This assessment includes the board of directors and C-Suite.
  • Prepare your plan to improve governance.

Footnotes

1 Investopedia 2022 August 22

https://www.investopedia.com/terms/c/corporategovernance.asp

2 Globe and Mail Board Games – 2022 August 222

https://www.theglobeandmail.com/business/careers/management/board-games/article-article-canada-corporate-boards-ranked-2021/

3 Office of the Superintendent of Financial Institutions – Corporate Governance – Sound Business and Financial Practices – September 2018

https://www.osfi-bsif.gc.ca/eng/docs/cg_guideline.pdf

4 Is your company planning to fail? Koor and Associates

https://koorandassociates.org/avoiding-business-failure/is-your-company-planning-to-fail/

What further reading should you do?

  • What is the purpose of your company?

https://koorandassociates.org/corporate-governance/what-is-the-purpose-of-your-company/

  • What is corporate governance?

https://koorandassociates.org/corporate-governance/what-is-corporate-governance/

  • What is a competitively differentiated board of directors?

https://koorandassociates.org/corporate-governance/what-is-a-competitively-differentiated-board-of-directors/

  • What are the decision-making challenges faced by directors?

https://koorandassociates.org/corporate-governance/what-are-the-decision-making-challenges-faced-by-directors/

  • How can the board of directors create value?

https://koorandassociates.org/corporate-governance/how-can-the-board-of-directors-create-value/

  • What are the core components of talent?

https://koorandassociates.org/creating-business-value/core-components-of-talent/

Tom Koor

How can M&A create value? V3

How can M&A create value? V3

What is the purpose of this article?

  • Enable the board of directors, C-Suite, and investors discuss how to achieve value from M&A.

You can download a PDF of this article from: How can M&A create value V3

What are the critical learnings in this article?

  • More than half of all deals destroy value for investors.
  • Focus on creating long-term value for the merged company’s ecosystem members, especially customers.
  • Create the VCO (Value Creation Officer) role. The VCO’s focus is on value creation.

What are the five types of companies doing M&A?

  • Traditional operating companies that will integrate talent, processes, technology, etc.
  • Private Equity firms, which control their companies, acquiring portfolio companies or add-ons to portfolio companies.
  • Venture Capital firms, which will be actively involved in the portfolio companies.
  • Financial investors, who will be passive and not actively involved.
  • SPACs (Special Purpose Acquisition Vehicle) and Search Funds.

Some of the comments below apply to every type of M&A, some apply only to some of the types.

More than half of all deals destroy value for investors.1

The root causes of M&A failure at the deal stage are:

  • The M&A target does not fit the business strategy and future business model.
  • Synergy estimates (both revenue and costs) are optimistic. Relevant external benchmarks are not used. No bottom-up analysis.
  • Weak due diligence.
  • Those accountable for delivering the benefits are not involved at the deal stage.

The root causes of M&A failure at the integration stage are:

  • Taking too long to put in place the leadership accountable for delivering results.
  • Poor change management.
  • Poor planning and execution.
  • Limited ongoing communications with stakeholders.
  • Losing customers.

The value of the integrated company must be greater than the value of the standalone companies.

I have had the luck to be at a board of directors meeting at which the newly appointed CFO presented the results of the company’s past acquisition to: the board and the newly appointed CEO. The combined sales and profits after the merged company were significantly lower than the pre-acquisition sales and profits.  I assume this is what led to appointing a new CFO and a new CEO.

Why are you doing M&A?

  • Support the purpose of your company.
  • Provide increased value to the members of your company’s current ecosystem and the future merged ecosystem. These members include: customers, employees, investors, suppliers, partners, the broader public etc. Some members may be negatively impacted (e.g. employees let go due to cost cutting).  You’ll also have the challenge of allocating value creation among the members.

How will you create long-term value?

#1 Increase the capabilities of your company’s talent pool to drive long-term value growth.  Talent includes everyone in your company, starting with the board of directors.  It’s possible you may have to exit inappropriate talent.

#2 Enable more customers to achieve more value from your company.

  • More customers with more problems and needs they are willing and able to pay to address.
  • More customers perceive your competitively differentiated value proposition.

You may have to exit some unprofitable customers.

#3 Enable key members of your company’s ecosystem to achieve value.

#4 Increase the ability of your new pool of assets to provide value.

  • Your assets include: Processes, technology, intellectual property, partner, suppliers, channels (marketing, sales, distribution).
  • Your new pool of assets may require a number of changes and exits. Duplication should be reduced. Assets which are obsolete or provide little or no value must be eliminated.

The M&A process may also require divestures of: assets, business functions, business units, subsidiaries, etc.

What will be your synergy targets?

Only 58% of acquiring companies publicly announce synergy targets.  Of those that do announce synergy targets, only 29% update investors regarding progress against targets. Successful acquirers have higher internal targets than what is externally communicated.1

What are your next steps?

Your next steps depends upon what type of company you are what type of M&A you are contemplating.  In call cases, you need the VCO (Value Creation Officer) role, which is focused on the achievement of long-term value from M&A.  The VCO recommend the structure, processes, talent, and decision making principle required. The VCO has no decision making authority. If your company decides to ignore the advice of the VCO, you increase the chances of failure.

Some of the things the VCO will consider include

  • As soon as you start thinking about M&A, create the VCO (Value Creation Officer) role. The VCO is focused on creating long-term value from M&A.
  • The VCO will: outline the overall stages and journey of M&A, ranging from first considering M&A through to the eventual achievement of value; outline how Value Creation should be built into the M&A process; not be a decision maker but will suggest the decision making process and criteria (utilize existing governance structures as much as possible); be a temporary role, and without any direct full-time reports.
  • Help define the decision making principles, process, and participants for each stage of the overall M&A process. Decisions will have to be made regarding the allocation of value creation, and value destruction, to the members of your company’s ecosystem.
  • Outline the purpose of your company and of the post-merger company.
  • Document the purpose of M&A.
  • Describe the ecosystem members of the merged company and the impact on them of the merger. Model how much more value will be created by the merged company compared to the standalone companies.
  • Describe your approach for creating long-term value.
  • Describe why you’ll be able to create more value than competing bidders.
  • Help determine the maximum amount you are willing to pay. This will depend upon the terms and conditions.
  • Outline the various teams e.g. deal team, integration team, talent team, due diligence team. There may be multiple teams e.g. the talent team addressing changes to the board of directors may be different from the team addressing the C-Suite which may be different from the team addressing customer contact centre. Each team is accountable for the creation of their plan and achievement of the benefits arising from plan execution.

The scope of the plans may include changes to: board of directors, C-Suite, talent throughout the company, the organization structure,  processes, technology, channels, partners, etc.

The talent team(s) considerations include the following:

  • Outlining the CEO, President, Chief Operating Officer, C-Suite and C-suite direct reports roles and organization structure for the merged company.
  • Assigning accountability for the roles, within the merged company, which will be accountable for achieving value. Set the targets for each role. If the people occupying the roles will not commit, then replace those people. If the people who will occupy the roles will come from the merged company, then determine their commitment to targets as soon as possible.
  • The people accountable for value achievement are also accountable for the plans to achieve that value.
  • Those who will be accountable for creating and achieving value must have a degree of involvement with the due diligence.
  • Before exiting talent, consider their improvement or reallocation potential, if they had advisors, coaches, or trainers.
  • The two critical ways of looking at talent are; the value of the role and the value (current and potential) of the person in the role.

Who is the VCO?

The VCO may be a part-time or full time role for someone already part of your company OR may be a temporary outsider. Who might the VCO report to?

  • The controlling shareholder (if a private company);
  • The board chair; or
  • The CEO.

 

Footnotes

1 “The real deal on M&A, synergies, and value”, Boston Consulting Group, BCG Perspectives, 2016

https://www.bcg.com/en-ca/publications/2016/merger-acquisitions-corporate-finance-real-deal-m-a-synergies-value

Further reading

Do you understand your customers? V2

https://koorandassociates.org/understanding-customers/do-you-understand-your-customers/

Do you understand your company’s external ecosystem?

https://koorandassociates.org/strategy-and-strategic-planning/do-you-understand-your-companys-external-ecosystem/

Is your company planning to fail?

https://koorandassociates.org/avoiding-business-failure/is-your-company-planning-to-fail/

“The six types of successful acquisitions”, McKinsey, 2017 May

https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-six-types-of-successful-acquisitions

“Change management in merger integration” Bain, 2017

https://www.bain.com/insights/change-management-in-merger-integration/

2023 Global M&A Report – Bain

https://www.bain.com/globalassets/noindex/2023/bain_report_global_m_and_a_report_2023.pdf