Due Diligence, that is “doing your homework”, comes in many forms in business transactions. One applies to M&A or investments where the investor’s team validate the information about the target company. Legal and financial representatives go about requesting various documents, such as financial statements, tax filings, corporate books, PR announcements, etc. Sometimes it doesn’t work well. (https://www.linkedin.com/pulse/mark-cuban-shark-tank-got-royally-screwed-howard-marks?trk=hp-feed-article-title-comment, http://www.wsj.com/articles/big-names-take-hit-on-theranos-1480379536) And the other approach to Due Diligence (“DD”) applies to pursuing investors. http://www.garage.com/resources/perfecting-your-pitch/. But these articles omit that the key elements to these DD are the detailed preparation of business plans, corporate records, competitive analysis, security interest searches, and other DD tools.
Recently, I was asked to participate in the fund raising of a new startup dealing with sensors. My contact stated that he had one potential investor who would be interested. But I asked to pause any drum beating until all “T”s are crossed and “I”s dotted. Why? Investors and VCs receive approximately 200 business plans a week requesting capital. Of that group, less than 5% get invited I solely based on the materials that they receive. In other words, the WRITTEN word and the graphics will get the company into the door. And whatever content being presented must be consonant with the experience that the audience has had in viewing so many business plans. Then, after that pitch comes additional DD to determine the final investment. Yet, since only 8-10 deals are funded annually, the percentage of success is low and can be worst without the right DD!
In my actual experience, I personally advised a NYC fintech team and had them meet the VC fund in Boston. In the fintech’s presentation, they claimed that they would be able to license 7-8 units in a year. The Managing Director pointed out that in his 10 years of experience, he has not seen any company license more than 5. Hence, the fintech company’s numbers were too sanguine and testified to their lack of experience in this space. In other words, the Fintech team’s DD was lacking and failed to attract the funding.
In other words, part of the company’s DD is to evaluate how the projections meet industry standards. What is the appropriate size of a management team? Which EBITDA multiples apply to my company? And so forth.
In the Howard Marks’ article we see another form of DD. Before investing, can everyone validate the quality of the management and truthfulness of the corporate documents? One M&A transaction had one investigate local county records to confirm no secured filings that compromised the actual physical assets when being purchased. In international transactions, one looks for Apostilled documents since many other countries rely on a formalized documentation to validate contracts. In other words, if you have a supposed contract, is it enforceable in the foreign jurisdiction? If not, then the contract is not worth much beyond the piece of paper. Corporate books must contain the right wording for the various board and shareholder meetings — otherwise, any apparent corporate action can be annulled. And, again, we can go on.
So, quote Yates, many a slip between the cup and the lip. Anything can go wrong in making an investment, to going to the wrong investors, or even putting together a business plan. The purpose of excellent DD is to mitigate those risks. And, if it cannot be done internally, outsource that skill set. As an example, I did some DD for a potential Maryland investment in data storage. When I spoke with the founder, who was foreign born, I knew that the business plan was too well written. I then confronted the founder and asked, who did author the plan. And he admitted a professional did and he compensated him. At least, he admitted to himself that, to attract funding, he did need some help. And guess what, he did get the funding.