Knauss Financial Dd

The Due Diligence Process:

A Financial Perspective

Troy Knauss , Fund Executive

Piedmont Angel Network

Adjunct Professor, Wake Forest Univeristy

[email_address]

Presentation

Define the risk of a new investment

verify the plan and ask the right questions

Due Diligence : A Financial Perspective

Each deal is unique

Is it an industry that you understand?

Is it a seed, early stage or later stage deal?

How much money is required to hit major milestones and inflection points?

What is your individual risk profile?

Who are your syndication partners?

When do you start?

Do not start due diligence unless you like the industry , the plan , the team , the deal , and believe you can add value

Due diligence is expensive and takes a lot of time

Never sign a Non-Disclosure Agreement

Early in the process, the entrepreneur may ask you to sign an NDA

Many investors will not sign

See a lot of similar deals

Not interested in stealing ideas

Long-term interest in reputation

Always go into a deal expecting to find reasons not to invest

Issues with management teams , market size , competition , intellectual property (IP), stage of development , and revenue assumptions (financials)

Risk: Management Team

Are they coachable ?

Have they done it before?

What is their experience?

Do they have knowledge in a specific industry?

Risk: Market Size

What are the barriers to entry?

Who are the competitors?

What is the growth rate?

What are the assumptions of the revenue model?

What do customers say? Is this a must-have?

Risk: Model

Does the company have a defined value proposition that customers understand?

What is the long-term growth strategy and how does it influence the revenue model?

Is there differentiation?

Risk: Financial

How much money is needed?

What is the structure of the deal?

Can the deal be negotiated?

What is the valuation? Do you have comparables to review?

What is the exit strategy?

Risk: Numbers

Can you hit revenue sooner rather than later? How much will it cost to generate?

How much salary is the team taking as a percentage of the fund raise?

Is the company allocating enough money for marketing dollars?

Risk: Numbers

Did the company develop a cash flow statement?

What does the capitalization table look like?

Does the company have any debts, liabilities, issues with uncollected A/R?

Due Diligence Process

Full Business Plan Review

Presentation from Management (Maximum 15 minutes)

Site Visit(s)

Receive Due Diligence Checklist

Review References

Conduct Competitive and Financial Analysis

Finalize the Deal Terms

Process: Site Visit(s)

Meet with management team and employees to determine culture

Review the organizational chart

Determine if this group is coachable

Is the company spending money on areas/people not needed at this stage?

Due Diligence

Process: References

Contact former employees, employers, and industry experts

Conduct background checks on all key employees

Be prepared to ask for key man insurance on certain employees

Interview Advisors and Directors

Talk to current investors, lawyers and accountants

Process: Competitive Analysis

What market share is required to hit the plan?

Use game theory to predict competitive response to business plan. Can you compete if the response is to lower prices?

Why would a customer buy from you? Differentiation? Price?

Process: Financials

What is the sales pipeline?

How leveraged is the company? Can the company get non-dilutive funding from banks?

How has the company performed against previous plans?

Process: Valuation

Do not use book value, market value or income value to determine early-stage valuations?

Early-stage companies:

No track record

Low or negative profitability and cash flow

Significant risk

Due Diligence : A Financial Perspective Today (Series A) Series B Series C Later Stage Valuation Valuations not growing significantly between Series A and Series C rounds VC money moving to later stage

Typical Valuation Expectations

Series A: $500,000 to $1.5MM

Pre-money valuation: Under $3MM

Equity: 10% - 40%

Expected Returns: 10X – 30X

No specific calculation (gut feel)

Due Diligence : A Financial Perspective Investment Sought Valuation At Exit Multiple $1,000,000 Pre-money Valuation $14 million $6 million $45 million 2X 3X $1,000,000 $2 million $30 million 10X $1,000,000 $2 million

Due Diligence : A Financial Perspective 2X 15% 4X 30% 5X 40% 8X 50% 10X 60% 5-Year Returns (Multiple) Internal Rate of Return (IRR)

Distribution of Returns by Venture Investment Average Returns

High = 1 or 2 times per month Low = 1 or 2 times per year High 3.7X (4.0 years) Low 1.3X (3.6 years) Impact of Participation Mentoring, Board, Financial Monitoring Returns with Monitoring

What can help increase valuations

Experienced management team ( first time entrepreneurs will exit company with 8%, second time, 20%)

Strong technology, large opportunity, and size of round to hit milestones

Venture Capitalist Valuation Method $2,000,000 Pre-Money Valuation 33% ($10MM / $30MM) % Equity Required $10,000,000 (Funds Required x 10) Required Cash Return 60% IRR (Multiple: 10X) Required IRR $30,000,000 Company Value 15X P/E Industry Plan expects 10% ($2MM) Net Profit (5 th Year) $20,000,000 Revenue (5 th Year) Year 5 Exit Year (Expected) $1,000,000 Funds Required

Process: Valuation

In today’s financial environment, investors can dictate valuation

Historical valuations are no longer applicable

Important to negotiate valuation in good-faith… do not want to invest in a negative entrepreneur

Term Sheet

Ask for a Board position

Ask entrepreneur to pay your legal fees and to prepare documents in accordance to your term sheet

Do not overpay … think about future rounds (2/3 rd rule)

Typical Deal Terms Convertible Notes vs. Preferred Stock Purchase Status of Company (C-Corp preferred) | Issues with LLCs (K1s) Dividends: Not Mandatory; Prefer no dividends Liquidation Preference: Minimum 1x Protective Provisions: Majority of Preferred Stock Holders must approve changes to ByLaws, issuance of new shares, changes to the number of Board members, redemption of shares, creation of debt, etc. Reporting Requirements: Monitoring reports that include performance to budget, new milestones, new projections, and cap. tables Repurchasing Rights: Not in all cases but more and more deals are requiring the founder to vest his/her shares