Importance of Due Dilligence

1. SENTE CAPITAL MANAGEMENT
DUE DILIGENCE IS A TWO-WAY STREET
One of the most important lessons an early stage venture executive team seeking to secure investment
capital must learn is that due diligence is a “two-way street.” There is nothing in the Private Equity
rulebook that prohibits a venture from conducting due diligence on potential investors. The primary
objective of Investor Due Diligence is to enable entrepreneurs to separate the “contenders from the
pretenders”. That is, to identify those individuals or entities that are no or low probability candidate
investors.
Thus, the scope of this paper is to present information that will enable an executive team to develop a
process to assess the “viability” of potential investors they encounter. NOTE: This paper is an organic
working draft that will be expanded and updated over the next six months. Additionally, this paper is
not intended as an exhaustive delineation of issues and advice.
INVESTOR MOTIVES
The concept of investment “contenders versus pretenders” raises the question, why would an investor
express interest in your venture if they truly have no interest in investment? The answers include:
To learn about your market space for free
To learn about your technology for free
To learn about your business model for free
To acquire information to use in conducting due diligence on another
similar venture
To acquire information to use in a competitive analysis
To receive a free education about a business segment /opportunity in which
they are not knowledgeable.
With these dynamics in mind, let’s examine how to identify the true investor “contenders”.
HOW TO CONDUCT INVESTOR DUE DILIGENCE
First, we need to make a distinction between individual investors (angels, high net worth individuals)
and institutional investors (VC, private equity firms, corporate venture capital). The differences between
individual and institutional investors require variations in the approach to due diligence. For example,
institutional investors typically manage a fund and have immediate access to investment capital.
Individual investors use personal funds and therefore are not necessarily liquid. On numerous occasion I
have seen an individual investor issue a letter of intent to fund (“LOI”) only to cancel weeks later because
they could not complete a certain transaction to achieve liquidity to invest.
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Copyright 2009-2010 - Hal Spice

2. SENTE CAPITAL MANAGEMENT
The process of conducting Investor Due Diligence includes the following questions:
1. What are the investor’s possible interests (objectives) in the venture?
ROI – Primary objective is to maximize return relative to risk.
Strategic – The venture can create some type of synergy with other
investments made.
Diversification – The investor has a portfolio of private equity investments
and seeks diversification to lower overall portfolio risk.
2. Investment capabilities – Does the investor have the ability to transact in a timely manner?
It is important that the ability to invest is not dependent or contingent upon completing
another transaction or achieving a degree of liquidity.
3. Investment Model – Money under management (fund) versus investors under management
(gatekeeper) versus “funding advisor” (member of larger networks such as angel or BD).
4. Historical Record – What was the investor’s participation in financing the past last two years?
How many deals were completed and what was the typical size of deal?
5. Investment Parameters (See next section below).
6. References – Investment partners in other firms, professional service providers (law firm)
and clients or companies funded.
INVESTMENT PARAMETERS
What are the investor’s guidelines or parameters used to filter deals? Factors to examine include:
1. Investment Range (in dollars)
2. Typical Size of Investment
3. Venture Stages Funded – Concept, R&D, pre-revenue, revenue ready,
early revenue, positive net income, secondary rounds.
4. Preferred Industries / Markets / Sectors
5. Geographic Preferences / Limitations
6. Structure of the Investment (Equity, Convertible note, pure debt)
7. Exit Preference – IPO, acquisition, management buy out
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3. SENTE CAPITAL MANAGEMENT
8. Investment Duration – in months
9. Risk Tolerance
BENEFITS
Conducting investor due diligence has two major benefits for the early stage venture.
Time Optimization – Time is one of an early stage ventures most important assets. Investor due
diligence saves time by quickly eliminating investor “pretenders”.
Enhances Impression of Executive Team – The vast majority of early stage ventures that
investors encounter have fairly naïve, inexperienced, executive teams. It is highly unusual for an
investor to receive a request from an executive team requesting information to conduct due
diligence on the investor. This request and subsequent related activities create the perception
within the investor that they are dealing with a savvy and formidable executive team. Creating
such an impression is of significant value during valuation and term sheet negotiation.
A FINAL WORD…
Investor due diligence represents one tactic in a crafted comprehensive strategy for early stage ventures
to differentiate themselves from other ventures seeking funding, and increases the probability to get in
front of a viable investor. In these current economic times, an entrepreneur needs every possible edge
they can create to secure funding.
For Additional Information Contact
Hal Spice 888.898.9381 – US HQ Toll Free
Founder and Managing Partner 650.867.1382 – US Cell Phone
Sente Capital Management LLC hal.spice - Skype ID
1840 Gateway Drive – Suite 200 hal@sente-capital.com
San Mateo, California 94404 USA www.sente-capital.com
See my blog – Private Equity Advice ala Hal Spice (www.halsspice.com)
PRM - Due Diligence Is A Two-Way Street V2.5.Docx Page -3- December 1, 2010
Copyright 2009-2010 - Hal Spice