Due diligence for startups

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Advice for buyers and sellers of start-ups to help with the due diligence process

Due diligence for startups

  1. https://www.flickr.com/photos/paurian/ START-UP DUE DILIGENCE a practical guide for after term sheets
  2. This deck hopes to scope out the process of due diligence for 1st-time buyers & sellers in a start-up acquisition
  3. This is not legal advice
  4. I’m not a lawyer
  5. And yes. If you are selling or buying a company, you should get a lawyer.
  6. Also… though I have been a seller, I am writing this as a buyer
  7. So sellers, be aware of my biases as you read this
  8. With that said, let’s go!
  9. BIG IDEA 1 MIND SET MATTERS
  10. Due Diligence is not an us-versus-them activity
  11. DO NOT 1) Approach it as an opportunity to catch someone lying 2) Tell little white lies
  12. You are conducting an external audit, but you are not doing it as enemies
  13. This is the first project between partners
  14. partners that need a positive, trusting working relationship throughout the execution of the acquisition and for many months or years after
  15. So, your mindset, attitude, and words matter They determine what you will see and how others will see you
  16. The focus should be on collaboratively validating the business value of the acquisition
  17. And by business value, I mean the synergy value. Not just the value of the selling business on its own.
  18. PS: Don’t rely on the Warranties Agreement to ensure that the deal is driven with ethics Just be ethical and positive
  19. BIG IDEA 2 COMMUNICATE AGGRESSIVELY
  20. The people performing the due diligence may be different from the ones doing the deal
  21. For example the buyer may appoint a lawyer or an accounting firm, and the seller may appoint a business management team or an outsourced accountant
  22. Whatever the case, much of the work will not be CEO to CEO
  23. So CEOs must ensure that the project team is driven by the business value of the deal, or they will investigate the wrong things
  24. And this means communication at the start and throughout the process CEOs are not allowed to disengage just because it is detail
  25. At the same time, it can be useful to keep the deal makers at arms length as we don’t want them spoiling relationship as we iron out the tough bits
  26. Also, don’t allow a due diligence to get sidetracked on aspects of the review that have no real impact on the value of the deal
  27. For example, if the valuation is primarily about IP that will eventually be driven through the buyer’s distribution network rather than the seller’s, other than making sure that there are no legal or debt-related skeletons in the closet, I wouldn’t go too deeply into the seller’s distribution network. It’s going to be deprecated anyway, so it doesn’t matter in the big picture. Instead, I’d focus on validating the IP and making sure the buyer’s distribution network will be able to integrate the new IP seamlessly.
  28. Finally, because the buyer’s team is likely to do interviews, the Seller’s CEO should ensure that everyone in the company, from CXOs to interns, are clear on the business plan, culture, processes, etc.
  29. Scripted answers, bad Single story driving a clear vision, good
  30. That said, you should already have strategic clarity in place regardless of an acquisition!
  31. BIG IDEA 3 MAKE IT THOROUGH, BUT DON’T LET IT DRAG
  32. How long should due diligence take?
  33. I think between 6 weeks – 3 months
  34. If it take longer than 3 months, the process may scuttle the deal
  35. Either the management team will be distracted from running the business and the numbers will free fall
  36. or the buyer will find something more sexy (or get bored) – typical CEO!
  37. Shorter than 6 weeks feels too cursory to me to deliver quality
  38. The following schedule makes sense to me
  39. WEEK 1 Understand high level business, deal terms, and deal valuation (employee, management, and client interviews, market research, competitive analysis)
  40. WEEK 2 Decide as a team what needs to be reviewed, and develop a due diligence project plan (hold workshops to do this with explicit action plans tied to specific people)
  41. WEEK 3 – 4 Management team collects collateral
  42. WEEK 5 – X Execute Due Diligence
  43. WEEK X+1 Prepare due diligence report with executive team
  44. WEEK X+2 Present report to deal team and discuss results and operational next steps
  45. BIG IDEA 4 BEWARE OF DUE DILIGENCE FORMULAS & CHECKLISTS (like this one)
  46. Like all business processes, recipes only get you so far
  47. Before anything else ask, "Why am I conducting due diligence?"
  48. You've got to be very clear about the deal terms that you are validating?
  49. If you are buying customers, but you won't really leverage IP, then spend more time on client due diligence
  50. Firms merge for synergy value
  51. 1 + 1 needs to equal 3
  52. So, make sure you validate synergy value
  53. This is not about checking boxes
  54. That said, the goal of due diligence is to…
  55. (1) validate the valuation that underlies the deal
  56. (2) surface any post-deal risks that could undermine that value
  57. BIG IDEA 5 VALIDATING VALUE
  58. Valuation can be understood roughly as the Net Present Value (NPV) of future forecasted profit.
  59. The NPV formula has two key variables 1) the 5-year profit forecast 2) the discount rate (what is the risk that the forecast is wrong).
  60. So, the first thing you need to do in a due diligence is to make sure to validate the profit forecast
  61. Since Profit = Revenue – Cost your job is to dig through both Revenue and Cost and make sure that you believe the assumptions that underlie the forecast
  62. Are salary costs scaling in proportion to Revenue in the plan, and do they flow in a way that makes sense from the previous 3 years? The basic business ratios should be consistent through growth. COST VALIDATION REVENUE VALIDATION
  63. Are salary costs above, below, or at market rates. For example, is profitability being artificially subsidized by reduced salaries or government grants? COST VALIDATION REVENUE VALIDATION
  64. What other costs drive the business in a meaningful way, and do they make sense? COST VALIDATION REVENUE VALIDATION
  65. How sensitive are profit forecasts to inflation in costs (higher salaries, rents, value chain, etc)? COST VALIDATION REVENUE VALIDATION
  66. To what degree are costs under the control of the company? For example, are costs highly relative to supplier prices? COST VALIDATION REVENUE VALIDATION
  67. If segment or geographic growth underlies the revenue strategy, are the investment costs of opening up a new segment calculated in? COST VALIDATION REVENUE VALIDATION
  68. Are costs dependent on supply, manufacturing or logistics partners, and are those relationships and cost structures locked-in? COST VALIDATION REVENUE VALIDATION
  69. How will operations be integrated after the acquisition? Are they integratable and can you impact the cost base? COST VALIDATION REVENUE VALIDATION
  70. Note here that my assumption has been that salary is the number one cost, so I focus on that first. However, this is dependent on the type of business. Whatever the case, focus on where the dial can be moved (or not) first. COST VALIDATION REVENUE VALIDATION
  71. With regards to Revenue, we are going to look at two variables: Price x Volume So you'll have additional questions to validate
  72. Given average sales lifespan and closure % rate, are there a sufficient number of deals in the funnel, at the right stages, to hit the revenue forecasts? COST VALIDATION REVENUE VALIDATION
  73. Does the growth in sales make sense, given historicals and the plan? Does it look like comparables in the industry? COST VALIDATION REVENUE VALIDATION
  74. Are the "% likely to close" estimates fair, or are they being too optimistic? COST VALIDATION REVENUE VALIDATION
  75. Given # of accounts that can be managed by 1 sales person times the number of sales people in the headcount growth forecast, is the sales team physically large enough to fill the funnel given the sales targets or do they need to scale up more? COST VALIDATION REVENUE VALIDATION
  76. Do you think that the company can find the right people forecasted to support revenue growth in the labour market COST VALIDATION REVENUE VALIDATION
  77. Are customer's comfortable buying at the proposed price? Does the price make sense vis-à-vis competition (especially as they grow into new segments) COST VALIDATION REVENUE VALIDATION
  78. Is volume dependent on distribution or retail partners and are those relationships locked-in? COST VALIDATION REVENUE VALIDATION
  79. Is this a one-trick pony, or is the company extending a proper product platform? COST VALIDATION REVENUE VALIDATION
  80. Can revenue synergies post-merger be realized? COST VALIDATION REVENUE VALIDATION
  81. Everything I just said for revenue, but for all revenue streams in the product halo (support & maintenance, peripherals, training, advertising, etc) COST VALIDATION REVENUE VALIDATION
  82. Once you have validated the assumptions around Profitability, you need to validate whether you and the founders of the firm being bought agree on the likelihood that the forecasts will be wrong. This is the Discount rate.
  83. BIG IDEA 6 SPOTTING POTENTIAL POST-DEAL RISK
  84. After you validate the valuation, you should make sure that there are no bugbears that might crop up in the future to undermine the realization of the valuation
  85. There are a bunch of good ones to look at, but remember from above, the goal is not that you are sneaking around trying to catch someone out in a lie.
  86. Also, this should be a cooperative process and it is totally acceptable that the selling company may not have all these risks covered.
  87. Business is risk
  88. The key is, 1) are the risks understood 2) is there a good process to prioritize & control the right risks.
  89. Go through the Org Chart and get bios for the Board of Directors, Advisory Board and key members of the operational team. Some buyers will do reference checks off the CVs. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  90. Go through salaries and bonus payments for the last 3 years RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  91. Make sure you understand Key-man Risk and that there are succession plans in place and being executed for critical roles. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  92. Is there a defined and explicitly managed culture (vision, values, events/activities, CSR, etc) and do employees have a unified focus? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  93. Are employees committed with high morale (interview them)? Is there Insurance / Pension / Employee Stock Option Plan exposure? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  94. Are key people incentivized correctly (too little or too much ownership)? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  95. Do you personally get along with the key people? Do they get along with each other? How significant is politics? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  96. Review the Employee Handbook (including benefits, holiday, vacation, sick leave policies) RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  97. Get a copy of all employee problems for the last 3 years like alleged wrongful termination, harassment, or discrimination or other labour disputes RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  98. Minutes and material for statutory meetings (like AGMs, Board meetings, resolutions, etc) RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  99. Key corporate secretarial documents (Articles of Incorporation and Bylaws, minute book, shareholder agreements, etc) and any amendments. You might even check with the relevant authorities to make sure Incorporation is in good standing. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  100. Shareholding structures/ownerships – a Capitalization Table “cap table” is best and Shareholder Agreements Information about subsidiaries if relevant RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  101. Does the company's corporate structure allow for a liquidity event and ROI? Is it too complex and do you understand which parts you are buying and dependencies on other parts? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  102. Determine if there are too many shareholders or too few? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  103. Review all agreements related to options, voting rights, warrants, puts, calls, subscriptions, and convertible securities RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  104. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Shareholder, or any other, loans, credit, lines of credit, contingent liabilities, and leases
  105. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING A copy of the General Ledger and Bank Statements up to 3-years back
  106. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Accounts Payable • How much is owed • To whom and how many creditors • How long has it been owed Look at these metrics as a trend over 3 years. For example, what is the average number of days over a 3- year period that it takes to settle a debt? What is the standard deviation of that metric
  107. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Accounts Receivable • Who owes us and how much do they owe us? • Is our receivables risk concentrated in specific debtors? • How many days does it take to collect? • What % of debtors never pay at all and what do we do in those cases? • Any outstanding invoice factoring And as with Accounts Payable, do the analysis metrics
  108. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Property & Equipment (deeds, leases, mortgages, surveys, zoning approvals or other permits, financing/Sale & Purchase)
  109. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Audited financial statements (and any adjustments) for previous 3 years, and unaudited statements for this year
  110. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Any letters from auditors.
  111. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING A description of depreciation/amortization/restructu ring methods and any changes to the accounting methods over the last 3 years
  112. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING A description of internal financial controls
  113. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING What is their financial year end and does it integrate with yours
  114. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Credit report (if possible and relevant)
  115. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Budget (next year) and strategic plan (5-year)
  116. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Tax returns for all relevant jurisdictions (3-years back) for withholding, corporate and employee
  117. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Inventory schedule
  118. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Get a schedule of the companies that make up 50% of the revenue with a breakdown of age, volume, account management plans, etc.
  119. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING A list of customers lost or fired over the past 3 years with explanations
  120. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Get a schedule of unfilled orders
  121. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING Everything I just said, but also for subsidiaries
  122. Make sure every employee is covered by an employment / consulting contracts (esp with regards to Confidentiality, non-compete, non –solicitation, and IP). If there is diversity in contractual terms, make sure you understand the diversity and that there is a plan to simplify. RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  123. Are employee benefits documented, understood, included in the financial model and are there any open-ended exposures RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  124. Go through all inward & outward • Non-Disclosure Agreements • Non-Compete Agreements • Letters of Intent • Outsourcing Agreements • License Agreements • Client contracts (past & present) • Marketing agreements • Supplier Agreements • Subsidiary agreements • Partnership / JV agreements RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  125. Make sure you understand any litigation claims, documentation, and proceedings, settled or threatened/pending (esp. employee non-compete or IP-infringement risk with previous firms) RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  126. Make sure you understand any government investigations, citations, permits, licenses and agreements and that you have copies of any communications with regulators RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  127. Make sure you see all Patents, Trademarks, Copyright registrations or any claims or threatened claims of infringement (inward or outward) RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  128. Make sure you understand how the company protects its IP and Trade Secrets RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  129. Make sure you reviewed any dividend policies or restrictions that could affect your liquidity RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  130. Review escrow agreements (money or software source code) RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  131. Go through all guarantees in which the seller is a party RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  132. Make sure all 3rd party software used in production is properly licensed RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  133. Is the engineering/product documentation in place? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  134. Is BCP in place if required? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  135. Can the platform scale with expected revenue/volume growth RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  136. Is the product platform old (needs rewrite soon)? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  137. Are the business requirements / function requirements documented? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  138. Is the R&D plan in place for the next 3 years? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  139. Does the firm employ the right people for platform management & Development? Is the technology so specialized that you will not be able to hire people in the future? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  140. What is the Quality Assurance process like? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  141. Is there a sufficient product support infrastructure in place to support forecasted revenue growth? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  142. Are there proper SOPs in place for Product Development & Management RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  143. Is there warranty risk? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  144. Is there product recall risk? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  145. For software companies: • Have an independent review of source code quality and extensibility • Ensure source code is in a source control environment • Review production incidents for the last 12 months • Review outstanding bug tracker and find out how long it takes on average to resolve bugs • Review all security incidents for the last 12 months • Understand any sub-component licensing dependencies (dependencies on Open Source Licenses for example) • Ensure that basic IT Controls are in place (Controlled access to production, data confidentiality, network security, etc) • Understand Software Development Life Cycle culture (waterfall or agile) and ensure that your existing teams can integrate with processes RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  146. Review Advertising/sales material & Press clippings (material) / analyst reports RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  147. Review Social Media image RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  148. Review forward-looking marketing plan & budgets RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  149. Any negative correspondence from clients over the last 3 years? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  150. Is there a process to manage operational & emerging risk? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  151. How mature are operations? Are they documented? What is the CMM level? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  152. Prepare a schedule of all law firms, accounting firms, consulting firms, or similar companies engaged with the seller in the last 3 years RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  153. Is there a clearly defined and executable exit plan? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  154. If the exit is dependent on aspects not including Revenue and Cost (such as proprietary data in the underlying user and usage base), validate those assets too RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  155. Will follow-on funding be required to execute 5-year plan and how does that impact valuation? RISK PEOPLE GOVERNANCE FINANCE LEGAL PRODUCT BRAND DELIVERY FUNDING
  156. That’s it Have fun with it and stay positive
  157. BIG IDEA 7 DUE DILIGENCE HAS NOTHING TO DO WITH WHY YOU DO THINGS RIGHT
  158. OK, so we just spent 100+ slides reviewing what things should be in place for a due diligence
  159. But why were we looking for those answers
  160. Because only the leaders of a tight run ship have the answers ready
  161. Those leaders don’t have the answers because they are subjected to due diligence
  162. They have the answers because they are good at what they do and the companies they run deserve their valuations
  163. Don’t get your act together because of a due diligence exercise
  164. Get your sh!t together now, because it is the right thing to do to make your company stronger!
  165. APPENDIX: If you really want to copy and paste the “checklist” 1. VALIDATION VALUE Valuation can be understood roughly as the Net Present Value (NPV) of future forecasted profit. The NPV formula has two key variables – 1) the 5-year profit forecast and 2) the discount rate (what is the risk that the forecast is wrong). So, the first thing you need to do in a due diligence is to make sure to validate the profit forecast. Since Profit = Revenue – Cost, your job is to dig through both Revenue and Cost and make sure that you believe the assumptions that underlie the forecast. With regards to Cost, I'd look to understand the following: Are salary costs scaling in proportion to Revenue in the plan and do they flow in a way that makes sense from previous 3 years? The basic business ratios should be consistent through growth. Are salary costs above, below, or at market rates (is profitability being artificially subsidized by reduced salaries)? What other costs drive the business in a meaningful way and do they make sense? How sensitive are profit forecasts to inflation in costs (higher salaries, rents, value chain, etc)? If segment or geographic growth underlies the revenue strategy, are the investment costs of opening up a new segment calculated in? Are costs dependent on supply, manufacturing or logistics partners, and are those relationships and cost structures locked-in? How will operations be integrated after the acquisition? Are they integratable and can you impact the cost base? Note here that my guess is that salary is the number one cost, so I focus on that first. However, this is dependent on the type of business. Whatever the case, focus on where the dial can be moved (or not) first. With regards to Revenue, we are going to look at two variables, Price x Volume. So you'll have additional questions to validate: Given average sales lifespan and closure % rate, are there a sufficient number of deals in the funnel, at the right stages, to hit the revenue forecasts? Does the growth in sales make sense, given historicals and the plan? Does it look like comparables in the industry? Are the "% likely to close" estimates fair, or are they being too optimistic? Given # of accounts that can be managed by 1 sales person times the number of sales people in the headcount growth forecast, is the sales team physically large enough to fill the funnel given the sales targets or do they need to scale up more? Do you think that the company can find the right people forecasted to support revenue growth in the labour market Are customer's comfortable buying at the proposed price? Does the price make sense vis-à-vis competition (especially as they grow into new segments) Is volume dependent on distribution or retail partners and are those relationships locked-in? Is this a one-trick pony, or is the company extending a proper product platform? Can revenue synergies post-merger be realized? Once you have validated the assumptions around Profitability, you need to validate whether you and the founders of the firm being bought agree on the likelihood that the forecasts will be wrong. This is the Discount rate. 2. SPOTTING POTENTIAL POST-DEAL RISKS After you validate the valuation, you should make sure that there are no bugbears that might crop up in the future to undermine the realization of the valuation. There are a bunch of good ones to look at, but remember from above, the goal is not that you are sneaking around trying to catch someone out in a lie. This should be a cooperative process and it is totally acceptable that the selling company may not have all these risks covered. Business is risk. The key is, are the risks understood and is there a good process to prioritize and control the right risks. People Risk Go through the Org Chart and get bios for the Board of Directors, Advisory Board and key members of the operational team. Some buyers will do reference checks off the CVs. Go through salaries and bonus payments for the last 3 years Make sure you understand Key-man Risk and that there are succession plans in place and being executed for critical roles. Is there a defined and explicitly managed culture (vision, values, events/activities, CSR, etc) and do employees have a unified focus? Are employees committed with high morale (interview them)? Is there Insurance / Pension / Employee Stock Option Plan exposure? Are key people incentivized correctly (too little or too much ownership)? Do you personally get along with the key people? Do they get along with each other? How significant is politics? Review the Employee Handbook (including benefits, holiday, vacation, sick leave policies) Get a copy of all employee problems for the last 3 years like alleged wrongful termination, harassment, or discrimination or other labour disputes Funding Risk Is there a clearly defined and executable exit plan? Will follow-on funding be required to execute 5-year plan and how does that impact valuation? Contractual / Legal Risk Make sure every employee is covered by an employment / consulting contracts (esp with regards to Confidentiality, non-compete, non –solicitation, and IP). If there is diversity in contractual terms, make sure you understand the diversity and that there is a plan to simplify. Are employee benefits documented, understood, included in the financial model and are there any open-ended exposures Go through all Non-Disclosure Agreements, Non-Compete Agreements, Letters of Intent, Outsourcing Agreements, License Agreements (inwards and outwards), Client contracts (past and present), Marketing agreements, Supplier Agreements, Subsidiary agreements, and Partnership / JV agreements Make sure you understand any litigation claims, documentation, and proceedings, settled or threatened/pending (esp. employee non-compete or IP-infringement risk with previous firms) Make sure you understand any government investigations, citations, permits, licenses and agreements and that you have copies of any communications with regulators Make sure you see all Patents, Trademarks, Copyright registrations or any claims or threatened claims of infringement (inward or outward) Make sure you understand how the company protects its IP and Trade Secrets Make sure you reviewed any dividend policies or restrictions that could affect your liquidity Review escrow agreements (money or software source code) Go through all guarantees in which the seller is a party Make sure all 3rd party software used in production is properly licensed Product Risk Is the engineering/product documentation in place? Is BCP in place if required? Is the product platform old (needs rewrite soon)? Are the business requirements / function requirements documented? Is the R&D plan in place for the next 3 years? Does the firm employ the right people for platform management & Development? Is the technology so specialized that you will not be able to hire people in the future? What is the Quality Assurance process like? Is there a sufficient product support infrastructure in place to support forecasted revenue growth? Are there proper SOPs in place for Product Development & Management Is there warranty risk? Is there product recall risk? For software companies: Have an independent review of source code quality and extensibility Ensure source code is in a source control environmental Review production incidents for the last 12 months Review outstanding bug tracker and find out how long it takes on average to resolve bugs Review all security incidents for the last 12 months Understand any sub-component licensing dependencies (dependencies on Open Source Licenses for example) Ensure that basic IT Controls are in place (Controlled access to production, data confidentiality, network security, etc) Understand Software Development Life Cycle culture (waterfall or agile) and ensure that your existing teams can integrate with processes Brand risk Review Advertising/sales material & Press clippings (material) / analyst reports Review Social Media image Review forward-looking marketing plan & budgets Any negative correspondence from clients over the last 3 years Delivery risk Is there a process to manage operational & emerging risk? How mature are operations? Documented? CMM level? A schedule of all law firms, accounting firms, consulting firms, or similar companies engaged with the seller in the last 3 years Governance (Corporate Secretarial) Risk Minutes and material for statutory meetings (like AGMs, Board meetings, resolutions, etc) Key corporate secretarial documents (Articles of Incorporation and Bylaws, minute book, shareholder agreements, etc) and any amendments. You might even check with the relevant authorities to make sure Incorporation is in good standing. Shareholding structures/ownerships – a Capitalization Table “cap table” is best and Shareholder Agreements Information about subsidiaries if relevant Does the company's corporate structure allow for a liquidity event and ROI? Is it too complex and do you understand which parts you are buying and dependencies on other parts? Determine if there are too many shareholders or too few? Review all agreements related to options, voting rights, warrants, puts, calls, subscriptions, and convertible securities Financial Risk Shareholder, or any other, loans, credit, lines of credit, contingent liabilities, and leases A copy of the General Ledger and Bank Statements up to 3-years back Accounts payable (size, velocity) Accounts receivable (size, concentration, velocity, collectability, average collection time, any outstanding invoice factoring) Property & Equipment (deeds, leases, mortgages, surveys, zoning approvals or other permits, financing/Sale & Purchase) Audited financial statements (and any adjustments) for previous 3 years, and unaudited statements for this year Any letters from auditors. A description of depreciation/amortization/restructuring methods and any changes to the accounting methods over the last 3 years A description of internal financial controls What is their financial year end and does it integrate with yours Credit report (if possible and relevant) Budget (next year) and strategic plan (5-year) Tax returns for all relevant jurisdictions (3-years back) for withholding, corporate and employee Inventory schedule Same thing for subsidiaries Get a schedule of the companies that make up 50% of the revenue with a breakdown of age, volume, account management plans, etc. A list of customers lost or fired over the past 3 years with explanations Get a schedule of unfilled orders.
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