Only one in ten startups make money. This means we could be doing better with due diligence. Here are some thoughts on the topic.

1. Proposal to Establish a Best Practices
Methodology for High Tech Startup Plan
Due Diligence
Thomas W. Lynch
CEO of Reasoning Technology Ltd.
www.thomaswlynch.com
512-782-9706
Thomas.Lynch@reasoningtechnology.com
2013 11 24

2. The Venture Capitalist's Goal
To make a Return On Investment
by selling a high tech startup program.
Here program is interpreted in the project management sense.
It is unique to Venture Capitalists among investors to work for
Return On Investment by selling a program.

3. High Tech Startup Program
●
Program - set of conjoined projects for bringing a new high
tech startup to market
●
Project – has a defined start, a set of linked tasks with re-
sources required for each, and a deliverable upon completion
– placed on a schedule.
● critical resources are needed to complete a project
● critical projects are needed to complete a program

4. Selling a Program
●
●
●
Stocks (acquisition)
Paid off convertible bond
Assets
●
●
●
●
team
intellectual property
customers
accounts receivable, etc.

5. Due Diligence Evaluation
A proposal is evaluated by estimating the size of the opportunity.
●
Opportunity - a program for which we, or the assembled group
of investors, has sufficient resources to support and has a positive return (ROI).
●
Best Opportunity
● Results in the best expected return for the portfolio per unit of
extra work in managing the portfolio.
● Does not destabilize the fund, for example, isn't 'putting all of
the eggs in one basket'.
● Indicators of a best opportunity, but not the only, is that this
opportunity has the largest expected return

6. Due Diligence Evaluation
A proposal is evaluated by estimating the size of
the opportunity.
●
Unit of Work for the Fund
● Dollar invested
● Expertise hours taken from the fund managers
● Effects on stakeholders
●
Expected Return
● Our fraction of the risk adjusted present value against the
market for the program

7. The Value Proposition
customer
company
needs
features
$$$
product
The success of the value proposition has two components:
1.
2.
The intrinsic nature of the product
The extrinsic structuring the business and execution of the plan
Even after perfect execution market is going to react to the product the way it
chooses to, not the way we want it to. This is the 'intrinsic nature' of the product.
The cost of changing this response beyond its intrinsic value, i.e. 'educating the
market' are beyond the reach of the typical startup.
On the other hand, structuring and executing the plan is determined by the team
and the resources we invest.

8. Plan Intrinsics
Two key measures of solid intrinsic value:
●
●
People in the market have a need for the features of the product
The product is feasible to produce
Both of these are a function of price.
Due diligence starts with a survey to determine if people have needs met by the
product features, how many such people there are, how we can we stereotype such
features
people, and how big is the stereotypical group. This data is derived from the
market not by the founders.
Engineering experts need to draw up project plans for implementing the product and
to have them reviewed.
These two things establish if money can be made. After this it does not really
matter if the proposed plan extrinsics hit the mark or not, because we can have
them changed.

9. The Needs Survey
With some thought, we can determine if an individual has needs for our features:
●
●
●
Without asking the person to 'imagine' or product, or to view a prototype
Without giving away our secret sauce or plans
Sometimes without the person even knowing he or she is being surveyed
Examples.
Does a person needs a new bridge: Do you live and work on the opposite sides of
the river?
Would a company like to advertise on a high tech sign at the entrance to the
university: Are many of your customers students?
Such surveys should be professionally designed.
Note, needs for: the product (customers), the company (acquirers), the team, the IP

10. Risk Adjusted Present Value Against Market
●
company worth on a given date:
present value of earnings
+/- supply and demand pressure (market expectations)
+/- buyers perception of value for the company
●
risk adjusted reward
= (risk as a probability) * reward
same as expected value for large number of trials
●
expected present value
use risk accumulates similar to depreciation, the value in the
far future events goes to zero
Would hope this value is similar to Risk Adjusted Present Value in Theory

11. E.g. Risk Adjusted Present Value of a Pear Tree
Year
Base Earnings
Prob Success
Expected Earnings
1980
200
1
200
1981
200
p=0.80
160
1982
200
p2=0.64
128
1983
200
p3=0.51
102
1984
200
p4=0.41
82
1985
200
p5=0.32
66
20
total
758 USD
ps is one minus the risk. I stopped five years out due to lack of confidence and
just punted with $20. I added the expected profit from the tree for each year to
find a present value of $758.
The buyer should pay significantly less than this to expect to have a profit. One
would expect a rational owner to sell if the buyer offers more than this amount.

12. When to Invest
When the investment represents the best opportunity.
●
The funds expertise is considered in the evaluation of opportunity.
●
Future likely deals also come into the evaluation through the present value calculations.

13. 'Has a Customer Already' Approach Flawed
Companies with solid intrinsics may fail to find a
customer because:
●
●
●
Corporate purchasing agents buy existing products, a startup
with no product yet won't even be on their radar.
Companies not in the business of development typically will
not want to start being in it.
Companies in the business of development
●
Already have an in house team
●
have existing outsourcing provider relationships
●
May go to the M&A market if they felt a new direction and
expertise was needed, or just hire people.
●
In general have a strong NIH culture
Hence, this approach will cause best opportunity
proposals to be lost.

14. 'Has a Customer Already' Approach Flawed
●
●
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Product development costs money.
Companies typically don't buy products two years before they
are delivered. (see prior slide)
This forces product development to be:
●
Inexpensive, best opportunity products that are not inexpensive are lost
●
Gentrified, only rich people can afford to start a project
●
Government program run – the antithesis of the start, a
government process determines who gets grants.
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From a university lab or incubator
Hence, this approach will cause best opportunity
proposals to be lost.

15. Conclusion
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●
●
●
●
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Invest in the best opportunities for the fund.
Best opportunities have solid intrinsics and estimated high return per unit of work for the fund.
Dictate the extrinsics.
Work to develop the program assets for which a need in the
market indicates they can be sold.
Determine need by gathering data from the market.
Determine feasibility by analysis.