Where to Start with Diligence Heuristics
By Appalachian Investors
Where to start when you meet a company requesting investment can be a difficult question. We all want to help entrepreneurs be better, but we also have to be mindful of our time and the fact that it is easy to become overwhelmed with reviewing ventures if you are not careful.
Entrepreneurs are needy creatures. We love them and they serve a critical place in our economy, but they will take as long as you give. So, we have developed some simple "rules of thumb" (use password: ACGJan2019) to help separate the wheat from the chafe quickly. We want to be respectful of the entrepreneur's time and resources, so we strive to give them a fast "yes" or "no." The worst thing you can do to an entrepreneur is a slow "maybe" that keeps them spending precious time and resources pursuing you for funding that is not going to happen. So, remember to be humane and exit the discussion quickly if you are not going to proceed. And, save your bandwidth for the diligence process on the right opportunities!
So, where to start? Once you have gone through a full diligence review a few times, you will begin to see patterns. And, out of those patterns will fall some simple heuristics that you can use to “quick screen” deals. They are not fool-proof and are not universally applicable, but they do serve to help you grasp the potential of the venture quickly so you know whether to fish-or-cut-bait. And, even if these heuristics all point negatively, you may still want to dig deeper for a number of personal or professional reasons. But, start with the obvious:
· Novel – is the plan or venture novel or is it just a better mouse trap?
· Product – do you like it, does it violate any laws of man or nature?
· Traction/execution – is this team setting and meeting milestones? Do they have clients? Do they have revenue?
· Projections – are their financial projections rational? Based on a solid sales model?
· WOW – does the company or entrepreneur make you say “wow?”
· Timing – is the timing right for the company, product, and business model?
· Team – is the team outstanding with a good track record? Are they the right team in the right positions?
· Margins – gross margins above 30%, 50% preferred, 70% = WOW?
· Market size and state - at least $1B, fragmented or unconsolidated, incumbents, 10x return possible?
· CAGR – how fast is the market growing - 5% per year minimum, 10% preferred, 25 - 50% = WOW?
· Barriers to entry/IP – does the company have a sustainable competitive advantage?
· Terms – are they offering industry standard terms - vehicle, template, valuation (if not known, not a deal killer)?
· Round Size – is this round appropriate and achievable, what else is converting with it (debt with discounts, interest, options, warrants), are they good stewards of capital?
· M&A activity in the market – are companies like this venture getting acquired in the market? Exit multiples on revenue?
· Intangibles – are their other qualities or community mandates that make this company attractive?
If you start here, you will quickly gain insight into the business’s true potential. Don’t over-think this on the front end. These are meant to be simple “rules of thumb” to help you quickly sort your dealflow. These questions help you identify the three to five critical questions that you need to answer before giving a final positive answer to a deserving entrepreneur, which is always a great feeling.
It is worth restating that your goal is to find or cultivate deals that OTHERS will want to invest in alongside you. If you invest in companies that others won’t follow, you have the financial and mentoring responsibility to support this company through exit to the exclusion, typically, of many other great opportunities. And, this quick screen list is a very useful tool for discussing the venture with your fellow investors. They will appreciate your organization and forethought here.
As a final note, it is up to you how you respond to an entrepreneur negatively or positively. Some investors simply have a form letter they send with generic statements that the deal does not meet their objectives. Some, and I fall into this category, will send a bullet point list of the top one to three reasons for passing on the investment. Most entrepreneurs will be very thankful for your time, review, and honest critique. At least they now have solid feedback to judge their venture's real potential and adjust their actions accordingly (mature reaction of a solid entrepreneur). But, some will use such an opportunity to try to extend the conversation in the hope that you will change your mind, which really shows naivety on their part. And, a small fraction will become very, very defensive because you don't understand their genius. In this case, it really does no good to respond further. End the conversation immediately. Responding further will only exacerbate the situation.
This was originally published under the Appalachian Regional Commission POWER Grant, PW-1835-M.
Copyright Appalachian Investors 2017
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