For Entrepreneurs -- Questions We Ask in Due Diligence and Why! Sheltowee Business Network Alex Day Oct 18 2019 For Entrepreneurs — Questions We Ask in Due Diligence and Why! By Eric Dobson Over the now almost 12 year storied history of Angel Capital Group, now a part of the Sheltowee Business Network, we have found key information is indicative of a team ready to use our capital to buy revenue, make use of our network and expertise, and to become business partners. These are key characteristics we look for because we have learned these lessons the hard way. Our Phase II application, found at https://theangelcapitalgroup.com/application/ is designed to get to key questions and to *test* the entrepreneur. Entrepreneurs who embrace the system generally do well. They are prepared with the right information (e.g. they have done their homework and understand how this works). They are more than likely coachable. Our business model is to coordinate and facilitate investing in ventures from Alabama, Florida, Georgia, Kentucky, Maryland, Mississippi, Minnesota, New York, North Carolina, Ohio, Pennsylvania, Tennessee, and West Virginia (states in which we currently have affiliated angel funds). Current applications must be from counties in the Appalachia region. Those in KY are: Adair, Bath, Bell, Boyd, Breathitt, Carter, Casey, Clark, Clay, Clinton, Cumberland, Edmonson, Elliott, Estill, Fleming, Floyd, Garrard, Green, Greenup, Harlan, Hart, Jackson, Johnson, Knott, Knox, Laurel, Lawrence, Lee, Leslie, Letcher, Lewis, Lincoln, McCreary, Madison, Magoffin, Martin, Menifee, Metcalfe, Monroe, Montgomery, Morgan, Nicholas, Owsley, Perry, Pike, Powell, Pulaski, Robertson, Rockcastle, Rowan, Russell, Wayne, Whitley, and Wolfe. If not, we will not accept your application without a lead investor with a signed term sheet. If you are applying through our application, you would be wise to read this fully, prepare your answers, and respond honestly. Hyperbole and “gaming the system” are easily detected in this process. That usually means the application goes in the digital, circular file. The process we go through starts with your application for funding. The information is posted on our internal website *for our members only*. Initially, the information is reviewed by the screening committee of one of our funds or groups (seven now, soon to be 10). The screening committee reviews the information and decides if the information is forwarded to their members. Once the members have reviewed the information, they will ask you to pitch, decide to invest, or pass on the deal. If they decide to invest, they can request the application be forwarded to all network members for review and funding by the Alliance. There are several distinct levels of review and diligence is performed at each level. The good news is by the time a company is invested, it has been thoroughly vetted and ready to use our investor’s capital wisely. If you use this process correctly, even if you do not receive funding, your company will be better for having gone through a professional diligence program. We sincerely want you to succeed, even if it does not involve our network. The application is broken up into four parts (so that you don’t run the risk of losing all your work if you have a browser issue): General Overview, Multiple Choice Questions (that are scored), Long Form Questions, and file uploads (Executive Summary, Pitch Deck, Proforma, Balance Sheet, Income Statement, Term Sheet, and Capitalization Table – more on this below0. Overview We need your contact information, website, and social media handles (Facebook, Twitter, LI, etc.). We are going to visit your website, social media, and take a look at you to decide if you are someone we want to be associated with for the next 3 – 7 years. We need your corporate address including corporate type (Inc. or LLC). We don’t invest in sole proprietorships or in S-corps. So, this is an easy litmus test to understand if you know what you are doing. We need a paragraph (no more than 4 sentences) that describes your company. We have multiple angel clubs and microfunds under SBN, each with its own affinity (For example, Nashville is healthcare, Knoxville is advanced materials, etc.). So, we need to know to whom to direct your information. We want to know why you get up in the morning. If you are not driven to get up and self-start every day, you are not cut out to be an entrepreneur. We want to know what the most compelling reason we should review the venture is in your mind. Selling shares is no different than selling products and services. If you can’t give us a compelling reason to take you seriously, we don’t. And, this is a great way to insert personality into the application process so we begin to know who you are and if you are creative, innovative, and focused on sales. We need to understand what you see as your top three strengths/advantages. We will read all your materials with these strengths in mind. We need to understand your top three non-capital related business risks. We will be looking in your materials to understand how you plan to mitigate these risks. Multiple Choice Questions: (scored 15 questions, 9 points max for each question = 135 possible points) “Is your product novel and disruptive?” We generally don’t invest in “better mousetraps.” So, we are seeking to understand if you are competing on value or price. We invest in the former. “What is the size of your investment round?” We generally invest in rounds of $250k to $2.5M. So, we are seeking to validate you are in our sweet spot. “What is your pre-money valuation?” We generally invest in companies, for a first round, of $1500k – $250k. We generally plan to do 2 or 3 rounds of capital with a company that is growing and executing its business plan. Second and third rounds tend to be $150k – $450k. That is why our syndicate model is so important. We can help you scale quickly. “What is the status of your product/service?” We are generally investing in companies that are within six months of meaningful revenue on both ends. Meaning we are generally seeking seed or early Series A deals. We understand product and software development cycles. So, we can estimate your time to revenue based on your product development status. “How much revenue have you generated in the last 12 months?” We will invest pre-revenue, but prefer a company to have clients and revenue. Valuations directly reflect the latter. “What is your revenue model?” We prefer recurring revenue models over laborious single product sales and fulfillment models. That is not to say we won’t invest if the margins are sufficiently large. “What are your gross margins?” Gross margin is a proxy for “room for error.” If you have large gross margins, you have room to make mistakes and recover. The opposite is true. So, this is really a measure of risk, more than money. “What are the total addressable and segmented addressable markets (TAM and SAM) for your business?” We generally invest in markets of $1B+. The reason is a market of this size will allow for several companies to start, grow, compete, and be successful. So, this is more a measure of “room to operate. And, we want to know how much of it you can command.” “What is the Compounded Annual Growth Rate (CAGR) of your market?” We generally like to see above 5% CAGR or better. As we get beyond 20% CAGR, the market is hot! So, this is a measure of interest by others in your market. “What is the state of the market?” We like to see unconsolidated markets where several companies can compete that will soon go through some sort of consolidation. In the consolidation processes, acquisitions occur, which is generally how we get our money back. “How is the market timing for your product?” Timing is a HUGE issue for an entrepreneur. Too early to market means you will spend your time…and our money….educating the market. Too late to the market means you will be competing on price if you can elbow your way in at all. Timing is the one thing an entrepreneur can’t control. “What is the status of your intellectual property (IP) or barriers-to-entry for fast followers (BtoE)?” We generally invest in companies with significant patent rights because, historically that has created barriers-to-entry for fast followers and driven acquisitions. That is not a fail-safe model, but IP adds to the value of a company at exit, and often is the reason for acquisition. We want to know if you have any intrinsic barriers-to-entry built into your company. “Does your team have a demonstrated track record of execution?” The experience of the team is the largest predictor of success we have found. So, we want to know if this is a been-there-done-that-learned-the-hard-lessons team or a one-man band newbie. “How much capital have you raised in the last 12 months?” Having raised meaningful capital in the last 12 months is the second largest predictor of success we have found. If your deal appeals to a broad group of investors, you have a higher likelihood of raising capital easily and with good terms. “Describe the mergers and acquisition (M&A) activity in your market over the last three – five years with a look to the future. Initial Public Offering?” If your market is hot, there is a higher chance you will be acquired. It is that simple. Name names here. It shows you understand your own market place. Long Form Questions: “Provide an overview of the management team. Why is this the right team to win in the market place? What unique skills and experience does the team have? Why should the investor trust the team with their hard-earned cash?” We are seeking information on your team, which is the largest determinant variable of success. Winners keep winning. “What is the point of pain that your company addresses? How is your product/service addressing it? Why is it critical to your clients?” We invest in companies that are addressing real-world problems for which we can clearly see a market for the solution. “What is your value proposition? Who are your clients? Why would they buy from you? What is their motivation? What is their ROI?” Clients buy products and services because it saves money, makes money, or both. We need to understand your monetary value to your customer. “Describe your business model. How do you make money? What are your revenue streams? How much revenue does a customer represent?” We need to understand how you make money. “Please provide an overview of the market for your product/service including market segmentation.” We need to understand the market from your perspective. “Provide an overview of your marketing plan. Who are you selling to and how will you reach them? What is their alternative? What is your “beachhead” strategy?” Please tell us how you plan to message your clients. We want to understand if you know the difference between marketing and sales. “Provide an overview of your sales plan. How will you sell to your customers? What channels will you use?” We need to understand how you intend to capture clients. We want to understand if you know the difference between marketing and sales. “Describe your commercial traction. Do you have paying customers? Describe your ideal customer profile.” Traction is the most important reason to invest in a company. “Please summarize your use of funds and financial projections including cash flow positive and break-even milestones. Describe your cost structure and capital needs.” How are you going to spend our money? If you are spending it on marketing to generate sales, we are happy. If you are spending it on human resources to keep the lights on and the doors open, we are not interested. “Please describe the sources of competition in the marketplace and your sustainable competitive advantage(s) that will help you win in that same marketplace.” We need to understand the competitive landscape from your perspective. We need to believe you have a sustainable competitive advantage that is worth our money and your time. “Describe your intellectual property position. Do you have patents? Trademarks? Copyrights? What barriers-to-entry do they create for your competition?” We need to understand what, if any, barriers-to-entry by fast followers you have created. We understand the value of IP and its challenges. IP still commands a premium in the Heartland. “Please enter the Myers Briggs personality profile results (ENTJ, INTP, etc.) for each of your management team (CEO, CTO, CFO, CMO, etc.):” The team, and more importantly the chemistry of the team, is critical to the success of the company. We use this information to begin to understand how your team will react to adversity and success. We don’t disqualify anyone based solely on this measure, but it does help us guide our diligence when we begin to analyze the team’s ability to execute and succeed. For instance, if you do not have a diversity of personalities on the team, we can expect dissension within the team at some point or you will succumb to “we think.” “Who are the most likely acquirers in your market that you will target for exit? Are you seeking IPO? Provide examples of prior exits and IPO values.” Understanding who you want to acquire you helps create a roadmap to acquisition and maximizing your valuation at exit. If you don’t have a map, it is easy to lose your way. “Are there any intangible advantages or reasons that we should consider this venture for funding?” We always consider intangible value of the company for investment. If we can do the right thing AND make money, the answer is obvious. “Describe your deal terms (e.g convertible note, SAFE Note, Series Seed, revenue sharing/royalty, preferred equity). Are you using industry standard terms (e.g. NVCA standard templates and terms)? Please list the terms.” Let us know what terms you are offering or, preferably, from a lead investor. “What are the top three key performance indicators (KPI) or metrics to measure success of your venture?” We will measure your performance against these indicators. Files Executive Summary – We request an executive summary that we can share easily with investors in our network and outside to introduce your company. This should be a one-page (two page at the absolute most) summary of your company, business model, marketing plan, sales plan, projections, competition, exit strategy, team, and current funding request. Proforma – The proforma is simply the numerical version of your business plan. So, we want to review your ability to plan a business’s growth and to understand the assumptions you have placed in your financial model. If you can’t plan a business, you can’t run a business. Pitch Deck – We need a pitch deck to provide more flavor and to judge your ability to communicate, to be succinct, and to be effective in your sales pitch. Make no mistake, you are selling shares of your company. If you can’t sell us shares, you can’t sell customers products and services. Business Plan – Despite the fashionable rumor that business plans are dead, they are not. We do appreciate seeing a business model canvas, but it does not replace a business plan. The business plan is just the narrative version of your financial projections. Assumptions in this plan better be in lock-step with those in the proforma. We are looking for a 10 – 12 page concise, to the point plan that better include the following: overview of your company, overview of you product/service, explanation of your business model, a marketing plan, a sales plan, a detailed overview of the competitive landscape, your financial projections, your use of funds, your capital plan, your biggest risks and mitigation strategies, your exit strategy, and your team. Balance Sheet – We need to understand your assets and liabilities. Income Statement – We need to understand your current financial position. Cap Table – We need your cap table so we can validate your valuation and to understand who we are getting involved with in your venture. Term Sheet – We need a term sheet so we can understand what terms you are offering or your lead investor has offered you. With these files, we can do a very fast dive on your company and give you a fast “yes” or “no” on our serious interest level. So, the more quality material you have prepared, and the more transparent you are, the faster you will get a solid answer. This may sound like a lot of information, but all of this should be in your business plan. You should be copying/pasting this info. If you are spending hours creating new content, you are not ready for professional investors to perform diligence on your company. That is what it takes to get investment in this day and age. We deeply dive into your business and want to understand your leadership capabilities so we can feel comfortable that you can run a business, will take advice when given, make hard calls when necessary, and be responsive to your new business partner……us.