If one of the trickiest parts of due diligence is knowing when to press ahead in the face of mounting concerns, surely the other tricky part is knowing when to suspend your efforts. The former is a challenge of overcoming inertia and uncertainty, and the latter is a challenge of overcoming momentum.
We talked about the importance of suspending final judgment in the early stages while you gather information, and we also talked about the role of natural “circuit breakers” in the process to make sure you don’t end up with a small minority of enthusiastic people leading to a bad case of deal momentum.
In a realm where every deal is imperfect, how do you tell when something is just too flawed to accept? Ham has been in this position many times before, so let’s see what insights he can offer.
Ham, what are some of the signs that it might be time to bail?
Give me a few hours and I can describe dozens of signs. Over the past 15 years, I’ve run into many different situations, but I would have to say the following five issues are the most common:
- Entrepreneur Integrity: If you suspect that you are running into ANY issues around the integrity of the entrepreneur, you are done.
- Big Surprises: Some of the surprises I have run into over the years include:
- Finding out the company has a lot of debt they need to pay off,
- A key founder quits during diligence,
- The company doesn’t have ownership of vital Intellectual Property.
- Big Shortcomings: These situations can be a bit more challenging to determine whether you are looking at something fatal or not. It takes a bit more judgement on the part of the diligence team. Examples might include:
- The size of the market opportunity is not large enough,
- The company requires too much capital to make this a slam-dunk win for early investors,
- Customer reference checks come back lukewarm.
- Loss of Enthusiasm and Interest: This is the case where you have lost all momentum within the diligence team and you won’t be able to raise any significant capital for the company. You might have one or two interested investors, but that’s not enough to properly support the company with this round of financing.
- Company Intransigence: There are times when the CEO is just not willing to compromise. For example, you start the negotiation of a termsheet, and your position and the CEO’s position are too far apart. If that happens, it can be very difficult to come up with a deal that’s seen as fair for both sides.
When you talk about integrity issues, what are you referring to? Is it always obvious?
When we look to make an investment in a company, the most important factor in our decision is the quality of the team. The key characteristic we look for in the CEO is integrity. That character trait might sound obvious, but I feel it’s very important to be on alert for trust issues when you are interacting with an entrepreneur. From the initial meeting with the company, during the due diligence process, and finally while negotiating the deal, I want to make sure the CEO is being honest and negotiates in a fair manner. If I sense any duplicity at this early a stage, I can be sure that things will only get worse as the company progresses from the honeymoon phase through the challenges faced by all startups.
Why do you cite surprises as a reason to give up? Aren’t surprises an expected outcome of a fact-gathering exercise?
There are surprises and then there are SURPRISES! When you first start diligence, you should expect to learn things about a company that you didn’t expect. Examples might include the product is really buggy, or the first few customers paid almost nothing for the product. These are the types of “warts” you expect to uncover in almost all early stage companies.
As you might surmise from the examples I gave in the list above (i.e. debt, loss of a key founder, lack of IP ownership), I am talking about surprises that indicate the CEO is hiding something from us or ignorant about what makes a company valuable. With debt, it could mean the CEO isn’t being truthful about the company’s financial position or is too financially unsophisticated to understand why that is a big problem. The loss of a key founder might speak to the CEO’s ability to build a great team. And finally, with lack of IP ownership, the CEO doesn’t realize the importance of IP to a future acquirer.
You talk about fatal shortcomings. Is one section, one area of weakness, enough to tank an entire due diligence process? If not, what does it take? If most startups need work in most areas, aren’t all of the sections going to be a little weak?
It’s important to distinguish between areas where a bit more work or experimentation is needed by the company versus true fatal flaws that will be very difficult, if not impossible to correct. The examples that I cite above (i.e. market size and capital requirements) are very tough to overcome.
Let me be a bit more concrete. Let’s look at Market Size. If you add up all the potential customers for the product and multiply by how much they will pay for the product, and you end up with a $5M market opportunity, the company shouldn’t be taking in any outside investors. It might still be a nice little business, but not one that can work with outside investors. The CEO is better off bootstrapping the business.
Here’s another example. Suppose the company has a product that needs a lot of explanation before the customer will buy, and therefore, they need to build a direct sales organization. Furthermore, their average customer spends $1,000 per year for this product. Unfortunately, their go-to-market strategy has a fatal flaw. A direct sales organization is too expensive given the price of their product.
All that said, sometimes the fatal flaw is not so fatal after all. In some cases, it’s the ignorance of the CEO that gives the appearance of a fatal flaw. For example, maybe the company I described above doesn’t need a direct sales organization. Perhaps a member of the diligence team can show the CEO how to sell the product using a strategy that is significantly less expensive for the company. That’s how a great investor adds value by applying their financial capital and human capital to help the company.
And, to answer your last question, there will be weakness in at least one section of the diligence report and probably multiple sections. That’s just the nature of seed stage investing. You can’t expect perfection when a company is at such an early stage!
How do you interpret team interest issues if the deal lead is always called on to be a cheerleader to some extent?
In the majority of diligence projects, the deal lead does play the role of cheerleader. The deal lead wants and expects the other diligence team members to be excited about the company. But, to be fair, not everyone has an upbeat personality. And, you can’t expect every member of the diligence team to remain enthusiastic during the entire diligence process. Individual risk tolerances and interest areas differ, so some will always want to get off the merry-go-round before others.
So how do you gauge whether interest in the company is high enough to justify continuing the diligence process? We use the interim call as an opportunity to do a roll call or “show of hands”. We also monitor the one-on-one interactions we have with the diligence team members. We pay attention to the level of expertise of the different team members. If your experts are bailing early, that is a bigger signal than if a few generalists wander off the reservation. And finally, we do our own gut check to see if we are just “not feeling it” and whether we think the larger investor group will be interested.
How do you define “company intransigence”? What is the difference between being busy and unresponsive?
At the end of the day, once you have the official closing on your investment, you expect to have established a strong partnership with the CEO. The investors and company management are now on this journey together. And, a long journey it will be. Most successful early stage companies can take 7-10 years before they reach an exit. If you run into “company intransigence” during diligence, you are setting yourself up for a very long and rocky marriage!
So, how do I define intransigence in this situation? I can think of four areas where the CEO has serious shortcomings:
- Responsiveness: It takes many days to get replies to our email requests
- Cooperation: Not helpful in setting up customer calls, management meetings
- Coachability: Not willing to take guidance from experienced business people
- Flexibility: Difficult to pin down for meetings and phone calls
You should expect that a CEO has much work to do and that your requests are not the only things on her plate. Remember, she has a business to run in addition to putting time into fundraising. That said, making sure that the company is properly financed is one of the CEO’s top priorities, and so being busy is not an excuse for lack of responsiveness. Ultimately, you are looking to build a great partnership. If you feel that it’s a one-way street, you will need to either fix the problem or move on to your next investment.