Ca # 5-0014
This note was prepared by Hal Nelson T’03 under the supervision of Adjunct Assistant Professor Fred Wainwright and Professor Colin Blaydon of the Tuck School of Business at Dartmouth College. It was written as a basis for class discussion and not to illustrate effective or ineffective management practices.
Copyright © 2004-2005 Trustees of Dartmouth College. All rights rerved. To order additional
note begins with an overview of due diligence followed by challenges with this process.
The Landscape of Due Diligence
Underneath the due diligence process resides a simple fact: a significant amount of knowledge resides with the experience of the individual, not the firm. Many practitioners have characterized the asssment of investment proposals to be about “pattern recognition.” Therefore tho individuals with significant experience tend to have a knack for identifying winning investment proposals. Becau this knowledge is hard to extract and codify, many firms struggle with consistently evaluating investment proposals. Either poor efficiency leads to delays in executing
Due Diligence Strategy
The due diligence strategy of a firm establishes the criteria for screening and evaluating potential investment proposals. This strategy outlines the types of investments that are consistent with the firm’s investment philosophy. Obviously, a
firm has to first define the types of investment that are a fit with the firm. Venture firms typically have a t of investment criteria that define the type of investments that they find attractive. The criteria include the stage of the business, the geographic region, the size of the deal, the industry ctor, etc. Once the criteria are defined, a firm will tailor the process to answer specific questions. The fundamental focus of the process is to rai flags with the deal.
As few as 10 to 15 % of business proposals pass the screening pha. The deals that pass the initial screen will be evaluated further with detailed due diligence. For the venture capital investment process, due diligence means a rigorous investigation and evaluation of an investment opportunity before committing funds. The due diligence process is designed to reduce the investors’ risk by understanding the issues and challenges embedded in a business proposal. In esnce, it involves asking and answering a ries of questions, just as the screening process but in much greater depth.
This information is ud to determine if the deal warrants further consideration in moving to the next pha of the process, valuation and deal structuring.
In addition, each firm must decide how they will execute the due diligence process. There are many alternatives depending on the resources available to the firm. The firm may allow the process to proceed in an ad hoc manner, while other firms may choo to u a defined, rigorous process. The firm may allow individuals to review proposals bad on their area of experti or assign responsibility to associates to conduct a general screening of all proposals.
One approach does not fit the needs of all firms, especially becau of industry specialization. In addition, there is no single question that will answer the simple question, “Is this a winning investment proposal?” However, there are opportunities to formalize the process and take a general look at best practices that will facilitate due diligence for a firm.
Due Diligence Process
Due diligence can be broken down to include an initial screening of the deal and a detailed evaluation in determining the suitability of a deal before moving to the next stage in which the valuation and deal structure is conducted. This note will outline the general practices involved in scre
ening due diligence and business due diligence.
Screening Due Diligence. The intent of screening due diligence is to quickly flag the deals that either do not fit with the investment criteria of the firm or the criteria
that are deemed necessary for success. Venture firms are often inundated with investment opportunities. The firms typically u process or mechanisms to quickly screen out the deals that are not of interest. There is no single best approach to screening becau each firm has to determine what is critical to its fund and what types of deals will fit. Fit is often characterized by the stage of the business, geographic region, size of the deal, and industry ctor. In screening for a high quality deal there are a few additional areas of focus. Therefore most firms screen bad on investment fit and investment potential.
Investment Fit –Determines if the investment proposal is consistent with the investment philosophy of the firm - Venture capitalists may be generalist or specialist depending on their investment strategy. As a generalist, a firm may invest in various industry ctors, or various geographic locations, or various stages of a company’s life. As a specialist, a firm may invest in one or two industry ctors, or may ek to invest in only a localized geographic area.
•Stage – Not all Venture firms invest in “start-ups.” Many firms will invest at various stages of the business life cycle from ed, to early, or even late
stage. A firm may choo to invest in a business when there is only an idea;
before a product or company is formed. This is known as ed investing.
Early stage investors may provide capital to a company in the first or cond stages of the business life cycle. And some firms invest during the late
stages of the business development cycle to facilitate the growth of a
company towards exit. Finally, buyout investing might assist management
or an outside party to acquire control of a firm.
•Geography – Often firms prefer to invest in deals that are in a local geographic area. The reason behind a geographic preference tends to simply be a desire to easily manage the investment. The investors will need to
spend time with the management of the company regarding strategic
business decisions, in addition to the other investments in the firm’s
portfolio. If the investment is located within the firm’s “region,” it saves
time in attending meetings, monitoring the investment, and visiting the
management team. In addition, location may provide access to resources
such as a high caliber labor pool, top law firms, or other needs of a
developing business.
•Size – Venture firms will often establish a minimum and / or maximum amount that they like to invest. There are veral reasons for defining the
range of investment. The lower bound is often related to the need for the
investment to be large enough to justify the involvement of the firm. The
firm does not want to dilute their time over a lot of small deals. Also the
minimum amount could be a result of the size of the fund and the need to
put a sufficient amount of capital to work. The maximum amount is often
related to the size of the fund as well becau the venture firm wants to
ensure that the fund remains sufficiently diversified.
•Industry Sector – There are venture firms that will be broadly diversified and will invest in industry ctors as diver as information technology, life sciences, and consumer goods, and others that may specialize in only one
technology. While technology investment makes up most of the investing,
venture firms also invest in companies such as retail, manufacturing,
business rvices, etc. It is nearly impossible to maintain the knowledge and skills necessary to understand all industry ctors, thus every investment
opportunity. Therefore, discipline is required to ensure that firms focus on
ctors that they understand, or solicit consultation, to maximize their
potential for success.
Investment Potential – Once the investment proposal is deemed to “fit” with the philosophy of the firm, a screening is conducted to test the viability of the deal. Although screening is unique to a particular firm’s needs, there are some common threads that a firm evaluates.
•Management – Generally speaking, one of the most important criteria in the screening process is the quality of management. In real estate it is often said that the three most important words are “location, location, location.” In
evaluating a business, many venture firms will proclaim the three most
important words to be “people, people, people.”
•Market – It is no cret that venture firms are looking for large, high growth markets. In fact, it would be surprising to e a business plan that does not
suggest a significant market. The ability to clearly articulate why a
particular business proposal will experience rapid market growth is
esntial. Most important is being able to explain the competitive landscape.
A deep understanding of the competition is a clear indication that one
understands the market.
•Product / Service – The key to evaluating a product or rvice is to ask, “What customer problem is being solved?” Once an understanding of the
solution is clear, the next question is, “Can the problem be solved
profitably?” The intent is to get a feel for the types of customers and the
value that is added by the product or rvice.
