What is Venture Due Diligence?
Introduction to Diligence…as-a-Service.
It is considered “best-practice” for investors to incorporate a due diligence process to evaluate a potential investment opportunity with an extensive list focusing on the internal structure of the firm, its persisting risk factors, and strategies to overcome them.
Before entering into a contract, investors and founders must both acknowledge that the verification process of an opportunity involves much more than just financial information presented by a company’s management team.
The due diligence process focuses on capturing an in-depth analysis of a potential investment to ensure that it resonates strategically, financially, and culturally with the business objectives of the investor.
But, what exactly is Due Diligence?
Due diligence is a broadly used term, though in context to VC or PE, it is defined as an investigation conducted by an interested party to analyze a business with an aim to find the best potential investment opportunity for investors.
Another form of due diligence can also be referred to as “sell-side due diligence,” meaning the seller conducts an inquiry about an investor to understand its potential opportunity from the investment.
An AI-based due diligence process, for example the TABS Suite Diligence-as-a-Service platform, is much less time-consuming and provides an in-depth analysis report within minutes, allowing the interested party to learn more about the company’s products, value, opportunities, and how it will resonate with their own processes.
For an effective result it is necessary to act with sufficient due diligence, failure to do so can lead to over-evaluation, weakened synergies and coordination problems post-investment.
The TABS Score adopts Artificial Intelligence and Machine Learning technology to provide a detailed report based upon a large bank of questions including sectors such as finance, HR, marketing, strategy, operations, culture, and more, in combination with the necessary documentation to provide a detailed analysis of the target company for investors.
Types of Due Diligence
Hard Due Diligence
- Hard due diligence is driven by legalities and numeric data.
- It is concerned with cost & benefits, structures, assets, and liabilities; focused more on quantitative values.
- It is oriented towards a “traditional approach and focuses on number crunching and assigning values to different sectors.
- It considers the financial position of an organization and the earnings before interest, taxes, depreciation, aging of receivables, payables, cash flow, and capital expenditures.
- Financial/Accounting, Tax, and Operational Due Diligence are all examples of hard due diligence.
A prime example of Hard Due Diligence is the case of Mattel and The Learning Company, where analysts found that Mattel’s missed the due diligence red flags concerned with slow sales, increased levels of account receivables, and losing the licensing agreement. In the end, the company was sold and sued for over $120 million by its shareholders.
Soft Due Diligence
- The soft due diligence process is concerned with people: employees, customers, partners.
- It is concerned with motivating employees and compensation packages created specifically to boost their motivation.
- It has come into increasing focus as an integral component of successful personnel catering to a successful investment.
- Considers the culture of an organization and the roles, capabilities, and attitudes of its people.
- Culture and Human Resources Due Diligence are the main examples of a soft due diligence.
An example of Soft Due Diligence is AOL and Time Warner, their merger resulted in the largest annual loss at that time due to quick diligence. Though there was no legal problem, a very important aspect was missed out: Workplace Cultural Diversity. The firms were not compatible with each other in terms of culture and people, resulting in a $99B loss.
Benefits of a Due Diligence Process
Prior to making an investment, investors take the time to examine the existing internal processes of target business and identify any risks. Once found, strategies to combat these risks are made and an in-depth analysis of the process is presented before entering a contact with them.
Essentially, a due diligence process is time-consuming and expensive, but with the developing AI and ML-based technology of TABS, investors can identify and assess risks, liabilities, and problems of the target business, and pose strategies in a significantly reduced amount of time.
The primary focus of TABS is to provide a comprehensive, holistic, and in-depth qualitative evaluation of a business/start-up using Diligence-as-a-Software for an investor to make an informed decision on the basis of a TABS Score report comprised of points for every section and its implication on the start-up’s performance and valuation in the market.
TABS Helps Organize & Display Your Due Diligence
TABS has curated an 8+ Core based checklist of Entity Setup Diligence, IT and Cyber Security Diligence, Legal Diligence, General Operations Diligence, Asset Management Diligence, Governance, HR, and any other questions / documentation you need for a structurally sound investment decision.
Entity Setup Diligence
Examines the structure of the business, a perspective around the ownership of the business, and analyses of general records to understand the standing of the company. This sets a precedent for an in-depth and targeted due diligence process:
- Articles of incorporation.
- Corporate bylaws and any amendments.
- Record of Meeting Minutes (containing ownership and board meeting minutes).
- List of subsidiaries and any other entities (i.e. partnerships and joint venture agreements).
- Jurisdictions lists where the company is authorized to conduct business.
- Business plan (executive summary, market analysis and plan, operational plan, and complete financials).
- List of officers and directors.
- Records surrounding issuances or grants of stock, options, and warrants.
- Documentation of past and current shareholder agreements, rights, and other matters concerning ownership.
- Copies of any voting agreements, trusts or proxies.
- Copies of right of first offer or refusal and pre-emptive rights.
- Transfer restriction agreements and registration agreements.
Explores the ecosystem to understand the target company’s market position. The analysis focuses on determining the market conditions, upcoming/existing competitors, trends, new technological threats/opportunities, and differences.
It is important to consider the “Consumer Sentiments” — “What is their feedback on the product/services?”, “What is the loyalty measure for a product or service?”, “Will consumer demand confirm the company’s claims about the company’s growth potential?”.
- List of products and services offered and in development.
- Market research including size, share, trends, drivers, demand, conditions, opportunities, threats, differentiators, and outlook.
- Profiles of major competitors.
- Customer analysis including customer segments, demographics, churn rate, satisfaction, customer acquisition cost, NPS score and lifetime value.
- List of major suppliers.
- Identification of any barriers to entry in the marketplace.
- Copies of long-term sales contracts.
- Agreements with distributors, value-added resellers, and dealers.
IT and Cyber Security Diligence
Investigating a company’s IT assets (or lack thereof) of diligence is conducted so as to evaluate sustainability, value, cost, measurement, and future development/modifications capabilities.
Another vital aspect to consider is how their systems integrate with your business or portfolio. As cyber-crimes are growing rapidly, incorporating a diligence process can identify potential cyber-attacks or security measures that need to be implemented to reduce the inherent impact on the IT sector.
- List of software used by the company and copies of any applicable licensing agreements.
- Any IT outsourcing agreements.
- A list of interfaces that link systems together.
- Information around security and controls framework.
- Details surrounding any hack, breach, or any other cybersecurity incident.
This includes understanding and assessing any existing or possible risks associated with the business. It is vital to review and collect documents (bank loan agreements, franchise agreements, etc.) pertaining to any legal matters faced by a company and any risks related to contracts or lawsuits.
Legal diligence greatly influences how a contract progresses. Issues such as a contract breach, active litigations, non-competitive clauses and past or pending lawsuits can affect the structure of a contract. After a transaction, the investor is responsible for any obligations, contingencies, and restrictions.
- Any pending or threatened litigation against or initiated by the company.
- Any settled or active litigation files against or initiated by the company.
- Any consent decrees, injunctions, judgments, settlements, or other orders.
- Copies of all contracts.
- Any loan agreements, bank financing agreements, and lines of credit to which company is a party.
- Licensing or franchise agreements.
- Copy of all guarantees to which the company is a party.
- Information as to any past or present governmental investigation.
- Copies of all attorneys’ responses to audit inquiries and all attorneys’ letters to auditors.
The financial performance of a business can be determined by collecting documentation for both the accounting and finance sector. The aim is to identify any unregistered debts and to determine the latest interim financial information and ROI of the target business.
Collecting this information in combination with other documents helps in estimating the real value and position of the company, ultimately justifying the investment estimate.
- Documentation around any tax liens or settlements.
- Federal, state, local and foreign income tax returns for the last three years.
- Documentation surrounding the capitalization of the company.
- Three years of annual and quarterly audited financial statements, with the auditor’s reports.
- Unaudited financial statements for comparison.
- Future financial projections.
- Budget plan.
- Any auditor communication to management for the past five years.
- Schedule of accounts receivable and accounts payable.
- A description of depreciation and amortization methods and changes in accounting methods over the past five years.
- Copy of the company’s general ledger.
General Operations Diligence
Analyzes the processes and systems of the target business to identify the risks posed by the existing business operations.
Investors have the opportunity to evaluate the performance of the current operating model, including sales, marketing, technology, supply chain and production, to identify the gaps and dormant areas that require investment and can result in possible future growth.
The goal is to analyze if the current operations are at a level that can support the business plan provided by the target business.
- Company’s operating model overview (both insourced and outsourced).
- Detailed description of the Change Management Process when a change to the operating model is needed.
- Overview of the organizational/functional structure of the teams.
- List of company’s primary and support activities.
- Details around distribution model and channels.
Asset Management Diligence
This is to verify what tangible assets are in possession of the company.
The documentation must include all the necessary information about the date and location of each asset along with the value, age, and quality. It also involves existing real estate on the company’s name, fixed assets, and inventory data.
- List of all owned or leased properties and applicable details (i.e. rent amount, location, dates, etc.).
- Details on all sales and purchases of major capital equipment in the last three years.
- Copies of all lease agreements for equipment.
- Copies of real estate deeds, appraisals, mortgages, leases, surveys, title policies, use permits and any other relevant documentation.
- Schedule of owned and leased fixed assets, including description, date acquired, value and location.
Human Resource Diligence
People are the most essential asset of an organization, as they are the most intrinsic part of the due diligence process. The documentation would involve collecting information regarding the total number of employees, compensation and benefits, location, policies, contracts, and organizational structure.
The data obtained from the personnel will help the interested parties to determine the key indicators for a successful business transaction and an integration plan if the investment is to progress.
- Employee demographic information (age, location, title, tenure, skillset, compensation, etc.).
- Employee handbook (should cover policies, benefits, procedures, and training).
- All employee, non-disclosure, non-solicitation and non-compete agreements.
- Copies of all stock options and stock purchase plans.
- Resumes of key employees.
- Assessment of the competencies, skill sets, and capabilities of employees
- Recruiting and onboarding process.
- Copies of payroll documents.
- Copies of any labor or employment contracts.
Environmental Health and Safety issues is a global agenda that is being worked on daily to reach higher standards. This includes on-site inspections and review of property records. Every business understands that if basic protocols are not in place to comply with environmental, non-pollution and sustainability laws, then it can deeply impact their value as well as reputation in the market.
- Interviews with past and present owners, operators, and occupants.
- Copies of any violations, complaints, or requests for information regarding environmental, workplace safety and health (from private parties or governmental authorities).
- Historical sources of information (i.e. aerial photographs, fire insurance maps, chain of title documents, and land use records).
- Federal and local government records.
- Permits and records relating to environmental matters such as underground storage tanks, air quality, water use, solid/liquid wastes and hazardous waste storage or disposal.
- Any records of environmental clean-up liens.
- Listing of hazardous substances (i.e. asbestos, pesticides or petroleum products) and any intentional or accidental spills/releases of the material.
- Details on workplace safety and health programs.
Bottom Line: No one can predict the outcome of a risky startup / venture investment. But it is possible, and made incredibly easy by the TABS system, to make sure all your t’s are crossed and your i’s dotted. For an investment to be successful on a baseline level (meaning, structurally a good investment), an examination of the target business must be conducted with due diligence. In order to save time and money, skipping steps may seem initially attractive, but oftentimes proves to be a loss in the end due to a negligible yet avoidable factor. Hence, an investment done through a systematic due diligence process can help you avoid costly surprises and identify risks in advance, resulting in a higher chance of a successful investment. You should never rely solely on a diligence opinion provided by a system like TABS, but it can be used to significantly augment your existing diligence processes.
The TABS Score is a statement of opinion derived from various algorithms, past deal data, as well as Founder input, and should never be received or understood as investment advice. Always conduct your own due diligence on every deal in addition to whatever tool you use to help organize the process.