Thoughts on Due Diligence

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Information about Thoughts on Due Diligence

Published on March 4, 2014

Author: thomaslynch3979



Only one in ten startups make money. This means we could be doing better with due diligence. Here are some thoughts on the topic.

Proposal to Establish a Best Practices Methodology for High Tech Startup Plan Due Diligence Thomas W. Lynch CEO of Reasoning Technology Ltd. 512-782-9706 2013 11 24

The Venture Capitalist's Goal To make a Return On Investment by selling a high tech startup program. Here program is interpreted in the project management sense. It is unique to Venture Capitalists among investors to work for Return On Investment by selling a program.

High Tech Startup Program ● Program - set of conjoined projects for bringing a new high tech startup to market ● Project – has a defined start, a set of linked tasks with re- sources required for each, and a deliverable upon completion – placed on a schedule. ● critical resources are needed to complete a project ● critical projects are needed to complete a program

Selling a Program ● ● ● Stocks (acquisition) Paid off convertible bond Assets ● ● ● ● team intellectual property customers accounts receivable, etc.

Due Diligence Evaluation A proposal is evaluated by estimating the size of the opportunity. ● Opportunity - a program for which we, or the assembled group of investors, has sufficient resources to support and has a positive return (ROI). ● Best Opportunity ● Results in the best expected return for the portfolio per unit of extra work in managing the portfolio. ● Does not destabilize the fund, for example, isn't 'putting all of the eggs in one basket'. ● Indicators of a best opportunity, but not the only, is that this opportunity has the largest expected return

Due Diligence Evaluation A proposal is evaluated by estimating the size of the opportunity. ● Unit of Work for the Fund ● Dollar invested ● Expertise hours taken from the fund managers ● Effects on stakeholders ● Expected Return ● Our fraction of the risk adjusted present value against the market for the program

The Value Proposition customer company needs features $$$ product The success of the value proposition has two components: 1. 2. The intrinsic nature of the product The extrinsic structuring the business and execution of the plan Even after perfect execution market is going to react to the product the way it chooses to, not the way we want it to. This is the 'intrinsic nature' of the product. The cost of changing this response beyond its intrinsic value, i.e. 'educating the market' are beyond the reach of the typical startup. On the other hand, structuring and executing the plan is determined by the team and the resources we invest.

Plan Intrinsics Two key measures of solid intrinsic value: ● ● People in the market have a need for the features of the product The product is feasible to produce Both of these are a function of price. Due diligence starts with a survey to determine if people have needs met by the product features, how many such people there are, how we can we stereotype such features people, and how big is the stereotypical group. This data is derived from the market not by the founders. Engineering experts need to draw up project plans for implementing the product and to have them reviewed. These two things establish if money can be made. After this it does not really matter if the proposed plan extrinsics hit the mark or not, because we can have them changed.

The Needs Survey With some thought, we can determine if an individual has needs for our features: ● ● ● Without asking the person to 'imagine' or product, or to view a prototype Without giving away our secret sauce or plans Sometimes without the person even knowing he or she is being surveyed Examples. Does a person needs a new bridge: Do you live and work on the opposite sides of the river? Would a company like to advertise on a high tech sign at the entrance to the university: Are many of your customers students? Such surveys should be professionally designed. Note, needs for: the product (customers), the company (acquirers), the team, the IP

Risk Adjusted Present Value Against Market ● company worth on a given date: present value of earnings +/- supply and demand pressure (market expectations) +/- buyers perception of value for the company ● risk adjusted reward = (risk as a probability) * reward same as expected value for large number of trials ● expected present value use risk accumulates similar to depreciation, the value in the far future events goes to zero Would hope this value is similar to Risk Adjusted Present Value in Theory

E.g. Risk Adjusted Present Value of a Pear Tree Year Base Earnings Prob Success Expected Earnings 1980 200 1 200 1981 200 p=0.80 160 1982 200 p2=0.64 128 1983 200 p3=0.51 102 1984 200 p4=0.41 82 1985 200 p5=0.32 66 20 total 758 USD ps is one minus the risk. I stopped five years out due to lack of confidence and just punted with $20. I added the expected profit from the tree for each year to find a present value of $758. The buyer should pay significantly less than this to expect to have a profit. One would expect a rational owner to sell if the buyer offers more than this amount.

When to Invest When the investment represents the best opportunity. ● The funds expertise is considered in the evaluation of opportunity. ● Future likely deals also come into the evaluation through the present value calculations.

'Has a Customer Already' Approach Flawed Companies with solid intrinsics may fail to find a customer because: ● ● ● Corporate purchasing agents buy existing products, a startup with no product yet won't even be on their radar. Companies not in the business of development typically will not want to start being in it. Companies in the business of development ● Already have an in house team ● have existing outsourcing provider relationships ● May go to the M&A market if they felt a new direction and expertise was needed, or just hire people. ● In general have a strong NIH culture Hence, this approach will cause best opportunity proposals to be lost.

'Has a Customer Already' Approach Flawed ● ● ● Product development costs money. Companies typically don't buy products two years before they are delivered. (see prior slide) This forces product development to be: ● Inexpensive, best opportunity products that are not inexpensive are lost ● Gentrified, only rich people can afford to start a project ● Government program run – the antithesis of the start, a government process determines who gets grants. ● From a university lab or incubator Hence, this approach will cause best opportunity proposals to be lost.

Conclusion ● ● ● ● ● ● Invest in the best opportunities for the fund. Best opportunities have solid intrinsics and estimated high return per unit of work for the fund. Dictate the extrinsics. Work to develop the program assets for which a need in the market indicates they can be sold. Determine need by gathering data from the market. Determine feasibility by analysis.

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