This article is the second in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
Risk is impossible to avoid in business - it is an inherent part, and necessary ingredient, in all successful undertakings. You shouldn’t be afraid of risk and allow it to turn you away from great investment opportunities. Instead, you should focus on understanding what critical risks are involved with an early stage company and the degree to which they have been mitigated with resources, smart planning and preparation. Understanding the adequacy of these plans is an important skill to develop for all investors. Risk is not bad; a lack of strategy for dealing with risk is. Remember, without risk, there won’t be a great reward!
7 Early Stage Investing Risks
Good decisions begin with good information. During due diligence, you will need to gather basic data to assess the adequacy of planning for each of the following areas:
As part of the assessment process, you will want to determine whether the risk level is low, medium or high for each area. For low risk areas, you shouldn’t put in any effort from a due diligence perspective. For medium risk areas, you might need to perform some cursory diligence. It’s the high risk areas where you will need to apply significant resources.
Christopher spent much of his career as a software company CFO performing due diligence before making acquisitions. And, over the last decade, he has led and worked on dozens of due diligence teams in advance of making investments in a wide variety of startups. His role as a Managing Director at Launchpad provides him with an interesting perch from which to observe how we evaluate and understand risk as part of our due diligence efforts.
Q: Christopher, at Launchpad most of our investments are in technology companies in areas such as software, life sciences, etc. Explain what risks we are looking for when we talk about Technical Risk.
When we talk about technical risk, we are asking “Does the widget exist yet, and if not, is there any chance that it might not be possible to build?” If a software product is in customer hands, even at a V1.0 level, the technical risk is low - it clearly can be built. If you are trying to build a silicon chip that needs to attain very stringent cost and performance benchmarks, or you are trying to get engineered microbes to create a substance at commercially feasible concentrations, and you have not achieved either, then technical risk is high. Technical risk really boils down to a question of whether you have a competitive offering built, or whether you are still trying to build it.
Q: What about Market Risk? What keeps you up at night?
Market risk is also called “market adoption risk” - it is the risk that customers will not want the product. Will the dogs eat the dogfood? Market risk is easy to begin to probe at - get some demos of the product into customers’ hands - but extremely difficult to accurately assess. For example, if you survey a bunch of customers about something innovative and relevant to them, of course they are all going to say they want it. But…
At what price?
At what cost of sales?
At what level of buying priority?
Market risk is about trying to assess whether there is going to be genuine demand or “pull” from a large enough segment of customers at a reasonable price, with an acceptable cost and length of sales cycle. It’s a lot harder than one initially thinks. Many investors have been burned by failing to recognize “false traction” at the beta customer stage. Market risk and market size are closely related - as you go up in customer buying priorities, you generally go down in market size - since more people feel a problem generally than acutely.
Q: We like to say that “Team” is the most important factor in whether we choose to invest in a company. What are some of the most important risk factors you look for with the team?
Assuming we are not talking about a team that is incomplete, totally lacking in skills, or has terrible chemistry - you would give a quick “no” in those situations - most team risk comes from the personality, temperament and character of the individuals themselves.
A high functioning team is more than a group of high functioning individuals, but you need to start with high functioning individuals as building blocks. You are looking for people with integrity, tenacity and both book learning and street smarts. And having a CEO with leadership charisma is also crucial. We talk in more detail about these themes in the team discussion, but suffice it to say, if you are alert, you can generally tell when you are in the presence of teams that are not working or are composed of lackluster individuals. Remember, during diligence you are in the honeymoon period - everyone is on their best behavior. If you see even the slightest hint of an issue, it is best to dig in a little further and get to the bottom of it. If there is trouble at this stage, it will get far worse when the stress and pressure of operating a start-up mounts.
Q: Since we are providing the financing for the company, shouldn’t we be able to control the financing risks?
No; financing risk is about future financing needs. We can take care of the immediate financing needed to get to the next few key milestones, and likely the next financing round as well, but …
How much additional financing will the company likely need?
Where will that money come from?
Will it be available on reasonable terms once the company has used up the current round?
Who are the right investors for this company going forward?
What will the market be like for financing in 18 months? 36 months?
These are issues we discuss when we talk about financing risk. And the only way to really address it is to know the macro market for financing and the benchmarks applied by those likely to be providing the capital. Then you can build a reasonable plan with the current financing round that has some room for error to get the company to relevant benchmarks for the next round.
Q: Regulatory risks are not a key factor for many of our investments. But some companies do face these risks. When do we need to understand how the regulatory environment will affect a company?
Not all regulatory situations introduce risk - sometimes they can provide tailwinds; new rules may hasten adoption of a company’s solution. But more often they are a form of permission you need to obtain, such as FDA-clearance or other certified vendor or standards-compliant status. These necessary permissions take time and cost money. And they pose the risk that the permission will not be forthcoming. Sometimes they come not from regulatory bodies, but out of the blue from Attorneys General, such as in the case of grey area undertakings like the Fantasy Sports sites, DraftKings and FanDuel.
Understanding what is involved to successfully receive regulatory approval or avoid enforcement scrutiny is critical to understanding the regulatory risk. And then there is always the risk that the regulatory environment might change suddenly and unpredictably in an adverse manner, so it is important to understand the landscape of possible changes.
Q: Every company will have some competition, so this is a risk that I would expect to be a frequently studied issue. What are some of the key issues you like to dig into?
Competition is not a problem per se. A favorite joke of mine is “show me an entrepreneur with no competition and I will show you an entrepreneur with no market.” Competitors can help legitimize a product category, bring press coverage and help defray the cost of educating customers. But...
They can drive up the length of the sales cycle by introducing fear, uncertainty and doubt in the minds of customers with future product announcements.
They can drive up the cost of sales by creating a lot of noise and counter-selling you have to overcome to be heard.
They can undermine pricing power and compress margins.
They can drive you to have to spend more on R&D to stay competitive.
And, even competitors with a worse solution but access to capital can use brute force marketing and selling techniques to take your market share by sheer effort and saturation techniques.
Understanding competitive risks is about understanding the relative attractiveness, both current and projected into the future, of your company’s offering, and understanding who the other players are - both now and in the near future. Other things to consider include:
Are the competitors all similar-sized peers looking to co-exist in a market large enough for all?
Or, are they deep pocketed giants who feel that domination of the market is strategically important and will give away a product if they need to?
Are there big players in adjacent spaces who could easily jump over into your space once it is validated as an attractive market?
At the end of the day, you want enough running room that you can grow faster than the market and get enough of a strategic toehold. You are trying to carve out space with some enduring value.
Q: Last question is on Intellectual Property (IP). What do we look for here?
There are two aspects to the IP analysis. The first is a basic defensive analysis: is there some white space here amongst everyone else’s claims? Are we free to even operate at all without infringing someone’s intellectual property?
The second is offensive: can we build some IP that allows us to protect our space and block others from competing using our methods?
A third aspect to consider with patents, particularly in crowded spaces, is whether a company can develop some patents that can be used as trading cards or counter-claims in case someone tries to attack the company.
Beyond the basic strategic offensive and defensive questions, you also need to do a tactical review to make sure the company is using 3rd party IP such as open source software and other licensed tools correctly, is perfecting ownership in employee-created innovations, and has proper controls to protect confidentiality - of the company’s information as well as information entrusted to it by partners. A lack of awareness and sophistication about IP can be an important risk factor in diligence.
Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.