This article is the thirteenth 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.
Have you ever been disappointed by someone or by some product that you purchased? Nine times out of ten it’s due to not having the right expectations for one reason or another. Investments are no different from other purchases. If you are not clear on what you are getting yourself into, buyer’s remorse usually results. In early stage investing, we use a term to describe setting expectations… it’s called “Goal Alignment”.
So what do we mean by this term? Goal Alignment is typically used to establish common ground around the long range plans of the company. It’s crucial to make sure the investors and the founders are in sync and want and expect the same things. Goal Alignment needs to cover a variety of areas, including:
- Long term company objectives
- Use of funds and aggressiveness of investment levels
- Long range financing plans and assumptions
- Exit strategies and expectations on size and timing
During the due diligence process, you will spend a fair amount of time interacting with the CEO. This is an important time to establish the basis for a working relationship between you and the CEO. You should use this time period to have pointed discussions around long term goals for the company. Hopefully, your expectations and the CEO’s expectations will be in alignment. That said, goal alignment is not a “set it and forget it” proposition. Your goals may be in sync at the time you first invest, but you will need to check in on a regular basis to ensure they stay in alignment!
Q: Ham, in a startup company, cash is always tight, so alignment on goals and spending priorities is paramount. What financial topics do you frequently discuss with the CEO during diligence?
One of the first conversations I have with the CEO revolves around where and how fast the company is planning to spend the cash we are investing. This “Use of Funds” discussion presents an interesting test for our early working relationship. Are we in alignment on issues such as compensation for the management team, key initial hires and marketing spend? Do we agree on what we need to learn about product / market fit before we pour on the gas? Is there a consensus about how many new markets we will enter simultaneously? (One can only imagine what those conversations must have been like at Uber, which has raised tens of billions to go on a spree to hire and enter every major market globally all at once. If you were not prepared for that, the dilution associated with raising that much capital, even at Uber’s valuation might come as somewhat of a surprise.)
Management compensation is often the most difficult financial/spending conversation you will have with a CEO. Frequently, I will invest in a company where the CEO and her team have forgone salaries for the past year or so. They don’t have the financial reserves to continue paying their personal expenses, and so, they need to start drawing a salary as soon as the round closes. If the salary requirements fit comfortably within the amount of capital being raised, then things should be okay. For example, if the company is raising $750,000 and that allows the company to make significant progress over the next 12 months, then salaries are most likely reasonable. On the other hand, I’ve run into situations where the CEO expected a salary similar to what he received working for a large corporation. This salary expectation would seriously limit the company’s financial plan and place key milestones at risk. Your challenge as a prospective investor is to convince the CEO that a high salary is not in the best interests of either the company or their personal future financial success if it means trading off a lot of their stock to get it.
Q: What other questions should you discuss with the CEO during diligence?
Another set of alignment-oriented questions might be along the lines of:
What are the growth milestones that allow the company to raise a future round of financing at a favorable valuation to the early investors?
Will there be enough funding from this early round to allow the company to achieve these important growth milestones?
Within every industry there are key milestones that allow a company to raise capital from different stages of investor. For example, in the software world, seed stage investors like to see a company that has a shipping product and a few paying customers. The next stage of investors like to see somewhere between $100K and $250K of Monthly Recurring Revenue (MRR). And finally, growth stage investors like to see upwards of $1M in MRR and a well defined set of growth metrics. Compare these milestones to those in the life sciences. Biotech and Medical Device companies tend to have milestones that are based on successful clinical outcomes, first in animal and then in human trials. Every industry is different. It’s important for investors and company founders to have a deep understanding of what those milestones are and how they should be applied to their company.
Assuming you are in agreement on key milestones, your next challenge is to make sure they are achievable in the timeframe and on the budget the CEO presents to you. We all know that entrepreneurs are optimists and this optimism usually results in missed schedules and over-budget projects. So keep this in mind as you scrub the company financial plan. Make sure you and the CEO set realistic expectations on what the company will achieve with the newly raised funding.
Q: Early stage investors participate during the first round or two of a company’s financing history. Why should early stage investors worry about a company’s long range financing plan?
Early stage investors need to understand a company’s long range funding plan so they can answer several key diligence questions:
What is the Financing Risk: Does the company need to raise capital from investors with deeper pockets than the early stage investors? If so, how likely is it for the company to attract these investors?
What is the Timeline to Exit: If there are many additional rounds of financing after this round, how will that impact the time before an exit occurs?
What are the Expected Returns: How will the dilution created by any future rounds of financing affect the returns of the early stage investor?
In general, I prefer to invest in capital efficient businesses because they tend to have a greater variety of exit options, including some with faster times to exit. So it’s important that I work with the founders to develop a realistic long term funding plan that will lead to a profitable exit for both the early stage investors and the founders. However, it’s not unusual to have two alternate funding strategies: one that leads to an early exit and requires minimal capital and another that builds a large company over many years and requires significant amounts of outside funding. Make sure the investors and the CEO agree on the point at which the decision will be made and understand the risks and rewards for each strategy.
Topics relating to financing are the biggest issues related to Goal Alignment. They tend to be the most contentious between investor and entrepreneur. Hopefully, you can keep an open dialogue so things don’t resemble a pair of spouses arguing over their household finances.
Q: Are there other topics you like to review in Goal Alignment?
Yes, there are secondary topics that are important to discuss with the entrepreneur during the diligence process. Two areas that I like to cover include Product Strategy and Go-to-Market Strategy. For example, the type of sales strategy can have a massive impact on the expense structure and capital intensity of a company, so it should be discussed. However, keep in mind that for your views and opinions on these topics to have credibility, you must have real product/industry knowledge you can share with the entrepreneur. Having productive discussions on these topics before you invest will help you to better understand the CEO’s thinking process. And, it will set the stage for future conversations during board meetings and strategy sessions.
Q: What are some goal alignment disasters leading to disappointments for early stage investors?
The biggie? Not making money on your investment! Here are two examples of how this can happen. In both cases the entrepreneur achieves the result they were looking for and the investor doesn’t.
Example 1 (Acqui-Hire): A young entrepreneur and her team build an awesome product in a hot market. They start shipping the product and get an early acquisition offer. They sell the company for $5M one year after they raise $1M from the early stage investors. They walk away with $3.5M in their pockets. Not bad for a couple of 25 year old founders. The investors end up with $1.5M and make a 50% return on their investment. The founders are happy because they made some quick money early in their career, and they are getting high paying jobs with a big company. What a great notch in their belts. The investors, on the other hand, walk away with a small return on an opportunity that had tremendous potential. This company had the potential to be a 10X or 20X return. Instead, it was a 1.5X return. Better than a sharp stick in the eye, but not what you were hoping for.
Example 2 (Lifestyle Business): A seasoned executive starts a company midway through his career. After raising $4M from investors over a few rounds of financing, the business starts to gain real traction. The company gets to cash flow breakeven, but it’s not generating much profit. Growth is modest at 10% per year. The CEO is drawing a nice salary in the range of $250K annually, and is satisfied with his financial and work situation. He enjoys being the CEO of a tech company and doesn’t want to sell the business. The company has become the dreaded “lifestyle business”. There is no easy way for an investor to get their money out of the company, and any chance of a 10X return are pretty much eliminated.
Exit strategies need to be discussed with the founders early on. Do they want to flip the company in a few years or are they building a big business? And, make sure they are not looking for a lifestyle business! Starting the exit strategy discussion early on is an important part of setting up the company (and investors) for success. Startups rarely survive without being a part of a larger ecosystem and it’s this ecosystem that plays the central role in an exit.
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.