This article is the twelfth in an ongoing series on Deal Leadership. To learn more about leading a deal efficiently, download this free eBook today: Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.
There are a million reasons not to invest in any given startup. Even in the best case, there will be unanswered questions, missing pieces, missing team members, projected losses and uncertainty all around. The diligence process tends to document all of the warts in one place. You would think a compilation of those warts would be the death knell - the final nail in the coffin.
So why do people invest in startups? Because of their potential, and because investors have the experience and necessary framework to put all those risks and uncertainties into the proper perspective. At the earliest stages, ALL startups have problems. The question each investor has to ask is whether those problems are insurmountable.
Through the years, Ham has evaluated hundreds of companies, and ultimately, invested in over 50 of these businesses. At Launchpad, he established a process that helps determine whether it makes sense to move forward and make an investment. So let’s see what he recommends to investors as they go through this very same challenge.
Ham, what do you do to place some standard procedures into your process of evaluating companies before making an investment?
First of all, there are three very important components in our diligence process. We find that it is extremely helpful in the early days of a diligence project to outline the following three items:
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Identify Key Risks - After listening to the entrepreneur’s presentation, we caucus to discuss first impressions and immediate top of mind questions and concerns. From that we are able to distill it down and pull together a list of 3 or 4 critical areas that need further examination. The answers to the key questions help us identify the areas of solid ground as well as the key risks that will need to be addressed for the company to achieve a successful exit for the investors.
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Develop the Investment Thesis - Ultimately when you are forming an investment thesis, you are building a model or likely scenario in your head. An important filter that can help when assessing potential investment opportunities is sometimes defined as the Three P’s: Potential, Probability and Period. For the sake of completeness, we cross-check against our due diligence checklist when forming these questions. But, to keep the process efficient and focused, our diligence team members work together to distill the list of key questions we are really trying to answer and disregard questions which will not add value in a given situation. The answers to the key questions help us identify the areas of solid ground as well.
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Acknowledge What Needs to Be Believed - Once we have a handle on the key risks, and we have built an investment thesis, we need to synthesize them into a workable company hypothesis. The best way to keep yourself honest when doing this is to take the trouble to acknowledge and actually list “what needs to be believed” for the investment to make sense. Thus, when we get to the final stage of our due diligence effort, and we write up our very brief report, we make sure we know and prominently document right at the beginning “What Needs to Be Believed” or WNTBB. If an investor just cannot get comfortable that something on the WNTTB list will come true, then maybe this deal is not for them.
What are the key things you look for in deciding whether there is enough positives to go forward?
First off, I expect to see enthusiasm is mounting for the company, amongst the team. Each of the sub-teams should be coming back with positive results from their research. It’s also important that the founders show the following key characteristics while we work with them: high integrity, a straight-forward style, passion about the opportunity, responsiveness in communications, accuracy in information supplied, transparency, cooperation, coachability, and engagement.
Furthermore, we like to see the company’s business continue to progress during diligence. We aren’t expecting miracles during this relatively short time period, but we do expect to see some positive movement. We know diligence takes a ton of time, but the team needs to show they can juggle, delegate and prioritize. They cannot let the business completely go on pause during fundraising.
Finally, as we evaluate demand for the company’s product, we expect the customer calls to go extremely well.
When you say “enthusiasm is mounting” does it have to be universal enthusiasm, a majority, or is a minority enough?
The answer to this question depends on your organization. Do you require that all investment decisions are made by 100% of your investors, a majority of your investors, or is a minority good enough? At Launchpad, a minority of investors is enough for us to proceed. So our view is that it does not have to be universal.
For Launchpad, the tricky situations are the divided due diligence teams. If no one intends to invest, it’s an easy decision. And, the same is true if everyone likes the company. But when the team is divided it is complicated. You need to look at what your experts think about the key risks in each of their areas. Are there any show stoppers that conflict with your investment thesis and WNTBB? As long as there is no third rail issue, such as a lack of integrity, our approach is to get all the perspectives documented in the report, consider whether the issue merits being on the list of WNTBB items. And assuming it still represents a legitimate investment opportunity, we circulate the report and let individuals decide based on their own personal risk profile.
Aren’t the founders exhausted and annoyed at this point in the process? How responsive, engaged, and enthusiastic can you reasonably expect them to be well into a diligence effort?
There’s an old joke that goes something like: “An entrepreneur will spend 100% of their time fundraising for their business and the other 100% of their time running the business.” If the fundraising process drags on for months and months, it will have a serious negative impact on the CEO. So, it’s important that the deal lead set realistic expectations with the entrepreneur. It’s important that the entrepreneur try to be responsive and keep the process moving fast. And, it’s important that the deal lead be aware of the entrepreneur’s need to operate their business at the same time they are supporting the diligence effort.
With that said, the CEO and her team can feel the momentum build as you near a final decision. They are learning more about their business from a well-run diligence process. So while they are tired, they should also be “smelling the oats in the barn” and having great feedback they are eager to test with the money invested in the round.
Why is it important for outside investors to start showing interest at this point?
At Launchpad, we like to lead the deals we are involved in, and we also like to have co-investors involved as an additional source of capital, both in the present and down the road for that company. It’s pretty typical that co-investors look to the deal lead to do the heavy lifting on due diligence along with negotiating the investment terms with the company. So we look for a certain level of outside interest as a good litmus test of whether others will be interested and how big an investment syndicate might be possible.
Want to learn more about leading a deal efficiently? Download this free eBook today Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.
