Investigative Due Diligence Can Expose Trouble Before It Strikes –

Not long ago, venture capitalists were criticized for their recklessness and imprudence in their rush to invest in New Economy companies.

Today, in a marketplace littered with e-commerce corpses, VCs have adopted decidedly new habits in their search for worthwhile investments. Still curious but far more cautious, VCs are reaching for new tools to help distinguish the good from the bad, the safe from the uncertain, the honest from the dishonest.

Investigative due diligence has emerged as one of the newest tools. Used by VCs, as well as executives contemplating merger-related transactions and personnel hires, investigative due diligence generates intensive background checks on key individuals involved in business deals.

The investigation produces a compilation of facts, assembled by an independent source, to allow the client to make an informed decision about a company or individual.

In the past, pre-deal due diligence was largely limited to a review of the company’s tangible assets, such as buildings and computers. In the New Economy, however, knowing the intangibles is far more important because a start-up’s success depends on ideas.

Through investigative due diligence, for example, investment banks can discover a person’s credit history and information on civil and criminal court actions. Why is that information important? Most substantial players realize that an investment is the acquisition of all of the credits and debits of an entity or an individual. Just like getting a mechanical once-over on a used car before handing over a check, investors need to know whether or not they are buying a lemon.

Regardless of how attractive an investment appears, it is just as important to dissect the personalities as it is to crunch the numbers. Has this company or person declared bankruptcy? Is he or she a defendant in a breach of contract suit? Have they ever been convicted of a crime? Are there ancillary facts that might make an entity politically or reputationally unattractive.

With technology investments, bankers will want to check where management learned their skills, whether it was in a basement or at Stanford University. They will also want to know if what a dotcom is proposing already exists in the marketplace.

The value of first-generation technology is obviously quite different from a second-generation model. Besides the danger of overpaying for a knock-off, an uninformed investment might land the VC in the middle of a copyright or patent infringement lawsuit.

In many industries, this process has become standard operating procedure, triggered by a flurry of horror stories that could have been avoided with the proper pre-deal due diligence.

Online broadcast network Pixelon is perhaps the best known case in VC circles. Investors are now suing the company for $4.85 million charging fraud after the company’s founder and former chief technology officer, David Kim Stanley, was arrested.

In 1989, Stanley pleaded guilty to more than 50 counts of fraud, having illicitly taken approximately $1.25 million from investors in Virginia and Tennessee. Authorities say that Stanley disappeared while on a prison work release program to pay off the debt. That was in 1996. Shortly after, he resurfaced in California with a new name and started Pixelon with Stephen Curtis, the companys former president.

According to news reports, Stanley was arrested after a parishioner in Stanley’s church saw a picture of the fugitive on the Virginia State Police Web site.

In the glory days of 1999 and early 2000, many eschewed investigative due diligence before investing for three main reasons:

* The gold-rush mentality: invest now, investigate later. Venture investing totaled $22.7 billion in the first quarter 2000, compared with $6.2 billion in the first quarter of 1999 representing a 266% increase, according to data from Venture Economics;

* The job market, especially for technical expertise, is so tight that few are conducting background checks;

* Many of the employees of the New Economy are in their 20s and go from place to place with their laptops in hand. Consequently, conducting a background check isn’t as simple as running a credit check against a traditional businessman that has lived in one location for several years. As a result, conducting a civil and criminal search across various states takes longer. Few start-ups are willing to invest the time, which may only take two to several weeks, depending on the level of detail wanted.

Wary investors can now turn to companies to provide investigative due diligence services. Here are just a few other types of background checks performed as part of a due diligence investigation:

* Full on-site checks in federal and local criminal courts for criminal convictions;

* Full on-site checks in federal and state civil courts for lawsuits, judgments, liens, bankruptcies, tax holds, divorces and other litigation;

* A variety of specialized services, including media searches and interviews.

These investigations are conducted by a team that includes lawyers, forensic accountants, researchers and other professionals from the federal and local law enforcement agencies, banking, finance and investigative journalism fields.

The first step in a typical background check is to review an individual’s credit history, which includes a list of previous addresses. The addresses allow an investigator to pursue litigation searches, both civil and criminal, in the appropriate jurisdictions. Next comes online searches for various infractions – liens, judgments, bankruptcies – and then searches of newspaper archives for reputational information.

One large firm specializing in background checks recently estimated that 15% of its cases produced information that affected the deal, and a few of the checks generated enough negative information to kill the deal altogether. The offenses ranged from padded resumes to criminal records.

Consider this case: A computer company hired a due diligence investigator to look into the backgrounds of directors at an acquisition candidate. The investigation revealed that one of the board members was going through a bitter divorce – a fact that was never previously disclosed by the director. The wife planned to win a large portion of the director’s stock in the divorce settlement and was planning to use that leverage to insist on a board seat – a battle that the client was not interested in fighting. Result: the deal was shelved.

Two other well-reported cases that revealed startling findings worth noting include a background check of a key executive of a tech start-up firm that uncovered a civil litigation case, criminal associations and an indecent-exposure conviction, and the case of a chief executive officer who was in jail at the time he was negotiating a deal.

It’s easy to see why investigative due diligence – specifically, background checks – have become so commonplace in the VC world. The success of large and small deals can often rest on the shoulders of a handful of individuals. Investors need full confidence in those folks.

Jim Muvaney is the Director of Research for KPMG’s Forensic and Litigation Services, and manages the investigative due diligence practice.