Viewpoint: Deals Close Faster With Due Diligence Filters –

There are some surprising statistics about how venture capitalists are finding deals. With the growth of the Internet and the universal acceptance of e-mail as the communications medium of the third millenium, it is not surprising that technology has become the predominant medium of business contact.

According to a recent survey by the Capital Connection, 42% of venture capitalists preferred the first contact to be by e-mail, while 29% preferred an initial contact by regular mail. That means over 71% of VCs prefer no personal contact with entrepreneurs during the initial go around.

Not only is human contact being reduced, but what venture capitalists request to see is also being truncated. The traditional information model for a venture deal generally follows this pattern: The emphasis is on a two to three page executive summary for one good reason – necessity. A typical venture capital firm may receive more than 2,000 business plans in a given year but will only back less than 1% of those submitted.

Obtaining a VC firm’s attention is considered a luxury, so entrepreneurs must reduce and present a company concept, its product, size of market, uniqueness, the projected growth and returns, its competitive position, management’s qualifications strategy for success, and capital needs on to two or three pages. This permits only the conceptual framework of each item to be sketched in the executive summary. It also means that an initial cut by a VC is made on how the concept is conveyed – does the idea meets the investment philosophy of the firm and is it the type of deal that the venture capitalist will make. The entrepreneur’s most common mistake is to address the wrong audience – his company’s market cap is too small, its margins are too thin for the factor of risk, its product or technology lacks a clearly competitive advantage or it has no discernable marketplace advantage.

The result is that venture capitalists are overlooking plum deals because of too little information. It is a little like a book publisher – overwhelmed with unread manuscripts – rejecting James Joyce’s Ulysses because the two-page summary was difficult to follow. VCs are more focused on presentation and not on the inherent nature of a business, thus insuring missed opportunities.

The narrow focus of this critical initial information is also counterintuitive. Venture capitalists have been consistent in articulating the most important criteria for selecting an investment opportunity with their oft-repeated mantra “management, management and management.” Only after that requirement is satisfied do VCs then look to other criteria. Stanley Pratt, former publisher of the Venture Capital Journal, for example, gave his expanded list as – “management, management, management, market niche and (then) product or service.”

While all of the factors in the executive summary are ultimately important, what is missing is a feel for the entrepreneur’s ability to build the business. A good idea can fail just as easily as a bad one. But even an idea that proves to be mediocre, can succeed in the marketplace with effective management. There is a substantive difference between an “executive summary” and the translation of the entrepreneurial idea into a successful business. Conducting effective due diligence on that translation is the key to successful investing.

The Evaluative Process

The old adage “I’d rather be lucky than good” is not a credo for survival or success in the venture industry. Accurately evaluating the business potential of a start-up is more difficult because the trend is to shorten the time between first contact and consummation of the deal. One of the attractions of today’s market is that the period for an investment to reach a major liquidity event, such as an initial public offering, has been dramatically reduced to the point that the IPO may actually occur before all thresholds for the entire VC funding have actually been reached.

This new-age speed to market, while clearly lowering investment risk, also carries a burden during the period before funds have been committed because the pace is advancing at both ends. The race to be quick to market means that the time to examine and to make your investment decision is also shortening. The Capital Connection survey also concludes that approximately 64% of venture capitalists are closing deals within 90 days of first contact. The other 36% are not necessarily slower but in fact are closing even more quickly. At least one subset of this group closes transactions within 30 days from an initial contact, resulting in less time to investigate and to reflect on a deal.

The difficulty of culling from an executive summary is one reason why venture capitalists often prefer to do business with a group, which is referred to them by an incubator, accountant or law firm. Referrals from accountants or lawyers generally mean that there is a business relationship with someone known and therefore the venture capitalist may be able to gain additional insight into the background of the idea and the business acumen of the company’s management. While not inconsequential, this does little for fleshing out the business model. Incubator referrals suffer from a natural consequence of their business because they take an investment stake in the business when it was just a gleam in the entrepreneur’s eye. In reviewing incubator submittals, the venture capitalist must be aware that the incubator is promoting his investment in the liquidity event to lessen its investment risk.

These biases from referral sources are one reason that venture capital firms do not use them exclusively. But the quest for more deal flow does not answer the problem of how to receive more meaningful deal flow in an increasingly time sensitive market.

Due Diligence Filters

The answer lies in receiving deals that have already passed through rigorous due diligence filters. In short, venture capitalists should develop avenues to sources that prescreen start-ups and perform their own due diligence before accepting an idea and assisting in its development into the market- place. Ideally, this would place a first tier venture capital firm more in the position of mezzanine financing in terms of examining of the risk, while still receiving the benefits of greater returns associated with first stage venture capital.

There are any number of service providers who are willing to take a portion of equity in return for assisting in development of a start-up if the idea appeals to them. There are very few that provide a full range of due diligence filters. Prescreening should include the following due diligence filters so that the deal flow would follow a pattern, which is different than the traditional model.

Generally application of this type of due diligence requires a team approach with access to attorneys, MBAs, management and technical professionals. The team, in essence, is helping to build the company long before it reaches the venture capital stage. Few professionals in the market offer this type of layered servicing and those who do are usually tied to affiliated venture funds.

The due diligence filters obviously have their own internal weighing system but should address the following questions:

Proving the Business Plan

What are the prospects for long-term profit? Are the assumptions realistic? What is the size of the market? What is the potential for growth? Is there disclosure of the pitfalls of the business? Can the company be built inexpensively – are high profit margins possible; can the business achieve a 50% gross profit margin? What are the pressures on margin? What are the key revenue drivers and associated expenses? What are the distribution channels and the cost of entry? What are the support requirements for the product? Does the model have recurring sales once the product has been purchased? Is the business plan built on a window of opportunity or is the window a long term one? How unique is its business? What facet of the business gives the company a market advantage? Will it be the 50% or 30% player in the market? What are the barriers to entry for competitors? How meaningful are the company’s advantage or perceived advantage? Can it protect its position? Is there an understanding of the need for a liquidity event to attract investors and key employees? Does the company have such a plan?

Developing Management Teams

Is there a proven track record? What is the integrity of management? Can they execute the business plan? What is their background, experience and areas of expertise. Do they have the passion and dedication? Can they articulate the vision? What challenges have they overcome in the past? How have they dealt with setbacks? Do they have the ability to build the management team? Has the stock option pool been set up to anticipate hiring needs? What will be the percentage of the unallocated option pool post-financing? Can they lead? Do they have knowledge of their industry and the necessary contacts? Have they shored up the management team with a properly composed Board of Directors or Advisers?

Protecting IP

Is there a technological or a proprietary advantage? Is the edge real or perceived? Has anyone evaluated the technology and the claims? Has the technology or confidential information been properly protected? Does the company have the technological wherewithal to bring it to market? How developed is its Information technology strategy? What portion of its business will be outsourced and how strong are its technology “partners”? Has outsourcing been used to enhance core competencies by adding personnel, distribution and production capabilities? What are the outsourcing metrics to assure product quality and on time delivery?

Market Opportunities

Does management show the ability to get it done? Has it acted efficiently to test out the market and how real are the prototypes that have been or will be developed? Are there significant technological problems that will prevent entry? Is there an HR plan in place and are the company’s human resources being used efficiently? Are skill sets being maximized and are there ways to outsource non-key business processes that will increase efficiency and lower costs?

Evaluating and Adding Value

Venture capital needs to lengthen the executive summary to add another category. Executive summaries should state what due diligence has been already done and by whom. The extra material will probably be read first as its shows the company’s true development stage and provides a ready reference list.

This type of prescreening sets the company up for the venture capital review. While the VC must do its own independent evaluation, it obviously shortens the time if the VC knows what due diligence has yet to be performed. It can quickly determine whether the unanswered questions are true impediments to funding. At the same time, it permits a VC to focus on how the VC firm can add value in the context of the company’s present development.

In sum, due diligence filters make it easier for venture capital to focus on its core investment decisions, to complete its own complementary due diligence, and to make decisions that can be executed within the time pressures of the market. t

By William Zucker, president of G+H Solutions LLC and a partner of Gadsby Hannah LLP, and Doug Fineberg, director of G+H Solutions and a counsel with Gadsby Hannah.