Knauss Financial Dd
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Transcript of Knauss Financial Dd
The Due Diligence Process:A Financial Perspective
Troy Knauss, Fund Executive
Piedmont Angel NetworkAdjunct Professor, Wake Forest Univeristy
Presentation
Define the risk of a new investment
verify the plan and ask the right questions
Due Diligence: A Financial Perspective
Each deal is unique>Is it an industry that you understand?>Is it a seed, early stage or later stage
deal?>How much money is required to hit
major milestones and inflection points?>What is your individual risk profile?>Who are your syndication partners?
Due Diligence: A Financial Perspective
When do you start?>Do not start due diligence unless
you like the industry, the plan, the team, the deal, and believe you can add value
>Due diligence is expensive and takes a lot of time
Due Diligence: A Financial Perspective
Never sign a Non-Disclosure Agreement
>Early in the process, the entrepreneur may ask you to sign an NDA
>Many investors will not sign• See a lot of similar deals• Not interested in stealing ideas• Long-term interest in reputation
Due Diligence: A Financial Perspective
Always go into a deal expecting to find
reasons not to invest>Issues with management teams,
market size, competition, intellectual property (IP), stage of development, and revenue assumptions (financials)
Due Diligence: A Financial Perspective
Risk: Management Team
>Are they coachable?>Have they done it before?>What is their experience?>Do they have knowledge in a specific
industry?
Due Diligence: A Financial Perspective
Risk: Market Size>What are the barriers to entry?
>Who are the competitors?
>What is the growth rate?
>What are the assumptions of the revenue model?
>What do customers say? Is this a must-have?
Due Diligence: A Financial Perspective
Risk: Model>Does the company have a defined value
proposition that customers understand?
>What is the long-term growth strategy and how does it influence the revenue model?
>Is there differentiation?
Due Diligence: A Financial Perspective
Risk: Financial>How much money is needed?>What is the structure of the deal?>Can the deal be negotiated?>What is the valuation? Do you have
comparables to review?>What is the exit strategy?
Due Diligence: A Financial Perspective
Risk: Numbers>Can you hit revenue sooner rather than
later? How much will it cost to generate?
>How much salary is the team taking as a percentage of the fund raise?
>Is the company allocating enough money for marketing dollars?
Due Diligence: A Financial Perspective
Risk: Numbers>Did the company develop a cash flow
statement?
>What does the capitalization table look like?
>Does the company have any debts, liabilities, issues with uncollected A/R?
Due Diligence: A Financial Perspective
Due Diligence Process>Full Business Plan Review>Presentation from Management (Maximum 15
minutes)>Site Visit(s)>Receive Due Diligence Checklist>Review References>Conduct Competitive and Financial Analysis>Finalize the Deal Terms
Due Diligence: A Financial Perspective
Process: Site Visit(s)>Meet with management team and
employees to determine culture
>Review the organizational chart
>Determine if this group is coachable
>Is the company spending money on areas/people not needed at this stage?
Due Diligence: A Financial Perspective
Due Diligence
Process: References>Contact former employees, employers, and
industry experts>Conduct background checks on all key
employees>Be prepared to ask for key man insurance on
certain employees>Interview Advisors and Directors>Talk to current investors, lawyers and
accountants
Due Diligence: A Financial Perspective
Process: Competitive Analysis
>What market share is required to hit the plan?>Use game theory to predict competitive
response to business plan. Can you compete if the response is to lower prices?
>Why would a customer buy from you? Differentiation? Price?
Due Diligence: A Financial Perspective
Process: Financials>What is the sales pipeline?
>How leveraged is the company? Can the company get non-dilutive funding from banks?
>How has the company performed against previous plans?
Due Diligence: A Financial Perspective
Process: Valuation>Do not use book value, market value or
income value to determine early-stage valuations?
>Early-stage companies:• No track record• Low or negative profitability and cash flow• Significant risk
Due Diligence: A Financial Perspective
Due Diligence: A Financial Perspective
Today (Series A) Series B Series C Later Stage
Va
lua
tio
n
Valuations not growing significantly between Series A and Series C rounds
VC money moving to later stage
Typical Valuation Expectations
>Series A: $500,000 to $1.5MM>Pre-money valuation: Under $3MM>Equity: 10% - 40%>Expected Returns: 10X – 30X>No specific calculation (gut feel)
Due Diligence: A Financial Perspective
Due Diligence: A Financial Perspective
InvestmentSought
Valuation At Exit Multiple
$1,000,000
Pre-money Valuation
$14 million
$6 million
$45 million
2X
3X
$1,000,000 $2 million $30 million 10X
$1,000,000 $2 million
Internal Rate of Return (IRR)
5-Year Returns (Multiple)
60% 10X
50% 8X
40% 5X
30% 4X
15% 2X
Due Diligence: A Financial Perspective
35% - 0X
Overall Multiple: 2.6X
Avg Holding Period: 3.5 years
Average IRR: 27%
3 yr
3.3 yr
4.6 yr
4.9 yr6 yr
0
10
20
30
40
50
60
< 1X 1X to 5X 5X to 10X 10X to 30X > 30X
Exit Multiples
Perc
en
t o
f T
ota
l E
xit
sDistribution of Returns by Venture Investment
Average Returns
-
10
20
30
40
50
60
< 1X 1X to 5X 5X to 10X 10X to 30X > 30X
Exit Multiples
Per
cent
of E
xits
Low Participation High Participation
High = 1 or 2 times per monthLow = 1 or 2 times per year
High 3.7X (4.0 years)
Low 1.3X (3.6 years)
Impact of ParticipationMentoring, Board, Financial Monitoring
Returns with Monitoring
What can help increase valuations
>Experienced management team (first time entrepreneurs will exit company with 8%, second time, 20%)
>Strong technology, large opportunity, and size of round to hit milestones
Due Diligence: A Financial Perspective
Funds Required $1,000,000
Exit Year (Expected) Year 5
Revenue (5th Year) $20,000,000
Net Profit (5th Year) Plan expects 10% ($2MM)
P/E Industry 15X
Company Value $30,000,000
Required IRR 60% IRR (Multiple: 10X)
Required Cash Return $10,000,000 (Funds Required x 10)
% Equity Required 33% ($10MM / $30MM)
Pre-Money Valuation $2,000,000
Venture Capitalist Valuation Method
Process: Valuation>In today’s financial environment,
investors can dictate valuation>Historical valuations are no longer
applicable>Important to negotiate valuation in good-
faith… do not want to invest in a negative entrepreneur
Due Diligence: A Financial Perspective
Term Sheet>Ask for a Board position
>Ask entrepreneur to pay your legal fees and to prepare documents in accordance to your term sheet
>Do not overpay… think about future rounds (2/3rd rule)
Due Diligence: A Financial Perspective
Typical Deal TermsConvertible Notes vs. Preferred Stock Purchase
Status of Company (C-Corp preferred) | Issues with LLCs (K1s)
Dividends: Not Mandatory; Prefer no dividends
Liquidation Preference: Minimum 1x
Protective Provisions: Majority of Preferred Stock Holders must approve changes to ByLaws, issuance of new shares, changes to the number of Board members, redemption of shares, creation of debt, etc.
Reporting Requirements: Monitoring reports that include performance to budget,new milestones, new projections, and cap. tables
Repurchasing Rights: Not in all cases but more and more deals are requiring the founder to vest his/her shares
Other Information>How long does a typical due diligence
take?
>What are the odds of making an investment?
Due Diligence: A Financial Perspective
Contact Information:Troy KnaussPiedmont Angel [email protected](336) 235-0941