Knauss Financial Dd

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The Due Diligence Process: A Financial Perspective Troy Knauss, Fund Executive Piedmont Angel Network Adjunct Professor, Wake Forest Univeristy [email protected] Presentation

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Transcript of Knauss Financial Dd

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The Due Diligence Process:A Financial Perspective

Troy Knauss, Fund Executive

Piedmont Angel NetworkAdjunct Professor, Wake Forest Univeristy

[email protected]

Presentation

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Define the risk of a new investment

verify the plan and ask the right questions

Due Diligence: A Financial Perspective

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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Due Diligence

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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

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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

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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

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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

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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

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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

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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

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Internal Rate of Return (IRR)

5-Year Returns (Multiple)

60% 10X

50% 8X

40% 5X

30% 4X

15% 2X

Due Diligence: A Financial Perspective

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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

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-

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

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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

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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

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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

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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

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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

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Other Information>How long does a typical due diligence

take?

>What are the odds of making an investment?

Due Diligence: A Financial Perspective

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Contact Information:Troy KnaussPiedmont Angel [email protected](336) 235-0941