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and associates, in-person meetings between the parties for a thorough review
of the business plan, and research with customers, suppliers, competitors,
and technology experts.
This stage of the venture process determines the company™s strengths
and weaknesses by assessing its realistic future profit potential, and its po-
tential of providing returns to the investors. Investors look into due diligence
to identify the risks in the venture and the deal.
Private investors investing in early-stage, direct investments are investing
into private transactions not subject to the same level of rigorous disclosure
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with which public companies are obligated to conform. Since entrepreneurs
are not required to provide this same level of disclosure, investors have
learned the hard way since 1999“2000 that they must assume full responsi-
bility to inform themselves about all aspects of the investment. Investors are
now going to extreme lengths in their preinvestment investigation and analy-
sis of venture attributes to make more informed investment decisions.
The depth of that due diligence will vary by investor or investment group
and by the specific venture opportunity. But typically the due diligence phase
will be headed by an individual if you are working with a group. As you can
see from the due diligence checklist below, responding to questions from
these many categories can consume time:

– Management team skills and background
– Reference check
– Industry sector research
– Customer/supplier/distributor interviews
– Product realization and tests
– Market growth potential and competition
– Technical expert questions on technology
– Valuation
– Financial history and projections
– Business strategy and concept
– Intellectual property and protection
– Supporting documents

Due diligence comes down to the investor asking questions”many,
many questions. Good ones. Due diligence becomes the entrepreneur™s “final
exam” that the venture passes (by raising the money)”or not. Entrepreneurs
need to be prepared to answer these many questions and need to appreciate
that others will be asked many questions as well”for example, questions
about fellow founders, all the management team, past employers, the ven-
ture™s potential customers, suppliers and distributors, and experts. In re-
search we reported earlier, the majority of investors surveyed stated that they
had used technical advisers in making past investments and planned to again
use technical experts.
To some degree, the questions entrepreneurs can expect to face are those
normally answered in creating a thorough business plan. Since questions
form the cornerstone of the due diligence process, we have collected over the
years questions asked of entrepreneurs by investors working on the process.
We have organized these questions in a separate due diligence chapter to help
the entrepreneur prepare for the more rigorous levels of investigation we an-
ticipate for them. By preparing, entrepreneurs may be able to shorten the
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time involved in the due diligence phase, thereby reducing some of the costs
in scrambling to find answers later, that is, at a time when such scrambling
could sink this already weighty process. So we urge entrepreneurs to project
a positive attitude to promote the venture™s strengths and competitive ad-
vantage; and we caution them to be candid about risk factors and weak-
nesses, particularly weaknesses in the management team, technology, or
market. In fact, the entrepreneur should preclude the investor™s detection of
such risks and weaknesses by being ready with proposals to remedy them. It
is preferable by far to be straightforward on such issues; being so accrues to
your credibility in light of lately more skeptical investors.


BUSINESS VALUATION
Business valuation techniques constitute an indispensable and integral phase
of the venture investing process. Investors have always sought comparables
for valuation. For example, in one of our previous books, we suggested
that the best test of the practicality of a deal™s pricing is whether it can attract
and be sold to another private investor at the same price, although not nec-
essarily at the highest price”in other words, sold at the same valuation to
the investor.
While the value of an illiquid company may be more a function of find-
ing an investor than of financial formulae and calculations, investors, sensi-
tive after being hurt by overinflated valuations negotiated in the boom times,
are prone to use various business valuation models, including among others
cost approaches (cost to recreate) and income approaches (capitalization of
income and discounted future cash flow analysis).
Regardless, value is generally agreed to be about finding the present
value of future cash flows, in which cash flows could be proceeds from the
sale of stock or interest and dividend payments.
Most investors use a combination of these approaches to ascribe value
to the early-stage, nonoperating company without revenues. Understanding
the salient drivers in valuing a company will help entrepreneurs make their
ventures more valuable in the perception of investors. Valuation is so impor-
tant, as well as technically complex, that we have dedicated an entire chapter
to adequately address the subject.
In this section, we want to convey to entrepreneurs that valuation is not
a precise form of financial analysis, but is more akin to an art form, or at
times, horse trading. Such subjective factors as experience and cohesiveness
of the management team, investor familiarity with the industry of the ven-
ture, perceived competitive advantage or lead to market, whether “mission-
ary” selling will be required to introduce the product, likelihood of the need
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for follow-on financing, the extent to which the deal had been “shopped,”
and how persuasive and committed the entrepreneur is perceived as being
are qualitative elements that can conspire to influence the most elaborate
quantitative financial valuation techniques. Entrepreneurs would do well to
pay heed to these subjective elements, as well as to their elegant financial ar-
guments of value.
Potential risks and rewards vary substantially during the different devel-
opment stages of a new venture. Despite every entrepreneur™s confidence in
his or her “sure thing,” more new ventures fail than succeed. Investors need
a few big winners to offset the losers. Depending on the risks, compound
rates of return from 20 percent to 25 percent or more are not unreasonable
expectations for investors to take the risk and loss of use of their capital. So
in our chapter on valuation, we will also present information on investors™
expected rates of return, and implications for entrepreneurs™ discussion of
exit plans.
Also, since value is in the future, any calculations are fraught with the
complications influenced by incomplete information, rapidly changing envi-
ronmental factors, unproven management, untested technology, and unde-
veloped markets. So determining value in the early-stage deal is subjective
precisely because so much depends on something that has not yet happened.
Last, the negotiation skills, styles, and techniques used by investors and en-
trepreneurs themselves to resolve their valuation differences can become es-
sentials that influence the valuation outcome.
The private equity players who threw caution to the wind in 1999“2000
are more realistic today. Premoney, seed-stage values of completed transac-
tions in the past year (2003“2004) have a median value of $3 million. First
rounds have a median premoney value of $9 million. Quite a drop from the
historic highs just before the dot-com bust. Gone are the astounding multi-
ples at which many Internet start-ups with no earnings or immediate poten-
tial for revenues had been valued. Investors have regained their gravity, and
entrepreneurs seeking capital need to pay attention to having reasonable ex-
pectations and be cognizant of the potential for down rounds.
Although the number of down rounds decreased in 2002“2003, this was
due more to investors shifting to later-stage investments rather than to their
reducing aggressive negotiation over value. In down rounds, preexisting in-
vestors are forced to address a steep decrease in valuation. This situation, if
not fully managed, can create considerable legal issues and liability for the
board and other inside stockholders. Remember that majority stockholders
have a fiduciary duty to minority shareholders, among others, and directors
can be held personally liable for breach of fiduciary duty. So it becomes crit-
ical in facing down rounds to demonstrate alternatives before resorting to
the financing at that value. There must be complete disclosure, approved by
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shareholders, perhaps an outside fairness opinion, and directors and officers
(D&O) insurance and indemnification.
In conclusion, valuing the early-stage company inevitably means that the
investor must take an equity ownership position that will produce an ex-
pected annualized rate of return over a reasonable period commensurate
with this investor™s tolerance for risk. Valuation, therefore, does crucially de-
pend on the creation or expansion of a sustainable, going concern into a
marketable commodity through an event that provides liquidity for the in-
vestors.
To the extent that entrepreneurs have mitigated risk through product de-
velopment, marketing, sales, customer endorsement, and development of an
effective, cohesive management team, the entrepreneur will see his or her val-
uation increase. Because of these characteristics about venture value, entre-
preneurs will appreciate the investor perspective with which they must deal:
investors must be convinced of the merits of the venture before discussing
valuation; investors believe that demand for capital exceeds supply and will
embrace this leverage in any negotiation; skeptical investors will always dis-
count entrepreneurs™ projections (give them a “haircut”); investors will build
their own cash flow models from the entrepreneur™s data, paying particular
attention to potential for dilution for unforeseen follow-on financings; and
last, investors in today™s market will be skeptical of entrepreneurs™ claim of
IPO™s as their primary exit plans. Even in boom times”now long gone”
fewer than ten percent of venture-funded deals provided liquidity via IPO!


NEGOTIATING AND STRUCTURING THE DEAL

Venture investor Anthony Perkins is quoted as saying, “If there is any guide
to structuring investments, it is to isolate whatever the biggest risk is in a
deal, and structure the initial investment so the money is used to eliminate
that risk.” In the new capital-raising reality facing entrepreneurs today and
for the immediate future, be confident that investors have altered their in-
vestment approach from the boom times of 1999“2000. Whether in re-
sponse to investment losses incurred, or for other reasons mentioned,
investors now place a premium on risk management, hedging strategies to
minimize the downside, and co-investment strategies to share the risk. As in-
vestors pay more attention to due diligence, aggressive valuation negotia-
tions to establish pricing and stricter deal terms have become the norm.
Certainly, for early-stage companies seeking private equity financing, terms,
or the key covenants in investment contracts, have changed.
For example, 75 percent of deals, according to the Strategic Research
Institute, are done at “down” valuation. Consequently, transactions that will
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The Venture Investing Process


meet with the motivations and goals of each party require innovative struc-
tures and time lines to avert overdilution of employees and founders. With
capital uncertain or unavailable for many young technology companies, and
valuations in a continuous state of flux, there is considerable stress on in-
vestors and entrepreneurs to emphasize negotiation of price and deal struc-
ture.
With regard to structuring transactions, the biggest change now facing
entrepreneurs is that deal terms are more investor friendly than was the case
five years ago. Deal terms that originated before the dot-com era have
gained momentum since the post-2000 meltdown of Nasdaq.
PricewaterhouseCoopers takes this view: “It is fair to say that entrepreneurs
don™t have a lot of leverage today; terms are structured to ensure greater pay-
off to ˜investors™ as compared to entrepreneurs and founders.” At bottom,
then, it is a case of supply and demand.


RISK AS A DRIVING FORCE BEHIND DEAL STRUCTURE

All investments, by definition, have risks. Early-stage, private equity invest-
ing carries very high risk. In direct investing, entrepreneurs must empathize
with the investor, understanding that ultimately there invariably comes the
intricate decision about how to manage that inherent risk. Common sense
tells us”as does our experience”that investors will do a number of obvious
things to try to reduce risk, for example, be highly selective and thoroughly
analyze every deal before they invest; diversify their private equity portfolio
by private equity class, region, technology, industry, or stage of development;
structure transactions with any collateral available; stage follow-up capital
infusions based on management performance and accomplishment of prede-
termined milestones; negotiate steep discounts as a premium for investing
early; never investing at the first price/valuation suggested by the entrepre-
neur; and search early for co-investors who will confirm the investor™s judg-
ment and be willing to invest a like amount at the agreed valuation”in effect
confirming the deal is worthwhile before they invest in it.
Risk can vary significantly, depending on different dimensions of an in-
vestment”for example, the category of the private equity class and the com-
pany™s stage of development. The private equity class of investments has
broadened to encompass a range of different transactions: preseed, seed,
start-up, growth, mezzanine, leveraged buyout, buyout, spinout, post-
venture, turnaround, special investment situations, and distressed security
investing. The life cycle of potential portfolio companies evolves from
start-up to expansion to mezzanine. Of course, risk stands significantly
higher in the earlier stages of the development of the venture, a stage in
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which founders attempt to comprehend the concept, the company™s reason
for existence. At this stage, management capability remains limited as they
struggle to clarify strategic advantage, develop a business plan, and com-
mence to prove practicability.
In addition to considering the stage-of-development risks inherent in
early-stage transactions, investors will typically analyze five other risks.
First, management risk does not center on the more obvious question of
qualification of the individuals; this aspect of due diligence is taken for
granted. The real management risk is whether the principals involved can
perform as a team and carry the venture through to a liquidity event, or
to exit.
Another risk involves the product. If we are dealing with a start-up or
early-stage company, with the product in development, the investors are
being asked to put up money before a prototype has been developed.
Whether the product can be made to work becomes a critical risk.
A third risk of these types of ventures centers on the market. Will the
market accept the product? Such a consideration involves the push-pull of
market forces. Having to push a product onto the market makes missionary
selling necessary”an expensive proposition tied to considerable risk.
However, a product being pulled by market demand means less risk.
Operations, another area of risk, depends on a company™s ability to meet
its sales projections. Can the company produce with quality the projected
volume to meet customer expectations, keep them happy, and maintain their
loyalty (and the company™s reputation)?
Still another risk associated with early-stage ventures is financial risk, an
assessment of how much money will be needed beyond the investor™s invest-
ment. If a venture needs $10 million in the next round, and the investor™s
contribution is only $50,000, a major financial risk looms. There is that
chance that the entrepreneur will not be able to raise such a sum in the cur-
rent market, unless the venture is stellar. So financial risk has to do with rais-
ing money for the balance of the present round and future rounds necessary

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