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PRESCREENING

Because investors must go through “mounds of manure to find a jewel,” they
tend to prescreen for red flags to weed out ventures that do not justify in-
depth due diligence.
The quality of the business plan suggests the quality of the venture, the
deal itself, and the people who wrote it. At ICR, fewer than two percent of
business plans received are given serious evaluation. The rest simply don™t
merit in-depth analysis. The business plan presentation is vital to getting an
in-person meeting with investors. We refer you to Appendix A on drafting an
investor-oriented business plan to better appreciate what investors typically
look for in venture documentation, organization, content, and presentation.
The source of the deal is another prescreening aspect. Was it referred by
a trusted colleague or intermediary, or was it sent over the transom via the
Internet by someone unknown to the investor or a circle of contacts?
Who are the company™s advisers? Who were the attorney, accountant,
business consultant, investment banker, or intermediary assisting the com-
pany with capitalization strategy? The quality of advisers associated with the
firm is an indicator of the good judgment of management.
Is the investor familiar with any of the other angel or venture capitalists,
family, friends, or cofounders who have invested in the deal? Investors add
relevant value through their experience and knowledge over and above the
capital they invest. The extent to which the current investor pool offers re-
sources to grow the company makes the venture more attractive to other in-
vestors.
One prescreening question we ask at ICR is whether current customers
or companies involved in beta tests will provide endorsement of the com-
pany, its management, or its technology. Relationships with customers or po-
tential customers suggest the potential for the company and its product to
succeed in the marketplace.
Sophisticated early-stage, private equity investors commonly have an in-
vestment plan and a portfolio allocation strategy. They will ask themselves
whether the venture fits with their investment strategy, for example, indus-
tries or technologies that they know and understand. They will also consider
if the company™s stage of development is compatible with their risk tolerance
and portfolio diversification strategy. There are varied levels of risk associ-
ated with seed, start-up and expansion stage business. Compatibility with in-
vestors™ tolerance for risk is a paramount condition in order to invest.
Investors have maximum limits. They are not confused about how much
they can invest per deal. In ICR™s study of 60 investors from its database, the
maximum amount investors would consider investing ranged from $25,000
to more than $1 million. There needs to be compatibility between the in-
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vestor™s preferred investment amount and the minimum investment accept-
able to the entrepreneur.
We also reported in ICR™s study that 23 percent of respondents pre-
ferred proximate location (within 300 miles) to where they lived. Is the
company located geographically in an area of interest to the investors, they
would ask. Not all investors are open to ventures out of state. Whether be-
cause of the difficulty of travel or because of their inability to monitor the
investment adequately, investors designated geographic proximity as an es-
sential consideration.
Chemistry between the investor and entrepreneur is essential to any fa-
vorable decision to invest. Angel investors in particular invest in entrepre-
neurs who positively enhance the investors™ images of themselves. We invest
time and money in those persons who uplift us, those who make us feel better
about ourselves. These are long-term commitments, perhaps eight to ten years
until liquidity”longer than most of today™s marriages. Chemistry among the
parties is a mandatory element for success, not just sale of the security.
Last, investors today are concerned about exit: Is the company™s pro-
posed exit route believable to the investor, and do the time horizons and re-
turn multiples fit with their investment strategy? Whether IPO, acquisition,
sale or merger, or building a sustainable company to operate for cash, posi-
tioning the investor for dividends or buy back, the liquidity event needs to fit
with the investor™s strategy and expectations.


MANAGEMENT
People get funded, not plans! The “A” manager with a “B” plan is always
preferable to a “B” manager with an “A” plan. High-quality people are the
primary criterion for investing in a deal. To assess management team quality
and its capability, investors will question the quality of management and, if
they are present, the members of the management team. Quality is explored
through questions about the individual entrepreneurs, for example. Investors
will ferret out the truth about each team member through reference and
background checks to verify the integrity, academic credentials, and people
skills, as well as through checks on civil, criminal, credit, and, yes, even driv-
ing records. Investors question management™s skills, correcting the inevitable
miscalculations and other mistakes as the company grows. Entrepreneurial
fervor, confidence, vision, and ability to solve problems are areas investors
look at keenly.
The past judgment of managers based on their business experience is
questioned. The management team is examined as well in terms of their di-
versity, skills, completeness of functional expertise, willingness to accept
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help, and commitment to the venture long term. The board of directors, ad-
visers, and investors are also assessed, along with management; for example,
board diversity and skills, ability to spend time, investors™ experience, con-
tact networks, and skill at counseling managers. Based on our research, in-
vestors have attempted to assess these characteristics of management with
such questions as those listed below:

1. Who are the managers of the company? Who holds the major author-
ity? Who is the key decision maker?
2. What are the major achievements of the CEO? How successful were
his or her previous ventures?
3. Is the CEO personally familiar with the specifics of the company™s op-
erations?
4. How has the CEO dealt with major problems the company has faced
before?
5. What are the CEO™s financial goals in being involved in the company?
6. What is the management team™s background? Do the team members™
past industry experiences dovetail with their current job responsibili-
ties? What are the members™ reputations in the industry?
7. Have team members been involved in any other start-ups or public
companies? Has any member of the management team previously
made money for investors?
8. What is the relationship between the management and the board of di-
rectors?
9. Who sits on the board of directors? What is his or her experience and
qualifications? Has he or she managed more developed, successful
companies?
10. What is the total compensation of all officers in the company? Their
salary, commission, bonuses, loans, expense reimbursements, profit
sharing, etc.? What was their compensation in their previous posi-
tions?
11. What is each manager™s stock ownership, and how much, if any, of his
or her own capital has been invested in the company? What is the
CEO™s ownership following financing? What is the ownership of out-
side directors?
12. Have members of management worked together before, or are they re-
lated? Do they exude a palpable team spirit?
13. Are there any vacancies in the management structure, or is any mem-
ber of the management temporarily filling a position until a permanent
professional is located? What is the plan to recruit and fill positions?
14. If the CEO were not available, is there a suitable replacement on the
team?
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Preparing for Due Diligence


15. Has any member of the management team sued or been sued within
the past five years?
16. Has any member of the management team ever been convicted of a
felony?
17. Are there any civil or criminal charges pending against any member of
the management team?
18. Has any member of the management team ever been terminated from
a management position? Has any member left the company? Why?
19. Has any member of the management team personally filed for bank-
ruptcy or been involved in a state receivership within the past five
years?
20. Has any member of the management team ever been the officer of a
company that has filed for bankruptcy?
21. Has any member of the management team been disciplined by a regu-
latory agency or professional association within the past five years?
22. Obtain personal and health data on all of the key managers. Are man-
agement personnel in good health? Has any member of the manage-
ment team disclosed any serious difficulties in his or her private life
(divorce, psychological breakdowns, alcohol or drug problems)?
23. Is any member of the management team not expendable? If yes, why?
What will happen if he or she becomes unavailable?
24. Have there been any SEC problems or violations in the past 10 years
for any manager, officer, or director? Has the management team
signed employment contracts? Do these include noncompete clauses?
25. Have there been any problems within management, and if so, have
those problems been resolved? Have there been any changes in the
management team within the past two years? How do they communi-
cate now?


BUSINESS OPPORTUNITY
This section of the due diligence framework assesses the business opportu-
nity. The audit questions relate to the product or service and underlying tech-
nology, market and competition, distribution, and the business model (i.e.,
how the company will make money), and will include questions about the in-
dustry, innovation in terms of R&D, and aspects of production.
Whether the venture™s technology is revolutionary, creating a new mar-
ket segment, or evolutionary focused on exploiting a narrow market seg-
ment, these questions will apply in due diligence. This part of the evaluation
gets to the heart of the business model: examining product/service design,
whether it works, and if the product or service is something the customer
250 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


wants. Investors may bring in experts to assess the technology and stage of
development. Feasibility is analyzed by talking with customers, distributors,
and others. Questions try to clarify the size of the market, growth rates, and
reasonable penetration goals. Competitors, proprietary advantage, intellec-
tual property, and positioning strategy round out aspects of the business that
investors will ask questions about. Investors will collect information to esti-
mate gross profit margins and look for recurring revenue streams in the busi-
ness. The sample of questions asked of entrepreneurs in the past about the
business opportunity are listed below.


Industry
1. What industry (or industries) is the company involved in? How many
companies are in the industry? How is the industry structured (prod-
uct, price, geography)?
2. Are any large players accounting for a significant share of the business
in the industry? Describe the market share.
3. How would you define the competitive structure of the industry (frag-
mented, oligopoly, monopoly, etc.)? Which way are mergers and ac-
quisitions heading (vertical or horizontal)?
4. What is the failure rate of companies in the industry?
5. What has been the annual industrial sales growth rate, and what is it
expected to be over the next five years?
6. What has been the annual earnings growth of the industry? What are
the projections for the next five years?
7. Is the industry subject to cycles? How volatile are industrial sales and
earnings during economic cycles? Indicate the best and the worst pos-
sible scenarios.
8. What are the significant barriers to entry into the industry?
9. What is the success rate for new entrants into the industry? Do any
company patents suggest the company™s industry will succeed?
10. What is the history of the industry? Have any recent events had an im-
pact on it?
11. What government agencies regulate the industry, and does the com-
pany expect any future changes in the degree of regulation?
12. To what extent is the industry unionized, and what has been the im-
pact of recent labor contracts in the industry?
13. Identify the key elements influencing future industry growth, for ex-
ample, market growth changes, economic trends, consolidations and
economies of scale, price differences, interest rates, government regu-
lation, environmental issues, technological innovation and product
development, and foreign competition. How might these factors influ-
ence projections for the company?
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Preparing for Due Diligence


Products or Services
1. What is the current product line? Describe each. How reliable are the
products? Are samples available?
2. Which product is the most profitable for the company?
3. How does the product work? What problem does the product solve?
Does it solve a “real” problem or fulfill a “real” need?
4. What is proprietary about the product?
5. Has all R&D been completed on the products? What is the timetable
for new product introductions?
6. How is the product priced? Who establishes the price and the price
structure? What are the past and present price trends in the industry?
7. What is the estimated remaining life span of each of the company™s
products.
8. If applicable, what is the current status of the patent for the process or
product? Is a copy available?
9. When were the products introduced? At what point are they in their
life cycle? Are changes in the products planned?
10. Can the product be massed produced, or does it require customizing?
11. Estimate revenues and the market share for all products over the next
12 months.
12. What are the margins for each product, and how will they change as
the market share increases?
13. What are the customer service requirements for each product?
Describe any customer service operations. Are any customer services
contracted out to third parties?
14. What is the company™s warranty policy? What is the current and pro-
jected warranty expense?


Market, Sales, and Distribution
1. What is the dollar size of the market by product? What is the annual
market growth rate by product? What are the projections for three
years? What are the data sources?
2. What is the company™s marketing strategy? What are the annual ad-
vertising expenditures, current and projected? What is the company™s
selling proposition?
3. What are the central objectives in marketing? How will the strategy
be implemented (e.g., is there an array of promotional activities
planned)?
4. How does the company™s marketing strategy compare with competi-
tor™s information? What market research has the company conducted?

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