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Are copies available?
252 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


5. How do sales breakdowns/projections by product compare with in-
dustry data?
6. Who are the company™s customers? What do they buy? How big is the
average order? Is there any backlog of orders, purchase orders, or let-
ters of intent? Are customers fiscally sound? To what extent are cus-
tomers repeat purchasers? How do customers perceive product
quality? Is the company dependent on a few key customers?
7. How does the company find customers? What is the time and cost to
close sales? Does this fit with projections? Is intensive personal selling
required?
8. What are the key variables in the buying decisions? What are the price,
quality, terms, etc.? Can customers shift from a competitor to the com-
pany, or is it difficult to change?
9. What are the sales performances of key salespersons to date? Are their
sales currently covering the costs of marketing and sales functions?
How are they compensated? How is their performance evaluated?
10. Has their performance been compared with sales projections?
11. Does the company participate at trade shows or conventions?
12. Does the company advertise? What is the average cost? Are there
standing orders? What are the advertising expenditures for the past
two years, and what are the projections for the next three years?
13. What is the cost of product packaging, and what image does this pack-
aging convey to the customer?
14. Is a sales force currently in place? Is their experience relevant?
15. What types of warranties, guarantees, or service contracts are offered
to customers?
16. If there is a customer problem, how is it handled?
17. Has the company established any distribution, joint venture, or tech-
nology transfer agreements?
18. How many distributors does the company use? How does the com-
pany select them? What is the rate sales volume? Does any single dis-
tributor account for a large amount of the company™s sales? What are
the remuneration arrangements with distributors? What are the credit
terms? Are copies available of distributor marketing agreements?


Competition
1. Ranked by sales, who are the company™s largest competitors?
2. Are they fiscally sound, well capitalized, and profitable? What are the
present and future respective market shares?
3. What is their focus: Are they expanding niches in the industry? Are
they expanding into new markets or diversifying into other industries?
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Preparing for Due Diligence


4. How does the company differentiate its product from the competi-
tion? What is unique about the product?
5. What are the barriers to entry in the company™s industry? Is it easy or
difficult to enter this business?
6. How does the company compare to the competitors in terms of prod-
uct, price, market share, functional expertise, capital resources, and
management?
7. Has the number of competitors increased or decreased in the past two
years, and do you expect this to change? Are there new entrants ex-
pected?
8. How do competitors usually deal with small competitors (push them
out of the market, buy them out)? What is there competitive strategy?
9. At what sales level do you believe the company is a competitive threat
to other companies, and how much market share does that translate
into?
10. How does the company plan to combat the competition, and vise
versa? For example, compare product features and price points to
those of competitors.
11. Has the company identified any of its competitors in the international
marketplace? If so, who are the three largest, and what are their geo-
graphic market shares?
12. What research has been conducted on competitive products? Is docu-
mentation available on competitors?
13. What competition might the company face from products from other
industries that may be substituted for its own?


Research and Development
1. Who are the key engineers and R&D managers and personnel? What
is their technical background?
2. What have been the costs and benefits of the major R&D programs
completed during the company™s history?
3. What are the current R&D programs and projected costs and time
until completion? What are the expected outcomes? How were these
programs selected? Why?
4. What new R&D projects are planned following financing? What are
the costs and anticipated benefits? How is R&D monitored?
5. How does the company™s expenditure (or projections) for R&D com-
pare to industry standards?
6. What is the company™s strategy to ensure protection of its proprietary
technological development, etc.? What about its patents, confidential-
ity agreements, and so on?
254 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


7. What is the condition of the R&D facilities and equipment?
8. Has R&D generated reports for management? Are copies available?

Production
1. Are there any pending issues related to the Equal Employment
Opportunity Commission or Occupational Safety and Health
Administration?
2. What type of production process is used (e.g., continuous or batch)?
What are the major operations? What are the sequence, relative cost,
and space requirements for each? What is the extent of automation?
3. What is the length of the production cycle and cost of the setup?
Identify the key components in the production process.
4. What is the level of technological complexity of the elements used in
the production process? Any downtime problems?
5. Is the process labor intensive? What could be automated? What would
be the cost of automation?
6. What backup systems have been created to deal with possible produc-
tion problems?
7. Is the company vulnerable in any way to current or projected energy
availability from suppliers for its production fuels or for transporta-
tion of its product to customers? What means of transportation are
used to ship the finished product to market?
8. What kind of scrap or waste is generated by the production process?
Are there potential issues with disposal, including environmental pol-
lution? If necessary, check with the appropriate agencies for air, water,
waste, and land issues.
9. What production stoppage has management encountered? Are there
any alternative sources of production if there is an interruption in the
current assembly line?
10. What are the optimum inventory levels for the finished product and for
raw materials? Is the current level of inventory at the optimum level?
11. Is any part of the production process subcontracted out? Who are the
subcontractors?
12. Compare the data from the above inquiries with available industry
data.


INTANGIBLES

In this section of the early-stage venture capital due diligence framework by
Camp, he assembles concepts not quantitative in nature, but, in fact, the
more subjective perceptions of investors. These concepts include focus, mo-
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mentum, “buzz,” “gut” feelings, and factors that do not readily fit in other
categories, for example, whether the deal is perceived as having been “over-
shopped.”
Focus”or lack thereof”is about the entrepreneur trying to be all things
to all markets. Our experience is that some entrepreneurs, driven by their
own creative juices, tend to diverge from the laser point focus needed early
in venture development instead of converging on an innovative solution for
a relevant problem in a targeted market. This leads to a waste of resources
and less impact on prospective investors.
Momentum has to do with the perception that the company has hit mile-
stones and the belief that this implies the likelihood of its making the next
goal or objective. For angels this is manifest in seeing the company as more
developed or “real,” that is, carrying less risk.
“Buzz” relates to how aware people “in the know” are of the venture or
its technology. Successful public relations seems more important to venture
capitalists than to angels, perhaps reflecting the angel penchant for privacy, or
perhaps the concern about legal aspects of promoting the private placement.
“Gut feelings” is perhaps the most underrated investment criterion in
private placements. While the due diligence audit suggests a natural ap-
proach to decision making, in fact, there exists a dimension involved in se-
lecting these types of investments that is more “right brain” or intuitive. It is
not only a decision based on what is said and on the data collected and ana-
lyzed, but what is unspoken, nonverbal information gleaned by astute,
highly experienced investors who themselves have been entrepreneurs. Their
antennae are sensitive to what is conveyed wordlessly, yet is apparently”to
them”accessible. These perceptions get processed along with logical analy-
sis in making the final investment decision.
Last, investors can draw conclusions about the quality of the deal if the
deal has been in the financing market for an extended time and was rejected
or only partially funded by other investors. The greatest risk to entrepreneurs
in misusing the strategies proposed in Angel Capital is to overshop a deal by
taking it to many inappropriate alternative financing resources. By commit-
ting this error, the entrepreneur will soon learn the hard way how small the
early-stage financing community is in their region. If a deal comes around to
investors a second time and is not funded or is underfunded, this circum-
stance sends a strong message that other investors have concluded that the
deal lacks merit, that it does not deserve serious consideration.


LEGAL DUE DILIGENCE
The early-stage venture capital due diligence framework organizes queries
about the selection of the business entity, intellectual property, past and
256 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


pending litigation, and transaction issues related to the offer to sell securi-
ties”specifically, according to Camp, legal terms, conditions, and provisions
that can have an impact on the investors return on investments. Having legal
counsel is obviously necessary for the entrepreneur at this point to under-
stand such provisions as the security to offer, conversion rights and terms,
carve-outs, pay-to-play, dividend preferences, warrants, voting rights, repur-
chase/vesting, and staged capital commitments. These provisions could be in-
cluded in various legal documents associated with the private placement, for
example, the private placement memorandum, subscription agreement,
terms sheet, stock purchase agreement, shareholders™ agreement, and ancil-
lary agreements, such as employee confidentiality agreements. During this
phase of due diligence, investors strive to explore and discover whether any
hidden or potential legal problems are lurking in the deal.
We are not lawyers, so the information in this section is not to be con-
strued as legal advice. The purpose is to sensitize the entrepreneur to terms
likely to crop up during negotiations with investors, terms about which the
entrepreneur may want to seek legal advice. But the main reason is to pre-
clude the entrepreneur™s using clauses that investors find unattractive.
Questions about the form of the organization have to do with whether
the venture is a corporation or an LLC. LLCs combine the advantage of cor-
porate limited liability with one-level taxation of a partnership and has es-
sentially replaced the S corporation. The C corporation permits free and
ready transferability of ownership by sale of stock, without affecting the con-
tinuing existence of the business or title to its assets. Investors prefer C cor-
porations because of their flexibility of financing through the sale of various
types of securities to many investors.
Corporation structure is also preferred for an array of tax benefits that
accrue to the investor and the corporation itself. If stocks are held for five
years, there are capital gains tax savings, and gains can also be deferred
through re-investing. The benefits to the corporation can help it to conserve
capital, something very attractive to the investor. Other questions may relate
to where the corporation was formed and whether any required government
filings were appropriately made.
Any questions related to intellectual property protection examine
whether there are any patents, copyrights, trademarks, or trade secret rights,
and whether there will be any impact of these assets on the venture™s poten-
tial. Concerns arise that perhaps third parties will claim intellectual property,
so this possible dilemma is also researched. Patents give exclusive use rights
to holders for extended periods, a protection many investors value. Such
value of the patents themselves may be scrutinized by the investors™ legal
counsel. Also subject to examination will be any agreements to protect the
integrity of confidential information. Copyrights, trade secrets protection, li-
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Preparing for Due Diligence


censes, invention assignment agreements, and other agreements are scruti-
nized during this portion of due diligence.
The framework organizes questions about the transaction into this
phase of due diligence. In our discussion of negotiating and structuring the
deal, we have already introduced rights and terms, antidilution protection,
carve-outs, pay-to-play, warrants, board voting rights, repurchase/vesting
terms and staged capital commitments, right of first refusal, and redemption
rights. Entrepreneurs and investors in successful deals tend to work together
in customizing this array of terms to best fit with their respective needs and
expectations.
Investors want to know the type of security, for example, convertible
preferred or preferred with warrants. Convertibility provides investors with
protection and priority early in the investment, and the ability to participate
in liquidity events later as well. Investors want to understand or clarify the
terms of conversion, for example, ratio of conversion or timing of conversion
and whether conversion is automatic or voluntary at investor discretion.
Antidilution protection protects investors™ share of ownership in the
company when it changes the structure of common stock or capital struc-
ture, for example, with a stock split. Antidilution protection ensures that
preferred stock holders, for instance, retain the same ownership share of the
company after any structural change as they held before the change.
Investors will ask questions about the type of antidilution protection that is
available and how it will work, because such provisions can become compli-
cated. Also subjects for investor queries are questions about carve-outs, de-
fined as exceptions for certain stock issues that do not trigger antidilution
provisions, and pay-to-play provisions that require investors to participate
in down rounds to ensure the continuity of antidilution protection.
When a particular early round has very high levels of risk, investors may
ask about warrants. Warrants provide holders a right to purchase additional
stock at a fixed or predetermined price for a set period. Investors may ask
about availability and terms associated with warrants.
Investors are concerned about control. One investor told us, “The only
time I™ve lost my investment happened when I had no control in the situa-
tion.” Investors making significant investments will want to know about rep-
resentation on the board and whether voting rights are obtainable.
To influence management, investors ask about equity incentives. These
are the purchase rights to buy back stock of exiting managers and employ-
ees, and vesting of stock to managers over time instead of issuing stock all at

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