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once. Investors also negotiate another control by staged capital closings. By
investing needed capital over time and only after management accomplishes
planned milestones, investors can control performance to plan and budget,
and so perhaps reduce some risk in the deal.
258 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


The final set of questions in the framework™s legal due diligence pertains
to exit and liquidity. Investors become involved in early-stage, private equity
financings because they believe that ultimately there will be a way of getting
out, and in so doing they will realize appreciation on their investment and
loss of use of capital for years.
Questions about registration rights focus on the investors™ right to par-
ticipate in liquidity events and to register their securities for public sale, for
example, an IPO. Also investors might want to demand registration rights
that give investors the right to mandate the company to register their shares.
Piggyback registration questions will query the rights for investors™ shares to
be included in any new shares issued by the company. Questions about drag-
along rights center on provisions providing investors to force the sale of the
entire company if investors find a buyer or merger candidate and negotiate
an acceptable deal. Anti-lockout terms have to do with the investors™ rights
to be bought out if such actions are acceptable to management. Tag-along
rights ensure that investors participate with entrepreneurs, if they decide to
sell out to a third party.
In addition to the questions explained above, our research among entre-
preneurs had identified the added due diligence queries investors have used
to assess investment parameters:

1. What is the company™s fund-raising strategy?
2. What is the total amount needed in this round, and what percentage
of that money is expected to be venture capital?
3. What will be accounted for in the use of proceeds once financing is
complete?
4. What is the funding schedule (how much and when)?
5. How much has been raised to date?
6. What are the terms and conditions of the private placement?
7. What will the total dilution be at the end of funding?
8. Is all equity diluted equally?
9. List all categories of investment made by the company (common or
preferred stock, convertible, debt, etc.).
10. What is the timetable for a public offering?
11. How much time is spent by management promoting the company™s
stock?
12. Is management experienced in raising capital?
13. Does the company have an investor/public relations firm? If so, what
are the terms of its contract?
14. What is the budget for promotional (funding) activities?
15. Who is the securities attorney?
16. Has the company granted director status to investor groups?
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Preparing for Due Diligence


FINANCIAL DUE DILIGENCE

The final section of the Camp framework focuses attention on financial
analysis. Investors will carefully analyze financial projections or pro forma
financial statements, since start-ups do not have historical financial data.
This is a way for investors to think through financial implications of man-
agement decisions made in preparing the business plan.
Investors will ask questions about burn rate (the amount of capital used
by the company per month to implement its plan), current and future fi-
nancing risk, and valuation. However, the primary focus here is on financial
forecasts or pro forma financial statement analysis. In the next chapter, we
will address valuation; in this section, we concentrate on analysis of finan-
cial projections.
Can management reach the forecast objectives? Projections are struc-
tured around the objectives developed by the management team during the
planning process. The marketing, sales, and operations strategies and plans
indicate the financial requirements. The industry trend analyses imply spe-
cific assumptions about likely future conditions. Investors will evaluate pro-
jections and the assumptions behind projections. Especially when projections
were prepared using spreadsheet software by the entrepreneurs themselves,
expect close examination.
The range of pro forma financial statements that investors will request
and analyze include budgets, cash flow data, income projections, pro forma
balance sheet and income statements, break-even analysis projecting when
the company will begin profitability, and cash flow break-even analysis spec-
ifying when the company can stop raising money. Cash flow statements pro-
ject the cycle of turning sales into cash that pay the cost of doing business
and to turn a profit. Cash flow analysis also reflects credit and collection
policies and projected financing activity. Cash flow analysis tells the in-
vestors when cash will be needed.
The remainder of financial statements analyzed will be the income state-
ment projecting revenues, expenses, and earnings over three to five years.
The balance sheet shows assets and liabilities and equity of the company on
a given date.


Questions About Projections
– How did management arrive at its financial projections? Develop a list
of key assumptions used by management to prepare the financial pro-
jections.
– If a company is actually generating revenues, has it met projections to
date?
260 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


– How might ratio analysis be used with the projections?
– Should projections be discounted? What impact does such discounting
have on the company™s valuation and the amount of equity appropriate
for the investor?
– Are the projected revenues accurate? What are the costs to attain rev-
enues? What are the projected profits?
– What is the estimated return based on discounted projections?
– What is the past record of actual cost against projected cost?
– What are the company™s expected financial needs? Investors want to
know funding requirements: how much? when needed? type of funding
appropriate? equity offered capital? Not only will investors ask how
much funding is sought, but how it will be used.


Questions About Capital Requirements
– What is the company™s capitalization strategy? Long term, short term, or
both?
– How much more capital, based on the company™s proposed funding
schedule, needs to be raised before the company can finance operations
and growth from income and from the use of traditional credit-type fi-
nancing?
– At what point will the company be able to internally finance future
growth?
– What is the total amount of capital needed for this round?
– What will be the total dilution at the end of the funding schedule? Is all
equity diluted equally? What securities is the company using or offering?
– Is there a timetable for IPO or exit?
– Does the company need approval of any entity other than the board of
directors for this financing?

The balance sheet illustrates the financial condition of the company by
showing what it owns and what it owes at the report date. The balance sheet
lists the assets required to support the operation of the business. The liability
section shows how these assets are to be financed.
The assets section of the balance sheet includes information on current
assets, property plant and equipment, other assets, and intangibles. Current
assets include all cash of the company. Current assets also include mar-
ketable securities at lower cost or market value, accounts receivable less
doubtful accounts, notes receivable collectible within one year, inventories,
prepaid expenses, and any other current assets. Property, plant, and equip-
ment can provide information on land, buildings, machines, leasehold
improvements, furniture, and vehicles, less any accumulated depreciation.
Depreciation relates to tangible assets, such as a building, car, and so on.
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Preparing for Due Diligence


Other assets, such as intangibles, will provide balance sheet information on
goodwill, patents, franchises, trademarks, copyrights, and licenses, less any
amortization. Amortization is a way of reflecting periodic changes to income
to recognize the distribution of the cost of the company™s intangible assets
over the estimated useful lives of those assets.

Questions on Assets in the Pro Forma Balance Sheet
Cash

– How many depository accounts? Identify all cash accounts.
– Average balance per account during the past year?
– Have all bank accounts been reconciled?

Receivables
– What percentage of the company™s sales are on a credit basis?
– What are the terms?
– What credit checks does management perform before extending credit?
– Are credit reports updated?
– What percentage are delinquent? How long before delinquent accounts
are collected? Is there an allowance for an account that may be difficult
to fully collect?
– Does payee recognize receivables as being due?
– How and when are receivables recognized?
– What percentage of sales are cash versus credit customers?
– What are the credit terms?
– Who makes the decision about extending credit?
– Does the company have any allowance for bad debts?

Inventory
– What inventory valuation method is used (cost or market value)?
– When was the physical inventory last reconciled (present market value)?
Was a year-end physical inventory taken?
– What is the turnover rate?
– What condition is the inventory in? Is any of it obsolete?
– Are inventory controls in place? What is the policy or procedure to min-
imize the amount of money tied up in inventory?

Fixed Assets
– Description, cost, and current value of each fixed asset? What is the re-
placement value for plant and equipment, and how does this compare
with the book value or the liquidity value?
262 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


– Are depreciation methods used consistently?
– What percentage of the company™s assets are leased? What are the
terms? How does the value of capital leases compare with the fair mar-
ket value?
– Who approves capital expenditures?
– Are any assets pledged as collateral or subject to liens?

Other Assets

– Is management expensing R&D, or is it capitalized as an asset and ex-
pensed over a defined period?
– Is management invested in marketable securities? Which securities and
why?
– Are there any deferred costs or intangible assets? How are these valued?
– Is there a pension plan? Are there any funding requirements?
– Are there any reserve accounts to cover bad receivables or warranty
claims?

The balance sheet liabilities section covers current liabilities and
long-term liabilities. Current liabilities are those that will be due within a
year and include accounts payable, notes payable, and accrued expenses; for
example, salary, interest, professional fees, insurance expense, warranty and
taxes, income taxes payable, and revolving lines of credit. Look at any large
accounts payable. Consider taxes in some detail. For example, take the time
to understand what the company™s applicable federal, state, and local income
taxes and excises taxes are and any special industry tax considerations, such
as depletion allowances (and write-offs). It™s important to understand in re-
viewing the income tax payable whether the company is current on all of the
taxes it owes and whether it has filed all tax returns, whether it has ever been
audited, and whether it is in compliance with sales and payroll taxes.
Long-term liabilities”those due beyond a year”include items such as
deferred income taxes because of accelerated write-offs, long-term notes, and
debentures.


Questions About Liabilities
– How much debt has the company incurred? How many loans does it
have outstanding? Request legal loan documents. What is its debt serv-
ice schedule and payment history?
– What collateral has been offered up for loans?
– Have there been any personal guarantees or corporate guarantees for
loans?
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Preparing for Due Diligence


– With what companies does the firm have payables due? Is any one com-
pany owed more than 10 percent of the payables? How old are out-
standing payables?
– Obtain a complete list of loans and notes payable and details on each.
Gather information on payment histories and any defaults, and on any
guarantees for loans.
– Are there any off-balance-sheet financings? What are their terms and
conditions?
– Any unrecorded liabilities or product liability claims?
– Are there any accrued liabilities outstanding?

Shareholders™ equity is the total equity interest all shareholders have in
the company. It is the amount shareholders would split up if the company
were liquidated at balance sheet value. In the balance sheet, the sharehold-
ers™ equity section involves a detailed description of all capital stock, whether
those stocks are preferred or common, and any additional paid-in capital.
Paid-in capital is any amount paid for stock over the stated value or the par
value per share of that stock. Also included in the shareholders™ equity dis-
cussion is information on any retained earnings of the company. Investors
may also ask about capitalization history.


Questions on Shareholders™ Equity
– A chronological list of all past financings.
– A discussion of why the company raised money and at what valuation.
– Evaluation of whether loans are all paid to date.
– Evaluation of whether dividends have been provided as promised.
– The state of investor relations.
– Description of any personal guarantees, assets, or collateral that have
been pledged by the company.
– Managers trying to pay off company debt or alleviate any personal debt
through the financing.
– The person (or persons)”if anyone”who will have liquidation prefer-
ence over the investor™s investment.
– The company™s present capitalization.

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