Venture Finance Fall 2002 Slide 1 Class 7 Notes Due Diligence Part 1 © Andrew W. Hannah

Venture Finance Fall 2002 Slide 2 Agenda Homework due tonight Teams – did you send it? Confidentiality Agreement – did you sign it? Gurus in the Garage Question Card C Midterm Evaluations Diligence Overview Harvard Model Market, Competition, and Comparables Gurus in the Garage © Andrew W. Hannah

Venture Finance Fall 2002 Slide 3 Iraq Revisited More information? What is Bush doing? While England Slept revisited? © Andrew W. Hannah

Venture Finance Fall 2002 Slide 4 Diligence Defining Diligence, Frameworks and Performing Diligence, Issues in Diligence © Andrew W. Hannah and William Hulley

Venture Finance Fall 2002 Slide 5 Definition of Diligence Macro: Researching a company to determine: Whether to commit to making an investment The size of the commitment The terms and conditions of the commitment Micro: Researching a company to determine: Risks and opportunities Unknowns Future needs of time, people, money Metrics for measuring success © Andrew W. Hannah and William Hulley

Venture Finance Fall 2002 Slide 6 What Makes Doable Diligence? Do you have access to the right resources? Primary research Secondary research Leveraging the company Do you have the right expertise? Investment Model revisited What deals have you done? © Andrew W. Hannah and William Hulley

Venture Finance Fall 2002 Slide 7 What Makes Good Diligence? Addresses a single point of the decision In a timely and economic fashion And provides a clear answer © William Hulley

Venture Finance Fall 2002 Slide 8 Marks of “Good” Diligence It asks a single question Is this a good CEO? Does the product work as advertised? Who is the competition? The question: Addresses a risk or opportunity Verifies a fact Answers an unknown Frames an uncertainty Can be addressed in a timely and economic manner © William Hulley

Venture Finance Fall 2002 Slide 9 Definitions of a Diligence Framework A target list of areas to evaluate in considering any investment opportunity A formal description of the rules used to judge any investment opportunity An attempt to rationalize ad hoc decisions about an investment opportunity © William Hulley

Venture Finance Fall 2002 Slide 10 Why Create a Framework? Know what questions to ask on any deal Insure deal to deal evaluation consistency Set expectations, time frames and goals Limit emotion, politics, selling Understand the post-deal milestones, effort © William Hulley

Venture Finance Fall 2002 Slide 11 The Harvard Framework © Andrew W. Hannah Business Opportunity People Deal Context

Venture Finance Fall 2002 Slide 12 People The Entrepreneur “An A-quality [person] with a B-quality project, but not the other way around.” General Georges Doroit With limited resources, a major mistake will kill the company Honesty, integrity and reliability are sacrosanct The Management Team Relevant skill set Commitment The Stakeholders: who is around the deal? © Andrew W. Hannah

Venture Finance Fall 2002 Slide 13 The Business Opportunity The Model Short version of how the business will make money Why will customers part with their cash? Market size, value proposition, profit potential, sustainable advantage Customer: benefit vs. cost Size: What is the upside? Winning investors don’t do deals that lack the potential for substantial returns because the risk is losing everything is high Scale and/or scope Timing Are the customers ready? What are the customers doing now and what may come along later? © Andrew W. Hannah

Venture Finance Fall 2002 Slide 14 Context What apart from entrepreneur and management team actions, can hurt or help this venture? The Economy Technology “I would say that it is important to divorce the notion of cool technology from one that is likely to be accepted by the market.” Steve McGeady, Intel Stage: can customer now do something they couldn’t before or is there a dramatic cost reduction? Regulation Competition: If there is no competition, there is no market! © Andrew W. Hannah

Venture Finance Fall 2002 Slide 15 Evaluating the Deal People Stakeholders The team Entrepreneur Business Opportunity Size The model Customer Timing Deal Price Structure Context The economy Technology Regulation Competition The evaluation is the great time killer: 40 +hours © Andrew W. Hannah How would you rank order these?

Venture Finance Fall 2002 Slide 16 Understanding Risk Technological risk Product/service risk Market risk Sales risk Competitive risk Financing risk Operating risk People risk © Andrew W. Hannah

Venture Finance Fall 2002 Slide 17 Summary Investment decisions come in two flavors The Macro - Should I, how much, what terms? The Micro - What are the risks, opportunities, unknowns? Good diligence Addresses a single point of the investment decision In a timely and economic fashion And provides a clear answer Good frameworks Are useful across many deals Clearly define what they do Demonstrate their value at the micro and macro level Understand the risks © Andrew W. Hannah and William Hulley

Venture Finance Fall 2002 Slide 18 Market Diligence Why does it matter? Revenue potential Units and pricing matter Market growth and shrinkage matter What are the supporting questions? Who is the customer? How many are there? How much money do they spend on products like this? What else competes for that budget? © Andrew W. Hannah and William Hulley

Venture Finance Fall 2002 Slide 19 Market Diligence (Cont.) Identify Sources of Information Company information Competitors product and company information Analysts Magazine Regulatory filings Trade associations Customers Define format for reporting (see handout) Question Source – who, what, when Answer © Andrew W. Hannah and William Hulley

Venture Finance Fall 2002 Slide 20 Gurus in the Garage Discussion What are the themes? Can the entrepreneur do it alone? What does that say about how you perform due diligence on the entrepreneur? What does that say about geography? What does that say about industry clustering? Can mentor capitalists be harmful? What is the most important role of a mentor capitalist? Is the Valley the “one and only” What could kill the valley? © Andrew W. Hannah

Venture Finance Fall 2002 Slide 21 Next Week Venture Capitalist on Due Diligence Craig Gomulka, Draper Triangle How VC’s do due diligence Diligence Card “A” In Three Weeks (moved from 10/22 to 10/29) Diligence Card “B” – comparables Read the PolyTronics business plan WA: 114 – 141 (this is different than the syllabus) © Andrew W. Hannah