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Advice for Entrepreneurs: Part Eight – Due Diligence Process

I’ve been asked to join the panel at a London Business Angels investor club night this week.  The event will focus on the topic of due diligence.  To get the juices flowing, I’ll focus here on some key aspects:

Staged due diligence is vital

The amount of time and effort put into gathering information needs to be staged to be fair to you and to the prospective investee.  In stage 1 we simply evaluate the business plan, presentation or other initial interaction.  In stage 2 we ask more questions but take the answers at face value.  At stage 3 we seek to reach a detailed conclusion as to whether we would like to invest in the company.  This is the main stage at which we take the technology, product/service and market apart and seek to understand them thoroughly.  Finally at stage 4, we seek to ensure that the legal and financial terms are fully acceptable.  Our experience is that the decision to pass from one stage to the next should be taken seriously and with regard to the time and implied commitment involved.

Decide how much to do before agreeing terms

We’ve varied in our approach to the amount of due diligence we do before agreeing investment terms. On one hand a greater degree of upfront research will indicate areas for further discussion and investigation.  It will also uncover issues that change our views on valuation or our interest in investing.  On the other hand, an early term sheet shows commitment and gains exclusivity.

The company seeking investment should provide the information

When I started investing, I would spend a lot of time undertaking my own research into the market prospects for potential investments.  Whilst we still do this on occasion, it’s far more valuable to understand what the company knows.  Our approach now is to provide the company with a set of headings for the main due diligence, and expect them to populate a dropbox folder with their information.  This has the twin advantages of helping us to understand the depth of the company’s own understanding and providing the basis for the warranty disclosure letter at the end of the process.

Talk to customers

An invaluable part of the diligence process is a series of calls to current and prospective customers.  Are they happy with their interactions with the company?  Does the product perform? Do their projected orders correspond with the company’s sales projections?  A few structured calls undertaken by a market research professional can be illuminating.

Don’t overdo it

It’s possible to overanalyse a prospective investment.  This can result in wasted time and thus deflate the return on investment.  With early stage technology businesses, especially those that are pre-revenue, some questions cannot be rigorously answered and the decision will come down to your personal judgement.  I always ask myself the questions “will this piece of research contribute directly to my investment decision” and “do I think that the management team will find the answers post investment”.

Undertaking a structured due diligence process is a super way of learning about the business and its management team.  Executed properly it leaves me with the confidence to entrust the company with my investment, or to walk away from the deal safe in the knowledge that ‘this one’s not for me’.

Many happy total returns

It’s one of those jobs I do over the festive break, checking on the performance of investments during the 2011 calendar year, and thinking about where different classes of assets stack up against the roller-coaster risk of angel investment.  It’s been a pretty scary prospect.

As a starting point, let’s look at equities in 2011.  The FTSE100 index started the year at 5899 and closed at 5572, a fall of 5.5%.  The FTSE100 Total Return (TR) index, taking into account the dividends paid by these companies, fell by 2.2%.  With a high of 6091 in February and a low of 4944 in October, you could have gained 3% or lost 16% from the start of the year.  Expanding this to the FTSE UK All Share index, total returns were -3.5% and the FTSE World Index performed even worse, with a total return of -7.6%.  That’s all pretty alarming, and if you hold these shares within managed funds in your pension plan, the charges would see you with falls of about 9-11%.  I know of very few investors whose shareholdings appreciated in value in 2011, and the ones I do know relied on an income and reinvestment approach, rather than on capital gain.

Compare that with cash.  With UK RPI inflation at 5.2% in December 2011, interest rates at say 3% were a built in guarantee of losses during the year.  Nevertheless, despite the risk of holding a fiat currency, at least cash performed better than equities.

Bonds were mixed in 2011 with UK and US treasury bonds ending the year at historically low yields under 2%.  Corporate bonds showed high yields but significant risk. The outlook for 2012 has to be generally negative for gilts and corporate bonds, with huge uncertainty around the key indicators of long-term inflation, interest rates, growth, bank and sovereign stability.  Gold and oil did well, with gains of 11.7% and 15.5% in the year.  House prices in the UK fell by about 2% during 2011, with only London registering modest rises.  Surely the UK outlook for house prices has to be continued modest year on year real-terms decline?

So with that gloomy review of 2011, and 2012 looking no better for any asset class, where does that leave me as an early stage technology investor in UK engineering companies?  Surveys in the UK and US point towards long-term annualised returns of 20-25%, and that’s before taking the benefits of the Enterprise Investment Scheme into account.  The real picture for angel investors I know is far more mixed, with a few substantial exits dominating overall return.

The reality for this investor is that I’ve written a number of cheques, and I’m happy with the performance of all of the businesses so far.  So my loss is either 100%, or else I’m sitting on a share of their future successes.  I’m a firm believer that technology creates a great opportunity for good management teams to build businesses with excellent market share, growth and profitability.  Economic downturns are for me the ideal circumstances in which to build businesses and invest for the future, so I’m looking forward to 2012 with gusto.

Export or Stagnate

I could even say ‘export or die’.  Predictions are bound to have huge error bars, but we know certain facts about UK technology and engineering business:

  • The UK is the 22nd most populous nation, with 0.9% of the world’s population
  • We have the 7th largest nominal Gross Domestic Product (GDP) at 3.5% of the world’s output
  • We are still the world’s 6th largest manufacturing economy
  • The US, Europe and Asia are our main trading partners, with the US alone accounting for 30-50% of global demand for many technology products and services.
  • The world economic outlook forecasts 2012 GDP growth of 1.6% in the UK

Compare the following forecasts

  • EU 1.4% (including Germany at 1.3%)
  • US 1.8%
  • China 9.0%
  • India 7.5%
  • Emerging Economies as a whole 6.0%
  • Worldwide 4.0%

The nature of technology is that it sees no national boundaries – your business should be born global.  Technology products and services can be sold worldwide with adaptation to local customer preferences.

Qi3’s recent survey of the instrumentation industry showed clearly that those companies which invested in export sales have performed better in today’s turbulent economic environment.  They have a broader exposure to demand in the growing economies, especially in Asia.

So what will you do to increase your exports in 2012?

Advice for Entrepreneurs: Part Seven – Sustainable Competitive Advantage

In this seventh part of my occasional series ‘Advice for Entrepreneurs’ I discuss how you can show potential investors that you are able to take advantage of the market which you are addressing.

Creating Sustainable Competitive Advantage

The core objective is to create an obvious and sustainable rationale for customers to buy from you rather than your competitors. Achievement of this in investors’ minds looks different for first movers and market followers:

For first movers: you will need to educate the market and build barriers behind you to stop new entrants catching up. Invariably people will have been spending their money on something else, so you will need to change their mind-set.  Is your product truly novel in customers’ minds, and can you lead the race from the front? Investors love technical novelty, but will people really validate your heroism, buy your product and laud you with market dominance?

For market followers: earlier entrants have demonstrated that there is a market, but are you a conquering upstart or a me-too supplicant? Why should potential customers switch allegiance? Can you build barriers behind you to dissuade further entrants and in front of you to undermine existing competitors?

Market Disruption and the Infamous USP

I like to understand how a company will disrupt its target market. For me this requires some key steps:

  • Rigorous definition and justification of the selected target market: Who do you intend to sell to, how many target customers are there and why have you selected this target market?
  • Target market share: What proportion of the target market do you intend to capture and over what time period?
  • Market entry strategy: How will you achieve this goal in practice? Once the product / service works, how will you scale up?

The concept of Unique Selling Proposition (USP) is much bandied about and generally misused. To be effective a USP should contain three things: uniqueness, a sales trigger and a specific proposition.  It is not just a list of nice ideas – and I suggest that 1 to 3 USPs are sufficient. You also must be able to live up to the claim, such as famously that made by FedEx: “When your package absolutely, positively has to get there overnight”.

And finally…

A three legged stool is more comfortable to sit upon than the pointy end of a stick. So I’m all for ensuring that I have three strong arguments against each competitor in the target market. And none of these three should be price. My rationale for this is twofold: established competitors can always reduce their prices to knock you out of the game, and price competition generally undermines technology-based brands.

The result of this strategy should be a set of clearly articulated statements that position your offering unambiguously in the mind of the customer, making the market your own.


Is your product really ready for the market?

I’ve been reflecting on the state of product maturity at the time entrepreneurs seek external investment. I tend to use Technology Readiness Level (TRL) as a starting point for discussion with entrepreneurs.

It’s relatively easy to distinguish between ‘concepts’ (TRL2-4) and ‘development projects’ (TRL4-6) which may be suitable for pre-seed, seed or early stage investment, but it’s the stages nearer to market (TRL7-8) that have been exercising me recently. We’ve been presented with several opportunities recently, each having made first sales, and claims that investment will accelerate the company up the ‘J’-curve to substantial sales revenue.

I suggest that four questions should be posed:

  1. Are the installed systems the final production version?  If not, can they be upgraded to this standard to provide a solid customer reference base?
  2. Can the first 2 years of sales post investment be fulfilled with exactly today’s products?  If not, what proportion of sales over this period is contingent on further R&D, and is this provided for in the business plan?
  3. What ‘cost-down’ programme is envisaged to reduce manufacturing cost as volume increases? Is this already specified, or a vague statement?
  4. What proportion of the funds will be applied to sales & marketing versus R&D?

One opportunity seemed less attractive when we realised that the experience of 20 installations had shown that a complete product redesign was required. So the next year would be spent in development before sales could recommence. The company had reached what it saw as the finish post, but to me felt like a new starting line.

Another entrepreneur told us his product was ready for manufacture of a batch of pre-production prototypes. Further discussion revealed that at least two further design iterations were required.

A third company has placed 3 ‘beta’ units, now has 10 ‘v1’ units sold, and has demonstrated that it can sell the next 2 years’ forecast based on the current platform.

So are these companies at TRL 7, 8 or 9?  Do they understand TRL or are they kidding themselves?

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