Do Due Diligence on Your Company Before Someone Else Does

Savvy proprietors of businesses who have been waiting for the right time to sell, merge, or attract investors, do due diligence on their own companies before approaching anyone else.  No manager wants to look like a deer in the headlights when a potential investor asks about an employee with a criminal record, a publicly registered customer complaint, or late property tax payment.  Company leaders need to anticipate the records suitors will request, both from the company and from public sources, like the Internet, the bank, and licensing agencies.  Prepared companies scrutinize themselves, as others with checkbooks invariably will, enabling management to approach suitors with a realistic valuation and a knowledgeable evaluation of the company’s strengths and vulnerabilities.  In addition, the process can save firms tens of thousands of dollars on professional service fees.

 Internal records:

A functional due diligence file will contain about fifteen sections.  A company with few employees and assets can expect to organize about 50 documents, some of which will need to be updated quarterly or annually.  Many companies already have many of these items in separate files, such as “Employees,” “Sales,” “Taxes,” and “Legal.” Pulling them together for a purchasing or investing audience serves two useful purposes: it encourages management to review their records with the eyes of interested outsiders and it reveals gaps that may not be obvious when records are segregated. The files should encompass records of the company’s: 

q  Organization and Good Standing

q  Capitalization and Stockholders

q  Authorization of Acquisitions and the Transactions

q  Financial Statements

q  Tax Matters

q  Employees Records, Benefit Plans, Salaries, Labor Disputes.

q  Material Contracts and Commitments

q  Licenses

q  Insurance

q  Litigation, corporate and personal

q  Patents and Trademarks

q  Real Properties owned and leased

q  Inventory

q  Books and Records

q  Operating Plans

Some information will strike a potential investor differently than a potential merger partner, while other information will be equally important to both groups.  Knowing the interests of each will enable the principals of a company to assemble records that matter to that target group. 

For example:
q  Corporate structure: Is the firm a corporation or a partnership?  In what state?  The answer has implications that make your company more or less attractive to your target audience than competing firms.  Ask your attorney.

q  Stockholders: What do the bylaws say about the rights of major/minor stockholders? Who are they? How many are there? Is management invested? Stockholders, like staff, can be perceived as either an asset or a liability to a deal.  Do the shareholders bring value beyond money or do they have a history of litigiousness?

*Potential buyers will demonstrate particular interests.  One might care about owner expense add-backs or owner assets; another may be concerned about related party transactions.  Others will have strong wishes for management to leave or to stay.  A company can’t anticipate everything, but its records will be scrutinized for “deal breakers,” omissions, and evasions.  Anticipate logical questions.

q  Management: Be prepared for tough questions.  Have background checks, performance reviews, and updated resumes handy.  Explain attrition.  Know which managers wish to remain with the company after a deal is struck and who wishes to leave.  Are non-compete documents in order?

 q  Material contracts and commitments:  Have customer lists, letters of credit, installment plan purchases, and current and pending contracts.  If there are any insider contracts, be sure to show those, too.  Are there any performance guarantees?  Are any deals imperiled by a change in management?  What about agreements with dealers and distributors?

q  Cash flow:  How well does the company manage seasonal or other fluctuations in its costs and cash?  Your accountant can help you design cash flow projections to show likely future scenarios.

q  Licenses:  Technology companies often base their valuations on their intellectual property, so records can quickly inflate or deflate suitor interest. Patents “to be filed” or “pending” are a lot less attractive than patents awarded or defended.  Equally important is who owns the technology.  Is it clearly the company or could it be an employee?  Was it developed in conjunction with another firm or university?  The answers can substantially raise or lower the valuation.  Professional service firms should have current records of all licenses, compliance forms, and proof of professional good standing. 

q  Insurance:  Physical assets can be strengths or liabilities, too.   If the company owns buildings or land, have records of ecological due diligence.  A building with a demonstrated lack of mold or property with no history of chemical storage or oil spills is worth a lot more than one without such a pedigree.  How is inventory insured in case of flooding the day the contract is signed? Does the company have key man insurance?  What about Errors and Omissions?   Such evidence assures suitors that they are unlikely to suffer buyer’s remorse, and therefore, can move a deal along faster than a company that leaves such questions unanswered. 

Public records:

 In addition to organizing records for outsider scrutiny, a company’s strategy should include a survey of its electronic presence.  It is very easy to check up on other companies, so each firm should do a regular Internet search of its company name and staff.  For example, www.hcad.org indicates whether Harris County based companies (and home owners) have paid their taxes for the year, how much they are, and the appraised value of the property. Licensing agencies, like the FINRA, have websites (www.finra.org) on which the public can search for the names of broker-dealers in good standing.  A company’s own website can be very revealing.  Is it current? Clear?  If you contact the business through its website, does someone actually get back to you?  A search on www.google.com or another search engine for the company or management team names can reveal useful information – positive or negative.  For example a Google search for recent potential clients revealed: (1) a businessman who has gotten a Cease and Desist Order from California for a business he was now trying to register in Maryland (2) a CEO who lied about his education background (he made up a university) in his SEC filings and (3) a company seeking investment that hadn’t paid its property taxes for the year.  Surely none of these is the first professional impression one wants to make on the World Wide Web.  Some records can be purged by corrective action; others can be buried by generating appropriate news items, like press releases, speeches, and article bylines.

Entrepreneurs seeking funding from others must be willing to undergo scrutiny from others, so do it yourself, first. 

Angel Investor FAQs: Preparation for investor meetings

Management should prepare strong, SHORT, consistent answers to the logical questions that investors are likely to ask.  SHORT answers enable investors to ask revealing follow up questions.  A long winded entrepreneur loses the opportunity to HEAR useful questions by informed investors. 

Conversations between entrepreneurs and investors are inherently uneven.  The investor has money.  The entrepreneur wants some of it.  So bear in mind that behind every stated question by an investor is the unstated question, “What’s in it for me?”  Effective answers should be attentive to the investor’s interests and concerns.

Explicit questions about the investor’s interests might be worded:

 “How is my investment secured?” 

“How long before the company is in the black?”

“What is your competitive advantage?” 

“Let me see the financial projections.”

“What will you do with my money?”
 

Implicit questions about “what’s in it for me” might be worded in a variety of ways.  Some examples of questions and approaches to answers:

“Tell me about your management team.”  This question is not about biographies.  What does the investor want to know?  Is this team going to be effective in this endeavor?  Is it going to make him rich or lose his money?  Consider answers that demonstrate why this management team is the best one to preserve the investor’s money and marshal it to a lucrative end.  Is the management team invested in this deal?  Consider the terms of the management’s compensation from the investor’s perspective.  Will its fortunes rise or fall before or after the investors?  Is this deal raising money first for management salaries? 

“Who is your competition?”  Never say no one.  This answer implies tunnel vision.  Rather, identify those companies that the public might perceive to be competitors, and then briefly explain either niche differentiation or your ability to deliver faster, cheaper, better, or with an enviable barrier to entry, or a low cost/high margin solution.  If an investor is interested in your industry but finds your answers weak, s/he might consider investing in your competition!  Besides, “smart money,” – investors who know your industry well - are testing your knowledge when they ask this question, and comparing it to their own.  Satisfied “smart money” investors do not have to do as much due diligence, and will often write a check sooner than investors outside of the industry.  Know what they know, about you, your competition, the market.  

“What is the structure of the deal.”  The investor wonders what he’ll be left with if the company’s potential is unfulfilled and the deal fails.  How attractive are the terms to the investor?  For example, what is the security of the investment, the use of funds, the seniority of the debt or equity, what are the interest payment terms?  Are there any tax write off advantages if he loses money?  Is his investment leveraged in any way, by the state, a grant, or other means.  The use of minimum/maximum funds raised will traverse what path to profitability?   Will the investor’s money pay salaries, buy assets or build inventory?  Does the state of incorporation protect the rights of investors?     

Naturally, entrepreneurs are optimistic about their future success; otherwise they wouldn’t be pursuing it!  Entrepreneurs are also ACCOUNTABLE for optimistic projections.  Written and verbal answers to investors ought to be delivered as though to the investor’s attorney, CPA, or banker, because sooner or later, they will be.  The bigger the deal, the longer the investor will spend on due diligence.  His research should mirror your research.  Verbs like, “believe, project, hope, anticipate, plan, expect” are to be expected in forecasting future business conditions.  Verbs like “will, promise, guarantee, know” could be construed, in retrospect by a disgruntled investor, as fraud or misrepresentation.  Also pay attention: the SEC holds entrepreneurs accountable BOTH for errors of commission (saying something that is false or misleading) and errors of omission (not mentioning something material to the investor’s decision making process).  Obvious examples of omission include suits against the company or members of the management team.  Less obvious examples might include “sweetheart” deals with friends and family of the management team for products and services targeted as a use of investor funds.  It is more appropriate to disclose this before you take a check, rather than afterward. 

By the time you are ready to approach investors, your company should have developed a due diligence file of documents about your own company that investors are likely to want to see.  By developing a logical list of “who, what, when, where, why, how” questions for these files, and prepping your management team on the appropriate responses to them, your company will convey an impression of knowledge, integrity, and full disclosure.