Monthly Archives: February 2013

Corporate Due Diligence Fast and Easy

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In two past posts, I talked about doing due diligence on startups. The first one was The Lack of Due Diligence is Appalling and Foolish where I lamented that most investors I met out there did virtually no due diligence whatsoever. Then I talked about how simple and easy doing The Due Diligence Customer Call was, and some suggestions on what to ask. There are two more topics I would like to tackle in the due diligence area. Last year, John Lanahan in our research team tackled research due diligence in Efficient Research: The Lean VC Way. The last part of due diligence that I will post about today is corporate due diligence.
In my Lack of Due Diligence is Appalling and Foolish post, I give a short list of documents I ask from the startup before investing. I have expanded that list slightly, adding debt obligations, business contracts, and then I modify it based on the situation and startup in question, but it has essentially been the same over the years. Most of the time I collect all this into a Dropbox folder and send it to my lawyer for review. It has always amazed me that it takes him only 1-2 hours to go through this- I guess when you look at a lot of this stuff, you get used to reading it and picking out specific stuff to look for. Every now and then, I get the opportunity to do corporate due diligence myself and yes I can definitely say it can take you only an hour to do this!
Generally, the corporate due diligence step I leave for the last step, after doing customer calls, reference calls, and research on the market. I don’t want to ask for corporate documents unless everything has checked out up to this point, since those documents are confidential to the company and I want to respect that.
Note that I am ONLY talking about early stage startups: companies that have been only in existence for less than a year and have not had many business operations. Corporate due diligence can grow exponentially when the company has been in operation for years and then there are tons of documents and contracts, which can take teams of lawyers weeks to review. So feel lucky that at early stage, you don’t have much company history to go through! But sadly, there could be a lot still to worry about….
So yes it can take only an hour! Just a few months back I did just this with a startup and zinged a bunch of questions back to them for inconsistencies and missing items. How does one do this? Some tips:
1. Do this often. Get used to reading legalese and understanding it quickly.
2. Learn to recognize standard legalese in corporate documents and when they diverge.
3. Learn to read and scan text quickly.
4. Take notes in a separate notepad or document while reviewing, so you can come back to important points or questions.
OK those are the preliminaries; now what to look for? Some common things I’ve learned to look for are:
1. Which items in the list are missing and why?
2. How many shares are authorized in the Articles? It is better to see 5M or 10M authorized. I would raise a flag if only 10K or similar shares were authorized. Lower numbers authorized also can indicate that someone incorporated by themselves at some online easy incorporation website – not the best option.
3. Scan through the board meeting minutes, assuming they exist. Identify any inconsistencies in personnel, consultants hired, stock granted to individuals and why, business dealings, operating directions, and information in the minutes and the other documents.
4. In the stock purchase plans, are people vesting or do they own stock?
5. If there have been previous financings, what do the terms of those financings look like? Do any have any effect on your money coming in at this time?
6. If there are any contracts, are there any problems with those contracts relating to future business?
7. If there is any debt, are there any liabiltiies to be aware of? Any liens on the assets of the company? Who gets paid back first and when?
8. Who is the lawyer? Be wary of lawyers who are not familiar with early stage startup work. Their lack of experience can cause all sorts of unwanted trouble – doesn’t mean they aren’t good lawyers, just means that lack of experience on what is acceptable and what is not can be a barrier to getting things done.
9. How much is owned by founders, employees, and, if any, previous investors? Is this acceptable to you?
10. Go to the site of the state in which they are incorporated and search for them in the incorporation database. Make sure they really exist there!
11. Write down all people and companies you encounter in the documents. Did they get money or stock? Or were there contracts that were entered into? Are they accounted for in other documents? Check the cap table – is anyone missing? Check on why anyone would receive money from the company.
There are many more that come up, but those are ones that I’ve encountered in previous deals. I also asked my lawyer for a broader set of Top 10 things to look out for, from his perspective, listed here:
1. No Organizational Resolutions (after Articles, to set up the company, appoint officers, etc.), or they are incomplete.
2. No qualification filed in state of domicile (e.g., DE company located in CA, no filing made in CA).
3. Docs are provided, but they are unsigned.
4. Company is set up by an Incorporator, but there is no Action by Incorporator adopting the Bylaws and appointing the initial Board.
5. Stock Options granted, but a Stock Option Plan was not adopted by the Company.
6. More stock issued than is authorized by the Company’s Articles/Certificate of incorporation.
7. No Board Consent or Minutes approving the current financing.
8. Notice of Stock Transaction (in CA, a 25102(f) Notice) not filed with the State for the sale of stock.
9. No Cap Table.
10. Founders acquired stock but did not sign a Stock Purchase Agreement.
My list and my lawyer’s list provide a great starting point. These lists are not, by any means, exhaustive. My best recommendation is always to collect the information and then send it to your lawyer for review and spend the money for it to be done by a professional. In lieu of that, it is always educational and interesting to go through these documents by yourself and try to spot potential problems. I always scan the documents, even when I send them to my lawyer, for practice, and also to double check his work because sometimes I may find something that he may miss, or I may care about something due to the nature of the company and situation but he won’t know it’s important since he isn’t as close to the deal as I am.
The next step is to then decide whether you’re OK with what you found or not. At early stage, it is common to find lots of corners have been cut to get to where they are now. Many early stage rounds are completed with big discrepancies in the corporate documents unfixed. If an institutional investor comes in, they will most likely demand clean up. I have often asked to clean up, even at low levels of investment. Rarely do I find that an entrepreneur won’t clean it up; most of the time he/she knows it has to be done anyways, so why not now?
Other red flags:
1. I have asked for corporate due diligence documents and the entrepreneur has refused to provide them.
2. The entrepreneur doesn’t want to clean up the documents, or constantly backpedals when you ask.
I have walked away from deals, after doing all sorts of other due diligence and then got to corporate due diligence and either one of those red flags pops up or I find something that I cannot live with. Do not skip this step!
Doing corporate due diligence is a necessary step no matter what the level of investment. It is best done by spending a little bit of money getting a professional eye to look them over. And it can be done on the cheap by doing it yourself.
Thanks to Mark Edwards of Edwards Law Group for contributing to this post.

Metrics for Series A

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Over this last year, I have been watching a whole group of startups attempt to land their series A. One aspect that has been shown to be incredibly important for sophisticated and series A investors is showing superior metrics and your knowledge surrounding them.
Why Metrics?
With internet startups, practically everything has been shown to be measurable.
Showing that you are tracking the right metrics means that you have experienced personnel in tracking the progress of your business.
Showing exponentially rising metrics means that you have found a way to grow and capture share that is grabbing customers in ever rising, large numbers, and that is hopefully growing faster than your competitors. Investors love startups that are growing exponentially in a short amount of time; for startups, time is your enemy and showing that you can get big quickly is critical.
Exhibiting metrics that are not only growing exponentially, but large in magnitude helps a great deal. But at series A level, the magnitude of the metrics may or may not be enough to land your next round.
Metrics on Demand
We have seen that investors demand that whomever is pitching should know every metric by heart and memorized. This shows that the team members are living and breathing metrics day in and day out.
If you cannot spew metrics on demand, you substantially reduce your ability to grab that series A. Investors are seeing too many pitches where the people pitching can recall detailed metrics from memory; it shows an obsession with tracking and deep knowledge of your business. If you don’t show an equivalent grasp of the metrics, then investors may get skittish and think you don’t know enough of about your business, thereby increasing the chance that something unknown might sink it.
You must also show proficiency with metrics, showing not only that you are tracking the right ones but that you are using them effectively to grow your business, and methodologies to improve and test them and also make them better over time.
Which Metrics?
As I sit down with startups, many need to track the same metrics. But different types of startups will have different metrics, and some will have different metrics they will focus on given the situation.
The topic of which metrics to track is too broad to cover in this post. Suffice to say there has been written on the topic of metrics, many of which can be found on the KISSmetrics blog. This book is about to be released: Lean Analytics by Alistair Croll and Ben Yoskovitz. You can buy the pre-release PDF at the O’Reilly site if you’re impatient to wait until March.
Some great articles and posts to read:
Single Startup Metric – this is also discussed in Lean Analytics. It is about focusing on one metric at early stage to drive the success of your business and not getting overwhelmed with too many metrics.
9 Metrics to Help You Make Wise Decisions about Your Start-Up – A great list of common metrics used to drive startups’ businesses.
Cohort Analysis – Measuring Engagement Over Time – Cohort analysis is very important. Showing increasing engagement across cohorts and over time is critical. Setting up the same graph with other metrics like LTV, which arguably is a measure of engagement, can be very valuable and worthwhile for an investor to see.
Ecommerce is a slog — what’s your angle ? – Fred Destin has an easy discussion on ecommerce metrics.
E-Commerce: What are the most important metrics for e-commerce companies? – A broader discussion on ecommerce metrics via Quora.
SaaS Metrics 2.0 – A Guide to Measuring and Improving what Matters – Written by David Skok of Matrix Partners. Great overview on metrics applied to SaaS businesses.
Many more great posts exist out there. Search on “ metrics” on Google and also in Quora.
By the way, toss Vanity Metrics. Save those for the press; don’t waste investors’ time with them. Definitely don’t use them for tracking the growth of your startup internally; they can lead you down the wrong path to death!
Are My Metrics Good Enough?
When you meet with seed investors, they may overlook the fact that you have metrics that are miniscule or non-existent. Seed investors often don’t have traction for proof and need to invest on the dream more than concrete proof.
When you get to series A, the bar gets raised significantly. Very few startups get series A on the dream today; we can always find the example startup or exception – but that’s the point – it’s the EXCEPTION not the rule. Much better to have shown that you have a good handle on metrics and the metrics themselves are great.
The elements of great metrics are easy. You need ideally all four of:
1. Show that you operationally have a great handle on metrics, tracking the right ones, showing that you are applying strategies driven by those metrics, and have on staff the right people doing the right things with the appropriate technology in place.
2. Exhibit metrics large in magnitude, ex. not 100s users, but millions of users (or maybe 10s of millions of users now).
3. Exhibit exponential growth in key metrics. Linear is not good enough for most metrics – an example where linear might be still great is linearly growing LTV over time. Mostly, show a real hockey stick up and to the right!
4. Show that your metrics are greater than industry benchmarks and/or competitors.
If you don’t have all 4, series A can be a real slog, potentially unachievable in today’s Series A Crunch laden market where there are too many early stage startups coming up for their next round. Why? It’s because too many startups have a handle on all 4 items above AND have higher magnitude and exponentially growing metrics than you. You’ve got your work cut out for you!
So the overall goal would be to achieve all 4. The first goal is item 1. Build the dream team for metrics and put in place technology to surface all sorts of metrics that you need. Use awesome tools like KISSmetrics and/or build your own. If you don’t have 1., then other 3 are going to be super tough and you’ll be reliant on luck to get there. Don’t rely on luck! Throw the odds in your favor of achieving the other 3 by being deliberate with respect to metrics, not haphazard.
Once you build the dream team and have the right technology in place, then you need to find the right metrics. Read those posts above. Get the right help – talk to others in your industry who have experience in metrics like yours and get their help in developing the right metrics for you to work with. Replace vanity metrics with better ones!
Let’s jump to item 4. This one is easy. Search Google, look at annual reports of public companies operating in your or similar spaces. Look on Quora for someone who may reveal metrics that you can’t find elsewhere. Search Slideshare for an elusive presentation that may reveal industry numbers. Check industry reports for more. Now you have a target – if you can show that your metrics are better than existing companies out there, that’s impressive!
Back to the hardest of the 4: items 2 and 3. How do you achieve these, and both in magnitude and exponentially growing numbers? Ack!
No magic I can impart on you from this post for sure. I will say that if you’ve got item 1, you’re well on your way to do the right things to get there. This is where the rubber meets the road and now YOU have to make your project shine.
What If I Don’t Have All 4 Items?
If you’ve got all 4 items, then why the heck are you reading this post? Go out and raise your series A!
However, if you’ve gotten this far, you may be one of the hordes of startups which do not exhibit all 4 qualities. What do you do now?
If you still have runway, go out and improve your metrics!
If you need to raise, then here are some suggestions to increase your chances, knowing that there could be hordes of startups with unfortunately much better metrics than you:
1. You probably can’t hire since you are running low on cash and need to raise, unless you can get somebody to sign up on equity. But you should go to investors with someone who at least is tracking and implementing a metrics driven approach in your startup. That person could also be you! Bring that person to the pitch so that they can show uber-expertise in metrics at your company.
2. The most common problem I’ve encountered are items 2 and 3. You either have low magnitude numbers or slow, linear growth, or both. If you have either 2 or 3, you still have a chance to raise on the vision and team. The better one to exhibit is exponential growth, even with low magnitude numbers. If you don’t have growth but big numbers, investors might think that your growth has stalled, or you’re doing something wrong, or both.
Metrics are an important part of the startup process. Investors today demand not only great metrics, but people on the team who understand the critical metrics in the business and can use them to grow the company. Implementing technology and process for metrics in your startup will greatly increase your chances of landing that next round. Don’t wait – do it now!