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START-UP
a practical guide for after term sheets
DUE DILIGENCE
https://www.flickr.com/photos/paurian/
This deck hopes to scope out the process of due diligence for 1st-time
buyers & sellers in a start-up acquisition
This is not legal advice
I’m not a lawyer
And yes.
If you are selling or buying a company, you should get a lawyer.
Also…
though I have been a seller, I am writing this as a buyer
So sellers, be aware of my biases as you read this
With that said, let’s go!
BIG IDEA 1MIND SET MATTERS
Due Diligence is not an us-versus-them activity
DO NOT
1) Approach it as an opportunity to catch someone lying
2) Tell little white lies
You are conducting an external audit, but you are not doing it as enemies
This is the first project between partners
partners that need a positive, trusting working relationship throughout the execution of the acquisition and for
many months or years after
So, your mindset, attitude, and words matter
They determine what you will see and how others will see you
The focus should be on collaboratively validating the business value of the
acquisition
And by business value, I mean the synergy value.
Not just the value of the selling business on its own.
PS: Don’t rely on the Warranties Agreement to ensure that the deal is
driven with ethics
Just be ethical and positive
BIG IDEA 2COMMUNICATE AGGRESSIVELY
The people performing the due diligence may be different from the
ones doing the deal
For example the buyer may appoint a lawyer or an accounting firm, and the
seller may appoint a business management team or an outsourced
accountant
Whatever the case, much of the work will not be CEO to CEO
So CEOs must ensure that the project team is driven by the business value of
the deal, or they will investigate the wrong things
And this means communication at the start and throughout the process
CEOs are not allowed to disengage just because it is detail
At the same time, it can be useful to keep the deal makers at arms length as
we don’t want them spoiling relationship as we iron out the tough
bits
Also, don’t allow a due diligence to get sidetracked on aspects of the review that have no real impact on the value
of the deal
For example, if the valuation is primarily about IP that will eventually be driven through the buyer’s
distribution network rather than the seller’s, other than making sure that there are no legal or debt-related skeletons in the closet, I wouldn’t go too
deeply into the seller’s distribution network.
It’s going to be deprecated anyway, so it doesn’t matter in the big picture.
Instead, I’d focus on validating the IP and making sure the buyer’s distribution network will be able to
integrate the new IP seamlessly.
Finally, because the buyer’s team is likely to do interviews, the Seller’s CEO
should ensure that everyone in the company, from CXOs to interns, are clear on the business plan, culture,
processes, etc.
Scripted answers, bad
Single story driving a clear vision, good
That said, you should already have strategic clarity in place regardless of
an acquisition!
BIG IDEA 3MAKE IT THOROUGH, BUT
DON’T LET IT DRAG
How long should due diligence take?
I think between 6 weeks – 3 months
If it take longer than 3 months, the process may scuttle the deal
Either the management team will be distracted from running the business
and the numbers will free fall
or the buyer will find something more sexy (or get bored) – typical CEO!
Shorter than 6 weeks feels too cursory to me to deliver quality
The following schedule makes sense to me
WEEK 1Understand high level business, deal
terms, and deal valuation
(employee, management, and client interviews, market research,
competitive analysis)
WEEK 2Decide as a team what needs to be
reviewed, and develop a due diligence project plan
(hold workshops to do this with explicit action plans tied to specific people)
WEEK 3 – 4Management team collects collateral
WEEK 5 – X
Execute Due Diligence
WEEK X+1
Prepare due diligence report with executive team
WEEK X+2
Present report to deal team and discuss results and operational next
steps
BIG IDEA 4
BEWARE OF DUE DILIGENCE FORMULAS & CHECKLISTS
(like this one)
Like all business processes, recipes only get you so far
Before anything else ask, "Why am I conducting due diligence?"
You've got to be very clear about the deal terms that you are validating?
If you are buying customers, but you won't really leverage IP, then spend more time on client due diligence
Firms merge for synergy value
1 + 1 needs to equal 3
So, make sure you validate synergy value
This is not about checking boxes
That said, the goal of due diligence is to…
(1)
validate the valuation that underlies the deal
(2)
surface any post-deal risks that could undermine that value
BIG IDEA 5
VALIDATING VALUE
Valuation can be understood roughly as the Net Present Value (NPV) of future
forecasted profit.
The NPV formula has two key variables
1) the 5-year profit forecast
2) the discount rate (what is the risk that the forecast is wrong).
So, the first thing you need to do in a due diligence is to make sure to
validate the profit forecast
Since
Profit = Revenue – Cost
your job is to dig through both Revenue and Cost and make sure that you
believe the assumptions that underlie the forecast
Are salary costs scaling in proportion to Revenue in the plan, and do they flow in a way that makes sense from
the previous 3 years?
The basic business ratios should be consistent through growth.
COST VALIDATIONREVENUE VALIDATION
Are salary costs above, below, or at market rates.
For example, is profitability being artificially subsidized by reduced salaries or government grants?
COST VALIDATIONREVENUE VALIDATION
What other costs drive the business in a meaningful way, and do they make
sense?
COST VALIDATIONREVENUE VALIDATION
How sensitive are profit forecasts to inflation in costs (higher salaries,
rents, value chain, etc)?
COST VALIDATIONREVENUE VALIDATION
To what degree are costs under the control of the company?
For example, are costs highly relative to supplier prices?
COST VALIDATIONREVENUE VALIDATION
If segment or geographic growth underlies the revenue strategy, are the investment costs of opening up a new
segment calculated in?
COST VALIDATIONREVENUE VALIDATION
Are costs dependent on supply, manufacturing or logistics partners, and are those relationships and cost
structures locked-in?
COST VALIDATIONREVENUE VALIDATION
How will operations be integrated after the acquisition? Are they
integratable and can you impact the cost base?
COST VALIDATIONREVENUE VALIDATION
Note here that my assumption has been that salary is the number one
cost, so I focus on that first.
However, this is dependent on the type of business.
Whatever the case, focus on where the dial can be moved (or not) first.
COST VALIDATIONREVENUE VALIDATION
With regards to Revenue, we are going to look at two variables:
Price x Volume
So you'll have additional questions to validate
Given average sales lifespan and closure % rate, are there a sufficient number of deals in the funnel, at the
right stages, to hit the revenue forecasts?
COST VALIDATIONREVENUE VALIDATION
Does the growth in sales make sense, given historicals and the plan? Does it look like comparables in the industry?
COST VALIDATIONREVENUE VALIDATION
Are the "% likely to close" estimates fair, or are they being too optimistic?
COST VALIDATIONREVENUE VALIDATION
Given # of accounts that can be managed by 1 sales person times the
number of sales people in the headcount growth forecast, is the
sales team physically large enough to fill the funnel given the sales targets or
do they need to scale up more?
COST VALIDATIONREVENUE VALIDATION
Do you think that the company can find the right people forecasted to
support revenue growth in the labour market
COST VALIDATIONREVENUE VALIDATION
Are customer's comfortable buying at the proposed price? Does the price
make sense vis-à-vis competition (especially as they grow into new
segments)
COST VALIDATIONREVENUE VALIDATION
Is volume dependent on distribution or retail partners and are those
relationships locked-in?
COST VALIDATIONREVENUE VALIDATION
Is this a one-trick pony, or is the company extending a proper product
platform?
COST VALIDATIONREVENUE VALIDATION
Can revenue synergies post-merger be realized?
COST VALIDATIONREVENUE VALIDATION
Everything I just said for revenue, but for all revenue streams in the product
halo (support & maintenance, peripherals, training, advertising, etc)
COST VALIDATIONREVENUE VALIDATION
Once you have validated the assumptions around Profitability, you need to validate whether you and the
founders of the firm being bought agree on the likelihood that the
forecasts will be wrong.
This is the Discount rate.
BIG IDEA 6
SPOTTING POTENTIAL POST-DEAL RISK
After you validate the valuation, you should make sure that there are no bugbears that might crop up in the
future to undermine the realization of the valuation
There are a bunch of good ones to look at, but remember from above, the goal
is not that you are sneaking around trying to catch someone out in a lie.
Also, this should be a cooperative process and it is totally acceptable that the selling company may not have all
these risks covered.
Business is risk
The key is,
1) are the risks understood 2) is there a good process to prioritize
& control the right risks.
Go through the Org Chart and get bios for the Board of Directors,
Advisory Board and key members of the operational team.
Some buyers will do reference checks off the CVs.
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Go through salaries and bonus payments for the last 3 years
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Make sure you understand Key-man Risk and that there are succession plans in place and being executed
for critical roles.
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is there a defined and explicitly managed culture (vision, values,
events/activities, CSR, etc) and do employees have a unified focus?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Are employees committed with high morale (interview them)?
Is there Insurance / Pension / Employee Stock Option Plan
exposure?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Are key people incentivized correctly (too little or too much
ownership)?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Do you personally get along with the key people? Do they get along with each other? How significant is
politics?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Review the Employee Handbook (including benefits, holiday, vacation, sick leave policies)
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Get a copy of all employee problems for the last 3 years like
alleged wrongful termination, harassment, or discrimination or
other labour disputes
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Minutes and material for statutory meetings (like AGMs, Board meetings, resolutions, etc)
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Key corporate secretarial documents (Articles of Incorporation and Bylaws,
minute book, shareholder agreements, etc) and any
amendments. You might even check with the relevant authorities to make
sure Incorporation is in good standing.
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Shareholding structures/ownerships – a Capitalization Table “cap table” is
best and Shareholder AgreementsInformation about subsidiaries if
relevant
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Does the company's corporate structure allow for a liquidity event and ROI? Is it too complex and do
you understand which parts you are buying and dependencies on other
parts?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Determine if there are too many shareholders or too few?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Review all agreements related to options, voting rights, warrants, puts, calls, subscriptions, and convertible
securities
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Shareholder, or any other, loans, credit, lines of credit, contingent
liabilities, and leases
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
A copy of the General Ledger and Bank Statements up to 3-years back
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Accounts Payable
• How much is owed• To whom and how many creditors• How long has it been owed
Look at these metrics as a trend over 3 years. For example, what is the average number of days over a 3-year period that it takes to settle a
debt? What is the standard deviation of that metric
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Accounts Receivable
• Who owes us and how much do they owe us?• Is our receivables risk
concentrated in specific debtors?• How many days does it take to
collect?• What % of debtors never pay at all
and what do we do in those cases?• Any outstanding invoice factoring
And as with Accounts Payable, do the analysis metrics
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Property & Equipment (deeds, leases, mortgages, surveys, zoning
approvals or other permits, financing/Sale & Purchase)
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Audited financial statements (and any adjustments) for previous 3
years, and unaudited statements for this year
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Any letters from auditors.
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
A description of depreciation/amortization/restructuring methods and any changes to the accounting methods over the last 3
years
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
A description of internal financial controls
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
What is their financial year end and does it integrate with yours
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Credit report (if possible and relevant)
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Budget (next year) and strategic plan (5-year)
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Tax returns for all relevant jurisdictions (3-years back) for
withholding, corporate and employee
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Inventory schedule
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Get a schedule of the companies that make up 50% of the revenue with a breakdown of age, volume, account management plans, etc.
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
A list of customers lost or fired over the past 3 years with explanations
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Get a schedule of unfilled orders
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Everything I just said, but also for subsidiaries
Make sure every employee is covered by an employment / consulting contracts (esp with regards to Confidentiality, non-
compete, non –solicitation, and IP). If there is diversity in contractual terms, make sure you understand
the diversity and that there is a plan to simplify.
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Are employee benefits documented, understood, included in the financial model and are there
any open-ended exposures
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Go through all inward & outward
• Non-Disclosure Agreements • Non-Compete Agreements• Letters of Intent• Outsourcing Agreements• License Agreements • Client contracts (past & present)• Marketing agreements• Supplier Agreements• Subsidiary agreements• Partnership / JV agreements
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Make sure you understand any litigation claims, documentation,
and proceedings, settled or threatened/pending (esp.
employee non-compete or IP-infringement risk with previous
firms)
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Make sure you understand any government investigations,
citations, permits, licenses and agreements and that you have
copies of any communications with regulators
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Make sure you see all Patents, Trademarks, Copyright registrations or any claims or threatened claims
of infringement (inward or outward)
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Make sure you understand how the company protects its IP and Trade
Secrets
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Make sure you reviewed any dividend policies or restrictions that could affect your liquidity
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Review escrow agreements (money or software source code)
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Go through all guarantees in which the seller is a party
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Make sure all 3rd party software used in production is properly
licensed
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is the engineering/product documentation in place?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is BCP in place if required?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Can the platform scale with expected revenue/volume growth
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is the product platform old (needs rewrite soon)?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Are the business requirements / function requirements documented?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is the R&D plan in place for the next 3 years?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Does the firm employ the right people for platform management & Development? Is the technology so specialized that you will not be able
to hire people in the future?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
What is the Quality Assurance process like?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is there a sufficient product support infrastructure in place to support
forecasted revenue growth?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Are there proper SOPs in place for Product Development &
Management
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is there warranty risk?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is there product recall risk?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
For software companies:
• Have an independent review of source code quality and extensibility
• Ensure source code is in a source control environment
• Review production incidents for the last 12 months
• Review outstanding bug tracker and find out how long it takes on average to resolve bugs
• Review all security incidents for the last 12 months
• Understand any sub-component licensing dependencies (dependencies on Open Source Licenses for example)
• Ensure that basic IT Controls are in place (Controlled access to production, data confidentiality, network security, etc)
• Understand Software Development Life Cycle culture (waterfall or agile) and ensure that your existing teams can integrate with processes
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Review Advertising/sales material & Press clippings (material) / analyst
reports
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Review Social Media image
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Review forward-looking marketing plan & budgets
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Any negative correspondence from clients over the last 3 years?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is there a process to manage operational & emerging risk?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
How mature are operations? Are they documented? What is the CMM
level?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Prepare a schedule of all law firms, accounting firms, consulting firms, or similar companies engaged with the
seller in the last 3 years
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Is there a clearly defined and executable exit plan?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
If the exit is dependent on aspects not including Revenue and Cost (such as proprietary data in the underlying user and usage base), validate those
assets too
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
Will follow-on funding be required to execute 5-year plan and how does
that impact valuation?
RISK
PEOPLEGOVERNANCEFINANCELEGALPRODUCTBRANDDELIVERY FUNDING
That’s it
Have fun with it and stay positive
BIG IDEA 7
DUE DILIGENCE HAS NOTHING TO DO WITH WHY YOU DO THINGS
RIGHT
OK, so we just spent 100+ slides reviewing what things should be in
place for a due diligence
But why were we looking for those answers
Because only the leaders of a tight run ship have the answers ready
Those leaders don’t have the answers because they are subjected
to due diligence
They have the answers because they are good at what they do and
the companies they run deserve their valuations
Don’t get your act together because of a due diligence exercise
Get your sh!t together now, because it is the right thing to do to make
your company stronger!
APPENDIX: If you really want to copy and paste the “checklist”
1. VALIDATION VALUEValuation can be understood roughly as the Net Present Value (NPV) of future forecasted profit. The NPV formula has two key variables – 1) the 5-year profit forecast and 2) the discount rate (what is the risk that the forecast is wrong). So, the first thing you need to do in a due diligence is to make sure to validate the profit forecast. Since Profit = Revenue – Cost, your job is to dig through both Revenue and Cost and make sure that you believe the assumptions that underlie the forecast. With regards to Cost, I'd look to understand the following:Are salary costs scaling in proportion to Revenue in the plan and do they flow in a way that makes sense from previous 3 years? The basic business ratios should be consistent through growth.Are salary costs above, below, or at market rates (is profitability being artificially subsidized by reduced salaries)?What other costs drive the business in a meaningful way and do they make sense?How sensitive are profit forecasts to inflation in costs (higher salaries, rents, value chain, etc)?If segment or geographic growth underlies the revenue strategy, are the investment costs of opening up a new segment calculated in?Are costs dependent on supply, manufacturing or logistics partners, and are those relationships and cost structures locked-in?How will operations be integrated after the acquisition? Are they integratable and can you impact the cost base?Note here that my guess is that salary is the number one cost, so I focus on that first. However, this is dependent on the type of business. Whatever the case, focus on where the dial can be moved (or not) first.With regards to Revenue, we are going to look at two variables, Price x Volume. So you'll have additional questions to validate:Given average sales lifespan and closure % rate, are there a sufficient number of deals in the funnel, at the right stages, to hit the revenue forecasts?Does the growth in sales make sense, given historicals and the plan? Does it look like comparables in the industry?Are the "% likely to close" estimates fair, or are they being too optimistic?Given # of accounts that can be managed by 1 sales person times the number of sales people in the headcount growth forecast, is the sales team physically large enough to fill the funnel given the sales targets or do they need to scale up more?Do you think that the company can find the right people forecasted to support revenue growth in the labour marketAre customer's comfortable buying at the proposed price? Does the price make sense vis-à-vis competition (especially as they grow into new segments)Is volume dependent on distribution or retail partners and are those relationships locked-in?Is this a one-trick pony, or is the company extending a proper product platform?Can revenue synergies post-merger be realized?Once you have validated the assumptions around Profitability, you need to validate whether you and the founders of the firm being bought agree on the likelihood that the forecasts will be wrong. This is the Discount rate.2. SPOTTING POTENTIAL POST-DEAL RISKSAfter you validate the valuation, you should make sure that there are no bugbears that might crop up in the future to undermine the realization of the valuation. There are a bunch of good ones to look at, but remember from above, the goal is not that you are sneaking around trying to catch someone out in a lie. This should be a cooperative process and it is totally acceptable that the selling company may not have all these risks covered. Business is risk. The key is, are the risks understood and is there a good process to prioritize and control the right risks. People RiskGo through the Org Chart and get bios for the Board of Directors, Advisory Board and key members of the operational team. Some buyers will do reference checks off the CVs.Go through salaries and bonus payments for the last 3 yearsMake sure you understand Key-man Risk and that there are succession plans in place and being executed for critical roles.Is there a defined and explicitly managed culture (vision, values, events/activities, CSR, etc) and do employees have a unified focus?Are employees committed with high morale (interview them)?Is there Insurance / Pension / Employee Stock Option Plan exposure?Are key people incentivized correctly (too little or too much ownership)?Do you personally get along with the key people? Do they get along with each other? How significant is politics?Review the Employee Handbook (including benefits, holiday, vacation, sick leave policies)Get a copy of all employee problems for the last 3 years like alleged wrongful termination, harassment, or discrimination or other labour disputesFunding Risk Is there a clearly defined and executable exit plan?Will follow-on funding be required to execute 5-year plan and how does that impact valuation?Contractual / Legal RiskMake sure every employee is covered by an employment / consulting contracts (esp with regards to Confidentiality, non-compete, non –solicitation, and IP). If there is diversity in contractual terms, make sure you understand the diversity and that there is a plan to simplify.Are employee benefits documented, understood, included in the financial model and are there any open-ended exposuresGo through all Non-Disclosure Agreements, Non-Compete Agreements, Letters of Intent, Outsourcing Agreements, License Agreements (inwards and outwards), Client contracts (past and present), Marketing agreements, Supplier Agreements, Subsidiary agreements, and Partnership / JV agreementsMake sure you understand any litigation claims, documentation, and proceedings, settled or threatened/pending (esp. employee non-compete or IP-infringement risk with previous firms)Make sure you understand any government investigations, citations, permits, licenses and agreements and that you have copies of any communications with regulators Make sure you see all Patents, Trademarks, Copyright registrations or any claims or threatened claims of infringement (inward or outward)Make sure you understand how the company protects its IP and Trade SecretsMake sure you reviewed any dividend policies or restrictions that could affect your liquidityReview escrow agreements (money or software source code)Go through all guarantees in which the seller is a partyMake sure all 3rd party software used in production is properly licensedProduct RiskIs the engineering/product documentation in place?Is BCP in place if required?Is the product platform old (needs rewrite soon)?Are the business requirements / function requirements documented?Is the R&D plan in place for the next 3 years?Does the firm employ the right people for platform management & Development? Is the technology so specialized that you will not be able to hire people in the future?What is the Quality Assurance process like?Is there a sufficient product support infrastructure in place to support forecasted revenue growth?Are there proper SOPs in place for Product Development & ManagementIs there warranty risk?Is there product recall risk?For software companies:
Have an independent review of source code quality and extensibilityEnsure source code is in a source control environmentalReview production incidents for the last 12 monthsReview outstanding bug tracker and find out how long it takes on average to resolve bugsReview all security incidents for the last 12 monthsUnderstand any sub-component licensing dependencies (dependencies on Open Source Licenses for example)Ensure that basic IT Controls are in place (Controlled access to production, data confidentiality, network security, etc)Understand Software Development Life Cycle culture (waterfall or agile) and ensure that your existing teams can integrate with processes
Brand riskReview Advertising/sales material & Press clippings (material) / analyst reportsReview Social Media imageReview forward-looking marketing plan & budgetsAny negative correspondence from clients over the last 3 yearsDelivery riskIs there a process to manage operational & emerging risk?How mature are operations? Documented? CMM level?A schedule of all law firms, accounting firms, consulting firms, or similar companies engaged with the seller in the last 3 yearsGovernance (Corporate Secretarial) RiskMinutes and material for statutory meetings (like AGMs, Board meetings, resolutions, etc)Key corporate secretarial documents (Articles of Incorporation and Bylaws, minute book, shareholder agreements, etc) and any amendments. You might even check with the relevant authorities to make sure Incorporation is in good standing.Shareholding structures/ownerships – a Capitalization Table “cap table” is best and Shareholder AgreementsInformation about subsidiaries if relevantDoes the company's corporate structure allow for a liquidity event and ROI? Is it too complex and do you understand which parts you are buying and dependencies on other parts?Determine if there are too many shareholders or too few?Review all agreements related to options, voting rights, warrants, puts, calls, subscriptions, and convertible securitiesFinancial RiskShareholder, or any other, loans, credit, lines of credit, contingent liabilities, and leasesA copy of the General Ledger and Bank Statements up to 3-years backAccounts payable (size, velocity)Accounts receivable (size, concentration, velocity, collectability, average collection time, any outstanding invoice factoring)Property & Equipment (deeds, leases, mortgages, surveys, zoning approvals or other permits, financing/Sale & Purchase)Audited financial statements (and any adjustments) for previous 3 years, and unaudited statements for this yearAny letters from auditors.A description of depreciation/amortization/restructuring methods and any changes to the accounting methods over the last 3 yearsA description of internal financial controlsWhat is their financial year end and does it integrate with yoursCredit report (if possible and relevant)Budget (next year) and strategic plan (5-year)Tax returns for all relevant jurisdictions (3-years back) for withholding, corporate and employeeInventory scheduleSame thing for subsidiariesGet a schedule of the companies that make up 50% of the revenue with a breakdown of age, volume, account management plans, etc.A list of customers lost or fired over the past 3 years with explanationsGet a schedule of unfilled orders.
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