Due Diligence by GründerAtelier – How and why we do it.
Author: Carlo Nateri
Estimated reading time: 7 min
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GründerAtelier, Due Diligence and Covid-19?
Covid-19 brought along many challenges, for big corporations as well as Startups. To us, challenges resemble fertile soil to foster growth. As many alike, we used Covid-19 to jump-start into fully digital work with our team distributed over several countries in their homes.
As a young and cutting-edge company builder born during extremely peculiar investment times, GründerAtelier has given due diligence a totally different look. Instead of having our business suffer the imposed transition from physical to digital, we brought in digital as our preferred asset. What do we mean by that? Well, as many are aware, confinement has challenged the established way of carrying out business, demanding a shift towards the digital ecosystem (e.g. tools, working style, working space) as the brand new face of entrepreneurship. Thus, in order to survive, multiple investors had to initiate the transformation towards this new working life, undoubtedly enforcing the adoption of different approaches to certain well-established processes, such as due diligence. At GründerAtelier, we started our own due diligence wholly digital!
Due Diligence and why it is needed
Due Diligence is defined as “the care that a reasonable person exercises to avoid harm to other persons or their property.” Substantially, Due Diligence is doing your homework. Often, Due Diligence is an investigation in a potential investment target, conducted by a potential buyer/ investor, and this is what this article is about.
Of course, Due Diligence is time-consuming, can be expensive, difficult, and boring. It’s way more meticulous than the basic controls you would normally do and we can say that if you didn’t think of it to be as fun as going to the doctor, you probably didn’t do it properly. You have to know just as much about the investment target as you do about your own business.
At GründerAtelier we invest our time and resources in a variety of young businesses. Checking them thoroughly before making a decision is crucial to our success. By implementing a tight screening process through our Due Diligence structure, which we will share with you below, we leave nothing to chance.
How do we do it?
First of all, we look at the Team Due Diligence. In order to do that, we focus on two main areas: skills set and organisation.
Starting with the skills, we dig deep into the expertise and experience of the startup team. We evaluate the skills’ relevancy to the product and/or market, and we want to have different and complementing backgrounds. Another important aspect is looking at the team’s reliability. It is fundamental to trust each other with the team we’ll be working with. Therefore, to grasp the trustworthiness of the team we look at the interactions between them and with us. It’s really a matter of gut feelings!
The next step is to look into the organisation. On this side, the ownership needs to be checked. In particular, we want to understand the degree of control of the founders and the organizational structure in place. Another important aspect is then the people that will work in the Startup or the ones that work with it. We want to understand the direction to take to acquire new hires and assess the balance between employees and outsourced professionals.
After assessing the team and the people around the Startup, it is time for the Technical Due Diligence. Thanks to this, we’ll be able to get the best view of the company, in terms of its market, its competition and its proprietary technology.
To fully understand the target market is really important. That’s why we need to define it. Is the product or service positioned in an existing market or is it going into a blue ocean? From that information, we can then estimate the size of the target market in terms of both revenues and players.
Then we analyse the competition. To do so, we focus on the players: who are the players already present in the market and those that are incumbents or who have just entered it. After gaining a deep knowledge of the competitors, we check if the Startup has a competitive advantage. This is crucial because we want to understand how the unique selling proposition compares to the other players and how they are planning on surviving long-term.
And from this, we finish up with the Technical Due Diligence with the analysis of the technology. In this sense, we first must understand the market readiness. To assess the level of readiness of the technology we evaluate the stage of the technology and its capabilities; we assess if it is defensible (e.g. through patents, trademarks, rights) and we look at its compliance and/or security. To conclude, we verify the scalability of the technology. To assess the speed and reliability through which it is developed, we look at the product roadmap. Here, we need to understand whether the technology objective is to enter the market as quickly as possible or a little bit further in time but in a massive way, trying to achieve a large market share from the beginning. The penultimate step in our Due Diligence process is the Financial Due Diligence, where we enjoy deep-diving into the numbers of the Startup. In order to do so, we also need some specific sources. Documents as the Business Plan, the Financial Projections, the Hiring Plan, the Company Ownership structure, Pitch Deck and Reference Market research. The main steps are to look into the comparables companies, the customers, the market, the scalability, the revenues and costs, the investments, the hirings and the capital.
Why do we look at comparable companies? First, to check whether the price proposed is in line with the market, or if a premium is justified by an equal advantage for the target customer. Then, we assess if the differentiation of the product/service offered is strong enough to justify the purchase. To do that, we execute the external analysis of the landscape and ecosystem of the niche in which the company operates in addition to the internal analysis of the different areas of the product offered.
The key questions to answer now are “Why are the other competitors not proposing the product/service already?” and “Why should customers choose this Startup’s product rather than others?”
To answer these questions, it is now fundamental to understand the customers. Who are they? What are the segments (by age, nationality, education, etc.)? What problem is this Startup trying to solve for them?
Then to understand the market. It is important to assess which market the Startup is trying to fit in and which is its annual growth (hoping there is one!). Then, what share in the market can be reached and how can the market be clustered.
To be a feasible investment, the business should be also scalable and be ready to catch the growth. In order to do so, it’s important to understand the “Fixed Cost to Build”: What does it take until it begins to generate revenues that cover the operating cost? Moreover, we have to know what will be the ongoing monthly or yearly operating costs to operate the business and if they will increase as the revenues and if the customer base will also expand.
At this point, for us, it’s crucial to analyze the revenues and expenses and assess if the projections are reliable. Do revenues grow in a feasible way? Are they in line with the market growth and with the business plan? Are they consistent with the expected number of units to be sold?
Can production be scaled up according to revenues? Which limitations are there (fabrics, machines, personnel, regulation). Are costs of Distribution realistic?
Is the cost of goods sold consistent with markups and the units sold projected in the business plan?
Are costs projected in the business plans actually appearing in the financial projections with the correct amounts?
Another important aspect of the Financial Due Diligence we do, is to check the investments that the Startup in which we want to bet in is planning to do in the future. We check if it’s possible to capitalize each investment and if the investments planned are in line with the business plan.
We then focus on the hirings plan. In particular, if personnel costs increase reasonably with the number of employees they’re planning to hire, check the cost per employee, and if those costs are in line with the market. We pay attention also to the social contributions, if any, check if those are increasing too. We also check if the personnel’s growth is manageable and if the future profile that would be needed could be hired as planned.
To conclude with the Financial Due Diligence, we study the financing. This means that the capital inflows and outflows, either via equity or debt, have to be correctly accounted for in the financial statements and that the repayments of debt instruments projected in the net income are in line with the interest rates.
The very last part we encounter in our Due Diligence process is the Legal Due Diligence. At this moment it is necessary to have access to some specific documents. These are the Shareholder Agreement, the Intellectual Property (Transfer agreement and Patent filings) and the Employment contracts.
We usually start with the IP. The first goal is to know if the IP belongs only to the Startup, that’s because it often happens that it is still held by the founders, employees or even third parties. This issue can be easily solved through an “IP – Transfer – Agreement”.
Sometimes, the Intellectual Property is not yet protected by a patent or, even worse, cannot be patented. Pay attention to this because it can prevent the Startup from achieving a competitive advantage!
We then move to the Legal structure among the founders and investors.
We start by looking into Vesting agreements and if they are defined precisely. Especially the so-called “Bad Leaver” events need to be defined in detail.
We also check for contractual non-competition clauses in the shareholder agreement. Ideally, three types should be covered: Independent prohibition of activity / Prohibition of employment / Prohibition to invest in companies that are directly or indirectly in competition.
The final step of our Legal Due Diligence and Due Diligence in general, regards the labour code.
Check for ineffective provisions or violations of mandatory labour law in the employment contracts or managing director service contracts.
This article on how we at GründerAtelier perform a Due Diligence is going towards its conclusion. Always remember that any kind of investment needs to be checked thoroughly, especially the riskier ones like investing in an entrepreneurial idea. The time we, and now also you, spend on the Due Diligence process, will save you much more time and money later on. It’s fundamental to understand every aspect of a Startup, to assess its strengths and weaknesses, knowing exactly whether to take or leave it and where, in case, intervene to transform your investment into a successful one.