The assessment of a Seed Stage or Series A Stage
company is essentially in two phases:
A preliminary screening phase is used to determine
whether the “minimum requirements” will
be met. And if met, a more subjective due diligence.
Given the relative immaturity of these companies,
the more detailed due diligence process for these
early stage companies is less about assessing what
they do have, and more about assessing their potential
for value creation. The potential for value creation
itself can be segmented into:
- understanding the strengths the company has
in its favour
- assessing the risks that they will face in executing
the business plan.
Phase I Due
Diligence - the “Minimum Requirements”
This list of investment criteria includes:
- Company’s product is addressing a very
large, global market (i.e. US$1 billion or more).
- Customers are experiencing “pain”
from unsolved problem (i.e. market pull) - not
just a “vitamin” (i.e. technology
- Customers have budgets today to pay for solutions
to that problem.
- Investee has a defensible plan to reach $100
million in revenue within 10 years.
- Investee has a defensible plan to reach $20
million in revenue in a 3 to 5 year timeframe.
- Investee will reach breakeven in a 12 to 24
- Investee’s technology/product is disruptive,
not just “evolutionary.”
- Investee has a sustainable competitive advantage
(e.g. patents), not just First Mover Advantage.
- Investee is likely 9 to 18 months or more away
from commercial product.
- While the Investee likely has an incomplete
management team, the Founder team is strong in
their respective expertise, with real strengths
in technical staff.
- Founding team includes:
- Technical strength;
- Domain knowledge;
- External/customer focus; and,
- Founders are open to an eventual “change
- Founders are open to devolving management control
to Board and/or new management.
- Founders are likely committed to Investee, even
under such changes in control.
II Due Diligence - Assessing Business Risks
The very immature nature of Seed Stage and Series
A Stage companies means that the business faces
significant risks to challenge the management team
and the execution of the business plan. While the
nature of the risks is important, it is also imperative
that the management shows foremost that they understand
the risks. Sometimes, the proposed response to a
risk is less important to an investor than having
the risk identified in the first place.
In addition to determining whether all of the material
risks have been identified, a business plan will
be evaluated on what the intended response is to
the perceived risks. Can it be removed? Can it be
mitigated? And if little can be done about the risk,
is it a “deal breaker” to the investor?
A risk assessment can be done in the major areas
of business planning, with examples including:
Human Resource risk:
What are the quality and “horsepower”
of the management team?
Is the team complete?
Does it have the best skills available for the business
What has been the team’s performance to date?
Has the CEO successfully started and operated a
similar company before?
Are there high calibre advisors and Board members
with knowledge and contacts needed to execute the
Business Strategy risk:
Is the size
of a success in this market sufficiently exciting?
Have a pragmatic business plan and strategy been
developed for success in this market?
What is the risk that one or several competitors
will get an unassailable lead, or dominate the market
early, or take some action to create a barrier to
entry (e.g. securing a business process patent which
prevents the company from operating)?
Are the planned
technical advances achievable?
Is the technical improvement “disruptive”
(i.e. a 3x or more improvement)?
Can the improvement be protected?
What is the risk that the technology will not work,
is irrelevant, or will be surpassed soon in a significant
Does the plan require significant technological
advances before the product can be finalized?
Is the product development effort (or customer purchase
decision) contingent on outsiders’ advances/success?
Has the market
need been conclusively demonstrated?
How large is the market and how fast is it growing?
Can the characteristics of the market (e.g. customers,
end-users, key influencers, channel members, competitors)
be readily assessed?
Is the market accessibility and sales cycle known?
What is the likelihood that the market will not
accept the product on a significant scale, or that
the market need will change?
How much capital
will it take to fund this business to cash flow
Will it be able to raise that capital?
How valuable will this venture be if it achieves
its business plan?
How long will it take?
How will investors exit the investment with liquid
Will this be
a complex and difficult business to run and control?
Does the team have the necessary skills to operate
III Due Diligence – Assessing Value Drivers
The concept of assessing a company’s “value
drivers” reflects that, due to the relative
immaturity of the company, one of the most important
determinants of success can be whether the company
can attract the next round of financing. That concept
in itself incorporates a myriad of other assessments
as to business risks. It also helps focus the due
diligence effort on a relatively few key areas.
One suggestion as to a company’s value drivers
is incorporated into the pre-money valuation model
developed by Dave Berkus, an active Angel investor
since 1993. Recognizing the necessity for simplicity
at the Seed Stage, he developed a pre-money valuation
methodology that focuses on the primary drivers
for value increases between the Seed Stage and the
Series A Stage.
His suggestions of value drivers offer one view
as to important value drivers at the Seed Stage.
Those drivers are:
- sound idea;
- Quality management team;
- Quality board; and,
- Product rollout or sales.
Research conducted by TA Associates, wherein they
describe the characteristics of success, offers
a similar view. In that research, they found that,
in the big winners (i.e. >10x return of capital),
the success was mostly due to good market
timing and strong market growth. The success
had less to do with strengths in the CEO or Board.
For the medium winners, management strength was
the most significant determinant. Their losers were
most noted for having “missed” the market.
TA Associates concluded that their ability to assess
and control success had most to do with the strength
of the management team. There was not much one could
do to influence market success or failure.
Table 1: Factors Affecting