Due Diligence and Corporate Clean Up in Private Offerings

Due diligence and corporate clean up are important steps in the private offering process and putting together a private placement memorandum. This post elaborates on these steps.

As outlined in the Overview of the Private Offering Process, when raising equity capital, one of the first things a company should do is prepare a business plan. Good business plans typically include a long-term capitalization strategy. The business plan often forms the centerpiece of the private placement memorandum (PPM), the disclosure document that is typically circulated to investors. When putting together a PPM, the goal is to create both a complete synopsis of the company’s current situation and an accurate summary of the company’s plans for the future.

With a good business plan in hand, people preparing the PPM often turn to “due diligence” and corporate “clean up.” As it relates to private offerings, due diligence is the investigation that ensures that the company-related information and summaries included in the PPM are accurate and complete.

It is not uncommon that during the due diligence process, issues are uncovered that either should have been addressed earlier but weren’t or that need to be completed or addressed prior to the company issuing securities to outside investors. Remedying those items is often referred to as corporate clean up.

The Due Diligence Process

While the due diligence process conducted by venture capital firms is often more detailed than that conducted by angel investors, one should expect at least a base level of due diligence from both groups. Virtually all venture capital firms and most angel investor groups have a formal due diligence process in which they request in writing certain information and access to particular documentation. Here’s a sample put together for angel groups. According to a study sponsored by the Kauffman Foundation in 2007, the median duration of actual due diligence work conducted by angel investors in their large sample was roughly 20 hours per investment. Interestingly, the same study found that the those angel investor groups who spent more than the 20 hours had a 5.9x return on their investment, while those who spent less than the median 20 hours had only a 1.1x return. Regardless of the actual duration of the diligence conducted by groups you may work with, the point that is imperative to get your “house in order” before opening the company up to outside scrutiny.

As part of your disclosures in the PPM, it is essential to accurately summarize all “material” facts concerning the company. A fact is material if a reasonable investor would consider it important in determining whether to purchase the securities that the company is selling. In other words, you need to include all relevant facts that an investor might consider important in making his or her investment decision.

The due diligence process for an individual company should be designed to capture those material facts. The areas that are subject to the due diligence investigation vary from company to company, but often include the following:

Organizational documents (e.g., charter documents)
Cap Table and Shareholder and option/warrant holder lists
Copies of agreements that affect equity holders (e.g., shareholder agreements, voting agreements, investor rights agreements)
Financial statements
Summaries of litigation or threatened litigation
Governmental licenses and filings (including patent applications)
Biographical summaries of officers and directors
Material contracts
Any conflict of interest transactions or arrangements involving the company and its current owners (including their affiliates)

The PPM should include summaries and descriptions of not only the items listed above and the business plan, but also anything else that may be material to a prospective investor’s investment decision.

Government agencies (such as the NASD) have frequently commented that there can be no definitive list of items to be described in the disclosure documents. For example, a company that is seeking funding to support clinical trials should likely also include a summary of additional funding that the company will need after the current financing in order to get the drug or product through all phases of the clinical trials. A software company that is reliant on the adoption of certain third party technologies probably should include details about that technology. In essence, every company is different and each due diligence process must be customized based on the nature of the offering and peculiarities of the company and the industry in which it operates.

Conducting corporate clean-up

Early-stage companies typically spend much of their financial and human resources on product or technology development and attracting and retaining talent. Whether it is because of lack of time, money, or experience, companies often fail to keep up with many tasks that may prove to be important to the success of the company.

What usually occurs is that during the due diligence process, areas that need clean up are revealed. If you think your company is good shape, consider these questions:

Have your key employees signed appropriate nondisclosure, assignment of inventions, and noncompete agreements?
Have you granted stock options or issued restricted stock to your key employees (perhaps as previously promised or alluded to) and if so, have you complied with the tax code section 409A requirements on valuations?
Are your shareholder and director meeting minutes up to date and in compliance with statutory and organizational document requirements?
Have all previous stock issuances and significant agreements been properly authorized in the board meeting minutes?
Have you filed applicable patent applications (or at least provisional patent applications)?
Do you have any agreements or arrangements with others that should be reduced to writing?

These and other matters need to be remedied or addressed before the private offering.

The other form of corporate clean-up prepares the company for its planned structure following the financing. For example, a company’s articles of incorporation and bylaws may need to be amended to reflect changes from the company being owned and run by a small group of founders to one in which there will be a significant number of outside investors. This is especially true if you plan to offer a type of security in the private offering that has not been previously authorized (such as a new series of preferred stock).

Also, sometimes a company will try to complete certain transactions or enter into agreements with one or more “household-name” companies in order to validate the company’s product or technology prior to the offering.

Conducting a thorough due diligence and corporate clean up are essential when offering securities. Doing both creates the foundation for a solid PPM: one that both provides a prospective investor with an accurate picture of the company and limits the liability exposure of the company and its officers and directors.

Preparing for the Investor Presentation

This post covers a number of best practices for presenting to investors, whether they be angel, venture capital, or strategic investors.

Several companies we are working with are currently preparing for investor presentations. This post covers a number of best practices for presenting to investors, whether they be angel, venture capital, or strategic investors.

Identify your Objectives for the Investor Presentation

Many companies try to accomplish too much with their initial investor presentation. Rarely do term sheets get prepared after the first presentation, let alone checks, unless it is a modest sum of money from an angel investor who is already inclined to invest. So what is a good objective for an initial investor presentation? In most cases, a good objective is merely to get to the next stage of the investor’s evaluation process. In some situations, the next stage could be a second presentation to a broader audience or a different group within a strategic investor’s organization. In other cases, it could be to start a formal due diligence process. Try to identify the prospective investor’s evaluation process prior to the initial meeting to help shape your objective for the presentation.

Know your Investor Audience

As is true for most presentations, your investor presentation should be tailored to your audience. Prior to the meeting, try to identify who from the investor’s organization will be present during the meeting. If it is going to be primarily business/finance people (as opposed to technical/scientific), you can expect the questions and discussions to center around their areas of focus and expertise. Also, see if you can identify who in the room is the ultimate decision maker, gate keeper, or influencer who can enable you to get to the next stage in the evaluation process. Adjust your presentation accordingly.

Adhere to the Investor’s Rules and Be Respectful of your Audience’s Time

Sometimes, investor groups or forums have particular rules about presentations. They can limit companies, for example, to a certain number of slides, certain types of slides, or a specified presentation duration. Adhere to their rules. If you have a one-hour meeting with a VC or strategic investor, don’t bring a 50-minute slide deck to the meeting (more on this in a bit). Unless going over the agreed upon time slot is driven by investor questions or two-way discussions, don’t be guilty of holding the investor audience hostage by continuing on with a presentation that seems to never end; a long presentation won’t make your case for investment more compelling.

Presentation Format and Investor Slide Deck Composition

Assuming you have identified your objectives for the presentation, you know your audience and the restrictions you are under for the presentation, what should the presentation look like? Usually, the presentation is given by one or two members of the management team (e.g., the CEO and CSO/CTO or CFO). The appropriate number of slides of an initial one-hour meeting is somewhere between 15 and 25 and should take no longer than fifteen to twenty minutes to present, without interruption. And yes, I know it’s not easy to do and I know it can be a time consuming process to get the presentation that short and succinct. If the investor is interested, you will have no problem taking the entire hour. If the investor is not interested, well, everyone can spend the balance of the hour answering emails.

The breakdown of the slides typically works something like this:

Speaker introduction and the investment that you are looking for (1 Slide)
Company introduction and “elevator pitch” (1-2 Slide)
Identify market(s) and current market problems/opportunities (2-3 Slides)
Company solutions and product(s) to address market opportunities (2-6 Slides)
Current development status of solution/product line (1-2 Slides)
Competition (1-3 Slides)
Marketing and distribution/regulatory approval process (1-3 Slides)
Revenue model(s) and financial history and projections (1-3 Slides)
Use of funds (1 Slide)
Management team (1-2 Slides)
Anticipated Exit and Timing (1 Slide)
Recap the 2-3 main points and state the investor “call to action” (1 Slide)

Of course, there can be variations to this format. For example, a presentation to a potential strategic investor technical team should include less on market opportunities and more on product and technology.

Many times, the initial presentation is the first opportunity that an investor has to evaluate you, which for most early stage angel and VC investors is more important than your product or technology. Presumably, if a prospective investor has read your executive summary/business plan and wants a presentation, you’ve passed the initial screen and the investor is already at least somewhat interested in your company. So, it’s important to remember that you are not only selling them your product/technology, but also you and your management team.

Backup Slides for Investor Questions and Areas of Focus

It is generally a good idea to prepare backup slides to address the key questions that you anticipate or areas that you are likely to be asked to elaborate on if the investor is interested. This goes back to knowing your audience. You may also want to develop a system to figure out how to access particular backup slides so that you are not fumbling through the PowerPoint while the investor has to wait.

Miscellaneous Best Practices for Investor Presentations

Finally, here are some miscellaneous nuggets to consider, based on the investor presentations I’ve seen over the years:

Coordinate in advance the audiovisual requirements (who is going to have/bring what)
Have a backup plan (e.g., hard copy of slides)
Use the PowerPoint slides as a guide to the discussion, not as cue cards
Maintain eye contact with your audience, not the screen
Let your passion and excitement about your business show through
Do not say that your company does not have competition or any other naive faux pas
Walk the fine line between exuding confidence, but not appearing overconfident
Address any 800 pound guerillas positively in the presentation rather than waiting for the inevitable questions and what could be construed as defensive responses
Avoid eye charts (e.g., detailed spreadsheets, elaborate process or flowchart diagrams); more text does not yield a more compelling case for investment
Similarly, convey no more than 2-3 points per slide, with font no smaller than 24 pt
If possible, use a good mix of images and text
And lastly, rehearse, rehearse, rehearse

Differentiating Introductions

Whether looking for an investor, a joint venture or joint development partner, or your next CEO, a warm introduction is almost always better than a cold one. But the quality and effectiveness of warm introductions vary considerably. Setting up the right type of introduction from the right type of person can be a test of your entrepreneurial skills.

Whether looking for an investor, a joint venture or joint development partner, or your next CEO, a warm introduction is almost always better than a cold one. But the quality and effectiveness of warm introductions vary considerably. In fact, setting up the right type of introduction from the right type of person can be a test of your entrepreneurial skills.

Elements of a Good Introduction

In essence, there are at least two elements to a good introduction: (1) the introducer is someone who the prospective investor, joint venture or joint development partner, or CEO listens to; and (2) the introducer has something persuasively positive to say about you or your company.

Types of Introducers

Using an unscientific approach, here are my tiered groupings of people from whom to make your warm introductions:

Top Tier Introducers

The introducer successfully concluded a recent close business relationship in which the prospective investor, joint venture or joint development partner, CEO, etc., did very well.
The introducer has an on-going regular business relationship with the prospective investor, joint venture or joint development partner, CEO, etc., that is going well.
The introducer is someone well known to the prospective investor, joint venture or joint development partner, CEO, etc., and he, she or it wants to do business with the introducer.
The introducer and the prospective investor, joint venture or joint development partner top execs, CEO, etc., are close socially (e.g., families going on vacations together)

Middle Tier Introducers

The introducer currently works with or has worked with the prospective investor, joint venture or joint development partner, CEO, etc., but not closely.
The introducer has a good close working relationship with an affiliate or existing partner of the prospective investor, joint venture or joint development partner, CEO, etc.
The introducer is an acknowledged scientific expert or significant player in the industry and is known to the prospective investor, joint venture or joint development partner, CEO, etc., by reputation

Bottom Tier Introducers

The introducer and the prospective investor, joint venture or joint development partner, CEO, etc., has an on-going regular or previous business relationship that is not going well (or did not go well) through no fault of the introducer.
The introducer knows the prospective investor, joint venture or joint development partner top execs, CEO, etc., only through casual social situations (e.g., reception, conference, party, mutual friends)

Of course, there are situations where a “warm” introduction from a hostile source can lead to a problem, one in which a cold call may yield a better result. But in most cases, even a positive introduction from a “bottom tier” introducer is better than no third party introduction. For example, I’ve heard a number of venture capitalists say that they have never (ever) invested in a company that sent directly its summary or powerpoint over the transom.

Ensuring a Positive Message in the Introduction

Just because you have someone lined up who is a top tier or middle tier introducer, does not mean you are set. As an illustration, I have a client who was looking for an introduction to a particular potential joint development partner. The client discovered that an MD working at one of the company’s clinical trial sites had previously done a lot of work with the targeted joint development partner. Upon discovering this, the CEO quickly moved to ask the MD for the introduction, which the MD agreed to do. As it turns out, the MD by his nature was very measured in his words when making introductions. In making this introduction, the CEO later found out that the MD spent as much time disclaiming knowledge about the company and its prospects as he did explaining in a measured way the positive results of the recent trials. While the CEO did get the meeting, he spent considerable time explaining why the MD was not more enthusiastic about the CEO’s company.

So, how do you ensure a positive message in the introduction? Ask the introducer what he or she is going to say. Provide the introducer with an elevator pitch length email about your company. Provide him or her an executive summary or the bullet points to touch on during the introduction. You should do as much work as possible for the introducer to make sure that his or her job is easy and that he or she gets the facts right. That said, the introducer should know the basics about your company as the prospective investor, joint venture or joint development partner, CEO, etc., will likely have at least one question for the introducer. If the introducer does not know rough headcount or revenue numbers, or whether the company has filed an IND, for example, not only can that be embarrassing to the introducer but it will also degrade the effectiveness of an otherwise good introduction.

While serendipitous introductions or connections do happen, many times a good introduction is the product of deliberate, diligent entrepreneurial efforts of finding the right person with the right connection to deliver the right message.

Capitalization Strategy: Begin with the End in Mind

“Begin with the End in Mind”: what a simple, yet profound concept. It is one of the habits of Stephen Covey’s 7 Habits of Highly Effective People. It is so simple, but too often overlooked.

When entrepreneurs start companies they often have vivid visions of success. Through the business planning process, entrepreneurs often develop and work through the various issues that need to be addressed in order to obtain the commercial success for which they are looking. But, what is the desired end state or exit? Or, is death the only exit? Seriously though, is the exit, sale of the company within 5 or 10 years? Is it working with and growing the company until retirement, with younger management or the next family generation buying out the company? Is it an intellectual property holding company collecting royalties from various licensees? Is it the sale of stock after a public offering? Too often, entrepreneurs dedicate only two or three sentences in the business plan to the intended exit, using almost boilerplate language. Of course, only time will tell how things will end up, but having a vision for a desired outcome will help drive decisions and planning, making your desired outcome more likely to come to fruition.

Backwards Planning Process

With the desired end in mind, the business planning process and capitalization strategy development can truly begin. It is what is referred to as the backwards planning process. Many people do this instinctively as part of their normal planning. Identify what assuredly has to happen in order to get you in position to meet your desired end state. Think of these “have to happen” items as interim objectives. It may be a certain level of sales or EBITDA, successful completion of a lead drug phase II clinical trial, a successful public offering, etc. Then, identify what conditions, tasks, and shorter-term objectives it will take to meet those interim objectives. Continue to repeat that process until you are back in time to the present day.

Capitalization Strategy

When looking at your capitalization strategy, it is a very similar process. In fact, it should go hand in hand with business planning. You also need to consider though the needs, expectations, and desires of your sources of capital—meaning your prospective investors, bankers, government agencies, customers, etc. Figure out what it will likely take in order for you to get the sources and amount of capital you need to reach your desired end state. When looking at equity capital, think through valuation issues, dilution, capitalization structure, liquidation preferences, etc. Again though, start with the end in mind and work back through time, through each anticipated round of investment, each grant and grant phase, etc. It will help you develop a coherent strategy and identify what needs to be done to get you where you want to be.

Understanding Investor Needs

I’ll go through more on investor needs, expectations, and desires in later posts, but for present purposes I will touch on two very basic ones to illustrate some of the considerations to include in developing your capitalization strategy: the amounts of money that different types of investors invest as well as when in a company’s life cycle those investors invest.

Here are a couple of charts to consider. The first one shows the ranges of investment amount by investor type. The chart contains generalizations. Of course, sometimes investments are outside of these ranges for unique deals or situations or current market conditions. For instance, this year we are in relatively tight markets so both the number of deals and the amount of investments by group are generally down.

Investor Amount by Investor Type

This next chart shows the stage of company development that investors generally invest at. As with the amount of investment, one see deals outside of these ranges based on unique opportunities or situations or the general market conditions. Also, there are variations by industry. For example, in therapeutics, the categories on the y-axis would be different: they would likely include positive preclinical animal data, filing a new drug application, commencing the clinical trial, completing phase I of the trial, etc.

Investor Interest by Company Stage of Development

The point to take from all this is that developing a coherent capitalization strategy is a deliberate process. It should take into account the entire time between today and the day you meet you desired end state, not just where your next grant or equity financing is going to come from. Have a long term strategy will actually help guide you through many decisions and assessments of opportunities that you will likely encounter.