(By K Ramakrishnan, Spark Capital Advisors Pvt Ltd.
Senior Managing Director – Strategic Relationships)*

The Need

Theory of fundamental finance postulates the direct correlation between risk and reward; however higher risk is not a guarantee for higher reward. Angel investors seeking to maximize rewards, among other motivations, allocate a certain portion of their investible surplus to investing in early-stage start-ups.

The risk in this asset class is manifold, and includes concept risk, execution risk, people risk, mortality risk, and liquidity risk. The chances of losing invested capital are reasonably high and it is prudent to minimize that risk.

The thought process of arriving at an investment decision for angels in a start-up typically follows, in sequence, assessment of business opportunity & size, business model & path to scale, founding team’s capability & passion, growth prospects, valuation, and likely path to exit.

On having taken an ‘in-principle decision to make the investment, it is imperative to exercise due diligence and take a deep dive under the details, where the devil often resides.

The investigative process of deep dive is the Due-diligence Review (DDR). DDR process unravels and provides pointers to minimize the underlying risks of an otherwise high-risk investment opportunity.

DDR assumes considerable importance in a start-up angel investment situation as the likely risks may not be visible or fully comprehendible when the founding team pitches the opportunity. Further, given the limited amount of empirical historical data & information in the early stage of the life cycle of start-ups, a detailed review assumes greater relevance.

DDR essentially spans understanding of three principal areas:

(i) all vectors of the business dimension,

(ii) analyzing the financial, accounting & tax details, and

(iii) reviewing the legal aspects relevant to the start-up; all carried out in a significant amount of depth and detail.

An investment opportunity that appears attractive and investible on the face of it may not stand the scrutiny of DDR and hence investors may need to revisit or reconfigure the investment decision or framework.

The Process & Scope

The approach to carrying out DDR differs in each of the areas highlighted. In some of the areas (business dimension) it would go through a process of interactions & conversations leading to a qualitative or subjective assessment – more grey; whereas in certain other areas (financial & legal) it would be based on the review of data & documents with objective yardsticks – more black and white.

The review period would need to cover three years or from the inception of the start-up, whichever is a shorter duration.

As such, it would be prudent to engage the services of specialist agencies or persons for the different facets of the DDR. It would also be efficient to carry out the DDR across all areas concurrently so that at the end of the exercise a wholistic picture emerges to enable a final decision.

Business DDR

Business DDR, more so in early-stage start-ups working on relatively nascent technologies or emerging market opportunities, would require a deep understanding of the specific area and also involve a considerable amount of subjective inferences and judgments.

In a network such as The Chennai Angels, which is an association of successful entrepreneurs, seasoned professionals and the like, it could be expected that the network and associated relationships of the members would understand the business segment that the start-up operates in or would have access to experts in the relevant area.

Thus, typically, Business DDR is carried out by members of the network who would have volunteered to lead the investment either by themselves and by co-opting experts in the specific area.

Business DDR entails extensive interactions with the founding team & key management, existing shareholders, competing businesses, vendors, customers, employees, and other stakeholders.

The span of coverage of Business DDR would vary depending on the nature and business of the start-up and the industry segment it operates in. However, the key aspects to be examined would be relevant, as such the scope of Business DDR would entail, inter-alia:

  • Understanding of the product or service offering
  • Customer need it addresses
  • Proprietary or enabling technology – its uniqueness, stage of evolution, ownership of intellectual property, cost & dependency
  • Business model & defensive moats
  • Go-to-market strategy – reach to customer and nature & dependence on intermediate network
  • Competition – nature, intensity & relative positioning
  • Influence or impact of statutory and other regulatory aspects on the business
  • Customer segment – B2B vs B2C, dependency thereof
  • Founding team’s & Key management team’s background, qualification, experience, stability passion, commitment & cohesion
  • Human resource – needs, availability & cost factor, as may be relevant to the business and the potential impediment to building scale
  • Composition, relevance, and influence of statutory & advisory Boards
  • Supply of inputs (including services & materials) – availability, costing & dependency, and the potential impediment to building scale

Financial, Accounting & Tax DDR

The task of carrying out Financial DDR is normally entrusted to a firm of Chartered Accountants. Financial DDR is a data analysis-oriented investigation to thoroughly review and analyze the MIS statements, accounting entries, historical audited financial statements, tax-related filings of the start-up and also understand the financial projections against the context of the past financial performance.

It would also include discussions with the bankers, credit rating agencies, auditors, and tax advisors of the start-up, as applicable & relevant. The key aspects are highlighted below.

Profit & Loss Statement

  • Build out of revenue (volume & price), composition & break-up across customer & market segments, growth rates, volatility, lumpiness & trend analysis
  • Product or service pricing logic, power & factors driving the same
  • Elements and break up of cost items – variable and fixed – trend analysis
  • Control of the business over various cost items, including scope to variables and likelihood to amortize fixed & overhead costs
  • Profitability analysis at contribution, gross, operating, and net levels and sensitivity thereof to fluctuations in revenue and cost
  • Unit level profitability analysis

Balance Sheet

  • Capitalization of the business as reflected in the equity & preference share capital and any other convertible instrument
  • Shareholding, including any employee stock option plans (ESOP), warrants, and other clawback mechanisms
  • Borrowings, including working and term debt, in the books and terms thereof – including the interest rate (floating versus fixed), tenor, terms of repayment, security & collateral
  • Details of all other liabilities, both concrete, and contingent, including payables
  • Contingent obligations that could potentially impair the balance sheet
  • Assets owned by the start-up – fixed and current; tangible, intangible, and intellectual – ownership rights thereof
  • Elements of working capital (current assets and current liabilities) and assessment of cycle

Cash Flow Statement

  • Cashflow from capitalizations, borrowings, and operations over the historical period
  • The customer payment cycle and vendor credit cycle to examine patterns
  • Revenue & cost recognition versus attendant cash inflow and outflow, assessment of debtor & creditor cycle

MIS Statements / Accounting Entries / Tax computations & filings

  • Periodic MIS Statements and cross-verification of the same with financial statements to understand variance & divergence, if any
  • Bridge between MIS – Accounting Entries – Financial Statements to examine consistency, accuracy, and integrity of numbers
  • Basis of computation of tax – direct & indirect, understanding of tax concessions, if any available, and any tax-related claims, disputes or litigations

Financial Projections

  • Assumptions underlying the financial projections, in the context of past financial performance, and reasonableness of assumptions
  • End-use of funds proposed to be raised and validation of the business needs of the end-use
  • Financial projection numbers juxtaposed against the narrative of the business DDR, past financial performance, and assessment of the probability of the projections materializing
  • Sensitivity analysis of financial projections across key assumptions

Legal DDR

Legal DDR is typically entrusted to a law firm that is also responsible to draft the transaction documents. It entails a comprehensive review of all statutory & regulatory documents & filings relating to the start-ups under various applicable laws, appropriate business contracts & agreements. Illustratively it will cover:

  • Incorporation documents
  • Secretarial documents & filings
  • Shareholder Agreements
  • Tax returns and filings
  • Employment contracts & Labor law compliances
  • Customer, Vendor, Rental & Lease contracts
  • Licensing & franchising agreements
  • Asset & property ownership documentation
  • Liabilities related contracts and documents
  • Insurance policies
  • Internal Policy Documents
  • All legal disputes & litigations

The above does not purport to be an exhaustive list of the aspects that need to be addressed. The scope and coverage will vary from business to business. The scope & methodology needs to be tailored bespoke specific to the situation. The depth of review & assessment would be a function of the nature of the findings themselves. It is also critical to apply materiality thresholds as the DDR are carried out.

Analysis of DDR Findings & the Investment Decision

The findings from the DDR would need to be collated and conflated to gather a detailed 360-degree view of the affairs of the start-up.

The subjective commentary from business DDR should read with the data-rich findings of Financial, Accounting & Tax DDR and documentary evidence of Legal DDR.

The findings are discussed with the start-up and the founding team to understand their perspectives so as to contextualize, revalidate or differently interpret the same.

Eventual incorporation of the DDR findings into the investment decision making can manifest itself in any of the following manners or combinations thereof:

  • The decision not to go ahead with the investment
  • To renegotiate value and commercial terms of the investment
  • To seek suitable representations & warranties from the start-up and the founding team and also secure appropriate indemnities for breach
  • Include certain actions as conditions precedent (or conditions subsequent) to the investment

It is important for each investor to individually review the DDR findings and the manner in which it is sought to be addressed before taking the final investment call. The degree of understanding and extent of tolerance may vary from individual to individual and hence it needs to be a personalized decision.

(*The views & opinions expressed in the article are solely the author’s and does not represent that of Spark Capital Advisors (India) Pvt Ltd)

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