Intellectual Property: Due Diligence -The Search is On

May 30, 2008

By William Greener, Ithaca Business Journal, May 2008

Do you remember when you first started dating? "Oh, do you think he likes me?" "What does he see in her?" We were all "scrubbing" (doing due diligence) long before we ever knew the meaning of the term.

I've heard early stage investors say that the goal of due diligence is to get to "NO" as soon as possible. As a seed investor, I wouldn't disagree; although I like to think of it more as a treasure hunt -- is there gold hidden somewhere around here? Regardless of how you spin it, the old adage that "time is money" is still as fresh as ever. Time is the commodity that no one has enough of. It is always working against investors and entrepreneurs alike.

In more formal terms, due diligence is a process of validating a potential investment. The process typically involves six areas of a company's business plan: the management team; the operating plan; technology assessment; market structure; competition and strategy; financial review; and legal review. (Note well -- due diligence starts with the company's business plan).

Not every investor or investment group uses the same due diligence criteria; and if they do, they do not necessarily give all criteria the same weight. In other words, while due diligence examines a lot of informational data, investment decisions often ultimately depend on how good it all "feels" to the investors.

Let's take a closer look at some of the areas that investors look at during due diligence and why.

The management team can be a real moving target and may very likely be incomplete at the seed stage. The composition of the management team also may be different during the seed stage to A-round than during the A-round to IPO, for example. It's easy to appreciate that businesses require different skill sets during different stages of their growth and development. Regardless, a company's CEO must have integrity, be trustworthy and have great sales ability, with respect to both goods and people. A proven track record is always a plus, but investors still like to know an early stage CEO's coachability and willingness to share equity.

What do potential investors want to know about a company's operating plan? This point examines company structure and location, current investors or shareholders and their stake, and current securities or classes of stock and any restrictions they may carry. What is the company's current or proposed organizational structure? Is there a strategy for getting/retaining additional personnel? Is there a process planned or developed for providing the goods and/or services of the company?

Technology assessment always plays a big role in due diligence. Many times our seed fund group will hear a pitch and afterwards ask "what exactly is the technology?" Often, a pitch talks about a new product, which, after questioning, turns out to be just a component of a product. A component may be fine, but investors want to know, preferably right from the start, what they are investing in. Furthermore, investors like to know whether the business involves a one-shot product or, better, a platform technology that may support various markets.

The market structure holds information about who the customers are as well as the market or customer "pain" and how the company's product/service will address this pain. Will the company's product/service be easy to for the customer to acquire or will there be significant switching costs incurred by customers to abandon what they have now for what the new business can provide?

Know thy enemy. What is the competition and what is the company's strategy to deal with it? Are there entry barriers beyond mere cost?

Investors are keenly interested in the financial review of the company. Very simply, what is the company worth today, what will it be worth down the road, and will the amount of money being asked for be enough to sustain the current financing round?

Last but not least is a review of the legal aspects. A major part of this can be the status of the company's intellectual property; is it owned, licensed, does it even exist and does it have value? Are there contracts or employment agreements that need review? How about tax issues, stock option plans, threats of litigation?

Due diligence really is an invitation to peek into Pandora's box -- actually, to throw it open and clean it out. Or, as some might say, 'no one expects the Spanish Inquisition,' unless, of course, it's due diligence time.