Prepare Early for Due Diligence or Risk Your Startup Funding and Exit

Prepare Early for Due Diligence or Risk Your Startup Funding and Exit

In this expert panel session about Due Diligence at the 2017 San Diego Startup Week, the panel discusses the importance of due diligence in an M&A transaction and raising outside capital. We cover many of the key elements in due diligence, the process, the tools, and when to prepare for certain aspects of the due diligence process. The moderator of the panel is Jeremy Glaser, partner at Mintz Levin and co-chair of the firm’s Venture Capital and Emerging Company Practice Group. Panelist include Brent Granado, General Partner at Sway Ventures, David Crean, General Partner at Objective Capital, Patrick Henry, CEO at QuestFusion, and Walt Tendler, CFO at Mission Ventures.


Jeremy:     Thanks for being here. My name is Jeremy Glaser. I’m a partner at Mintz Levin. I’m the co-chair of our Venture Capital and Emerging Company Practice. I help companies raise money. I help companies buy companies. I help companies go public. I help companies get sold to turn you all into multi-millionaires. That’s always our goal. Thank you for being here. I’m going to ask the panelists to introduce themselves.

Brent:        I’m Brent Granado of Sway Ventures, a venture fund that was founded four years ago. We have offices here in La Jolla as well as in San Francisco. We invest specifically in software driven technologies.

David:       I’m David Crean with Objective Capital Partners. I’m one of the managing directors. I’m an investment banker. What does that mean? I sell companies. I buy companies. I help companies raise capital. I do some strategic advisory. I also do some licensing in partner. I specifically cover healthcare and life science but you can apply a lot of the same ideas to technology.

Patrick:     I’m Patrick Henry. I run a few different companies. The most recent here in San Diego was Entropic Communications. I joined in 2003. We took it public in 2007. We weathered through the downturn eventually building our valuation. I also do advisory work for emerging growth companies. I recently wrote a book called Plan, Commit, Win: 90 Days to Creating a Fundable Startup that you can find on Amazon, Audible and Kindle.

Walt:         Entropic is a chip company, right?

Patrick:     Yes, it’s a chip company.

Walt:         Who is the end user?

Patrick:     The cable operator. Basically, we enabled multi-room DVR. We have a chip that allows you to use the TV cable as a high-speed streaming media network for the home. Before our technology was available, you could only have a DVR in one room. If you wanted to have a second DVR, you couldn’t watch the movies from one to the other.

Jeremy:     And this has become quite ubiquitous now.

Patrick:     Yes. It’s in 70% to 80% of US homes.

Walt:         I’m Walt Tendler. I’ve been the CFO of a bunch of life science and tech companies. Several companies in San Diego. Three things typically happen. You get acquired, you go public or you go out of business. There aren’t that many that go public. That’s also why I’m switching from job to job. I’m not always chased out. I spent nine years working for two different venture firms.

I’ve been on both sides of the board, presenting to the board and as an observer-director for a lot of companies. I’ve drafted about 40 term sheets, which is not in the tool set for the average CFO. That was from the venture side.

We worked with Cooley at the time, which is where I met Jeremy. Cooley gave us a template. But for the terms that we wanted in the deal, participating preferred, follow-on rights and those kinds of things, we knew what we wanted at the early stage. It wasn’t just the lawyers doing it. It was us setting the terms.

I’ve seen this game before. We’ll try to explain to you why. I’ve seen a lot lately young CEOs that are really good with technology and companies, who deserved to run their company, but they don’t know what they don’t know. If you’re successful, you want some infrastructure and understanding of what someone will look for when you’re raising an institutional round of money.

What will someone look for when they come to acquire you? What should you look for if you want to make a small acquisition of a company? Sometimes you’re tying an anchor to your leg and you don’t know it. These are the kinds of things. As Jeremy said, it’s hard to make it exciting. As some of my fellow panelists will point out, it does get exciting in a bad way from time to time.

Jeremy:     Walt, you did a great job outlining where to deal with these matters, the different transactions. Brent, tell us a little bit about the cast of characters that will be involved in this process. It can be quite large.

Brent:        There’s generally a very large swath of individuals that are involved in this. The one thing that I would point out as we start off this diligence conversation is understanding that diligence starts the moment you meet the investor or the buyer. In that case, I’m reading everything you’re doing. I’m trying to figure out whether or not you know your business very well.

That comes with some general questions and then we move down the pathway. Your pitch is the start of the diligence. If you get past that, then it gets deeper. The players can be lawyers, the investor, yourself, CPAs and investment bankers. We have technical diligence folks that are involved as well.

On the engineering side, they will come in and take a look under the covers to see if what you’ve built is legitimate. It’s sometimes hard to tell depending on the technology. That is also stage dependent. If you’re really early stage, it’s an easy look. If you’re later stage, it takes much longer and can be quite a bit more painful.

Jeremy:     It’s a detailed process. There are a lot of different players looking at lots of different things. It needs to be structured and organized. Patrick, in your book, you talk about the importance of being structured and having a process in place so that they can manage it as opposed to react to it. Can you talk about the importance of having a process? Tell us a good story about where it didn’t happen and how much fun that was.

Patrick:     Most of my experience has been in raising money and buying companies, not as a banker, but as an acquirer of technology companies, especially with Entropic and CQ Microsystems. I’ve bought about 10 companies total between those two companies. There were a lot of M&A transactions. As was mentioned, the due diligence starts when you have that first conversation.

Some startup CEOs are so guarded with the information that you can’t have a conversation. You don’t have to give away the secret sauce but you have to get into a situation where you’re willing to show some transparency. It’s not necessarily the “how” but the “what” you do. Jeremy and I have done some video blogs around whether or not investors will sign a non-disclosure agreement. They traditionally won’t.

Maybe if they’re getting into the hardcore due diligence and they’re starting to look at the technology, but even then, probably not. You have to learn how to share information in a way that you keep people interested without giving away the secret sauce.

Another example was when we were selling Entropic to Max Linear. The companies knew each other very well but there was still, “What are your key milestones? What’s happening in the next quarter.” There is that measuring period. Anytime you’re selling a company, everyone says, “Is there something wrong? What’s wrong here? Why are you selling it now? Why are you raising money now?”

There are always these questions. We need money so that we can continue to grow. We need to scale up because we have complementary technologies. Together, we can do something bigger. Those are some examples of things that typically happen.

Jeremy:     I have a question for the audience. How many people have raised capital from outside investors? That’s good. Of those who raised your hands, how many of you did any sort of due diligence on the investor? Very few. By the way, don’t feel bad. That’s very typical. We always focus on diligence as someone looking your company, doing diligence on your company. But it’s really important to do due diligence on the investor. David, do you want to talk about that a little bit, how to go about with due diligence on the investor?

David:       Yes, that’s a two-way street. Not all money is green. You have to understand what they’re going to be asking for in return. For some, it’s $1 million for a certain share in the company along with other things. That’s very different from your non-sophisticated investor. That’s what I call dumb money. Do your homework.

They’re sort of giving you a colonoscopy and going through all of your information. Do the same thing on them. You are then showing that you have active interest in them as an investor or team member. You’re inviting them into your shop. Do your homework on them. It shows that you’re actively interested and you care about your business. It’s a lot of great planning.

We talked about transparency. Planning is really important. It sends a message to the investor. They will think, “This guy is really serious. This is not just some really smart guy with a biotech or technology company. He actually cares about his business. He only wants to invite in the best.”

Brent:        My favorite CEO that I’ve ever dealt with was the one who put me through the ringer on diligence. “I want to meet the other companies that you sit on the board of. I want to talk to other investors that you work with. How do you work together on the floor? What’s your exit plans? Can you help me raise money?” It was things like that.

Jeremy:     Walt, do you want to add anything about diligence and investors?

Walt:         No, I think we covered that. It’s a two-way street. You don’t always have the power. But if you do and you can be selective, it’s a long-term relationship.

Patrick:     Especially if they get a board seat. It’s important to know who you’re working with.

Jeremy:     There’s so much information that’s available to you, especially online these days. It’s amazing to me when people don’t do their due diligence. I’ll tell you a story. I won’t name any names. I had a client that was a very large investment fund. They had their money with a bunch of investment managers. They did not have a good diligence process.

I came in asking questions. As I was sitting in their office, I jumped on the NASD website and immediately found this investment firm that they had a lot of money in that had a lot of serious problems in the past. They had never even done that. When someone is going to be putting their money into your company, especially today, there are rules that the FCC put out called The Bad Actor Rule. You don’t want someone who is a “bad actor” to be an investor in your company or on your board. You should never take money from anyone without doing the minimum of a Google search. It’s amazing to me how often people haven’t even done that.

David:       I would extend that beyond just investing. If you’re raising direct or capital through debt financing. If you’re talking about strategics. If you want to do a deal with someone in your space or industry, whether it’s a licensing partner deal or through M&A. Do your diligence on them.

Why is this the right product or technology? Is this in the best industry of your company and shareholders to give it to Company X? Would it be more advantageous in terms of maximizing asset valuation to give it to someone else? Understand why you’re reaching out to them, understand what’s in it for you and for them.

Jeremy:     How many people in the audience are angel investors? The investor is the one doing a lot of due diligence on a company. I want to turn the focus so that you understand the investor’s mindset when looking at a company. Walt, let’s start with financial diligence. What is the investor going to be looking for? What does the company need to have ready?

Walt:         We’re talking about raising money, which isn’t quite the same procedure as when you’re selling the company. They want to know that everything is in line. What does that mean? To me, it’s obvious, but I’ve lived it for over 20 years.

Do you have agreements with all of your employees? Do you understand your cap table and what everyone owns, or thinks they own, in the company? Is that clean or are there questions? Are you organized? Are your financials current? Do they make sense? Can you explain them? Do you know the things that drive your business?

If you’re going to raise money, how are you going to use that money? How much do you need to get to an inflection point where you and the investors can then command a higher rate for the next round of financing? These are the kinds of things that you need to look at.

Jeremy:     Do they need an audit?

Walt:         Not necessarily. In the old days, I put together about 20 different loans from banks from Square 1 to Silicon Valley Bank to Republic. Whenever you had a loan agreement, it was nice because you had some money that you could use. I’ll give an example later where we had to use that money as our last runway before an acquisition to pay payroll.

One of the things the lenders often require now is that you have an audit. An audit is expensive. I started life as an auditor. It’s not necessarily of great value early in the life of the company. It depends. You may need to have one afterward, depending on the investor requirements. Yes, later on.

Jeremy:     You touched on projections. David, do you want to talk about projections, how they’re put together and how an investor will poke at those? I’ve sat through a lot of pitches where I’ve watched investors ask very specific questions about the projections, and you want to have the answer right there. If you’re not sure, don’t lie.

David:       It’s really important, not only from an investment standpoint but also looking at strategic companies. They say, “Thanks, you just showed us two or three years or your financials, your P&L, your balance sheet and cap table. That’s looking back. Now let’s project looking forward.” That’s going to start setting the table for valuation. We’ll get into this discussion about the pro forma.

What do you anticipate this technology, drug or device to look like in three to five years? You have to make some reasonable assumptions. You can’t fault the conclusion but we always go down to the assumption. People are going to chip away at your assumptions. How can you tell me that you’re going to get 30% market share? Get real. Do your homework.

Put forward a reasonable pro forma of about three years. What does this look like, looking at the competitive headwinds? That’s really important. It’s something that investors will look at. VCs look at it constantly. They’re going to say, “Are you kidding me? You’re telling me you’re going to take this much market share? It just doesn’t make sense. You have better technology out there.” Maybe there is a specific niche that you’re going after. Put forward a reasonable pro forma with solid assumptions. We’re going to whack away at the assumptions.

Nine times out of ten when I’m representing a client, I’m selling the story. If I don’t believe in it, I’m going to have a really difficult time trying to sell your story. Do a good job. Hire the best if you have to, in terms of market research. Work with your CFO to make reasonable assumptions on revenue growth and cost of goods. Make sure it’s reasonable.

Jeremy:     I need Patrick and Brent. Patrick, I’m going to have you play the role as investor because I know you’re also an investor. What are the business issues that investors look for? What are you kicking the tires on?

Brent:        I want to piggyback on the comment of the cap table. You want to understand who’s in your cap table and how you’ve designed it. If your law firm has designed it for you, you need to sit down and talk to them about that. I’m going to have a conversation with you about who’s on there and how you figured out the conversion to know if you understand your business.

The financial model as it relates, we see two to three years. Three years would be awesome. We don’t really see the third year much anymore. Defensible assumptions are beyond critical. Understanding the size of your market and the competitive nature that’s in it is important.

Recently, I’ve seen a lot companies that are not aware of their surroundings. I’ve been in meetings. I know that every one of you firmly believe that you are very different than what’s out on the market. But if I ask you who your competitors are and you tell me “no one,” that’s probably not good.

When you get under the covers and the diligence, I’m going to look at your corporate governance and see how you did your last round of financing, whether or not there were any out-of-the-norm preferences, whether it be for liquidation or [0:19:24.2] of the Series A or the Series C, other PIIAs, which are property agreements locked up with your employees. I can’t take the risk of knowing that you have a bunch of engineers working for you but they haven’t dedicated their IP to the company. That’s a major issue.

Jeremy:     I want to underline that one million times. From the moment you form your company, every person that comes into your company has to sign one of those. If you don’t, going to get them and filling in the gaps is a nightmare. It is the Proprietary Information and Inventions Agreement. They’re saying, “Everything I’m doing here belongs to the company. I’m not going to walk away with my technology.” It’s really important.

Brent:        I think that’s in relation as well to advisors, too. They sometimes get left out of the scope. The reality is, there is some value that’s being brought to the table by them as well, so you want to lock them up.

Jeremy:     Patrick, why don’t you talk about some technology reviews?

Patrick:     This is what I get about 90% of the time. Whether it’s the executive summary or the presentation, it is very product focused. It’s 35 or 50 slides that you couldn’t read if you were in the back of the room. It’s way too much information. A good investor presentation is 10 to 12 slides.

When you get into detailed due diligence, you have a cap table. You have your financials. That’s supplementary to the presentation. An executive summary should be one page. They are trying to shove way too much information, and the wrong information, into it. It forces the investor to parse through things, which is more challenging.

Have a one-page executive summary. Have an elevator pitch. Have a presentation, maybe two presentations. One is a deep dive and one is more straightforward. Instead of spending 90% of the time talking about the product, spend 20% of the time talking about the product and 80% of the time talking about the business.

Once an investor understands what the product is and what it does, it’s really about how you make money. How you make money is how I make money. They are the same types of questions. What’s the market? How is it growing? How are you addressing it? What’s the competitive landscape?

Who are your customers? Do you really understand your customers? What problem are you solving for them? Is it an urgent problem where they’re in excruciating pain? They’re waiting for someone to solve this problem and your solution alleviates that pain.

Do that in a way that people can understand at a visceral level. I’m more patient than most VCs. With VCs, it’s short attention span theater. If you don’t have their attention in the first five minutes, they’re looking at 200 deals and investing in three. You need to have this stuff at your fingertips and understand your business.

They want to know that you understand your business. This is how we make money. These are our customers. These are our competitors. This is how we have the competitive advantage. You will never get to due diligence if you don’t do that part first.

There are a lot of entrepreneurs who don’t do their homework in terms of really understanding their business model. I met with a consumer products company about a month ago. It was like a coffee conversation. They didn’t have slides. We just talked. They said there was no competition.

I looked on the web afterwards and there were about 25 better capitalized companies than this company. Either he didn’t do a good job explaining why his product was different or he’s incredibly naïve in what he thinks his product is versus the competitive landscape. At least do simple things like a web search on your product. If other products come up, you need to be able to explain that.

Brent:        I have one other item. It’s customers. One of the things that most people don’t truly appreciate is when we say, “Can we get three customers to talk to?” A lot of entrepreneurs freak-out about it. I understand that they want to protect the relationship, so they’re very hesitant on making that relationship.

At the same time, you need to understand that your customers know that this is coming. It’s a relief to them to hear that someone with a piggybank of dollars wants to put it into your company. It means that you’re going to be around much longer to service their needs. Don’t be so afraid to make that connection.

Patrick:     Prepare the customer for the call. There are many times where I will get on the call and the customer says, “Who are you?” Tell them, “This person is going to call you. These are the types of questions they will ask. This is my relationship with them. Answer as honestly as you can. We’re trying to raise some money, so try to be nice to us.”

Jeremy:     Here is a quick summary. There will be legal due diligence. There are contractual relationships. Do you have things well documented with employees and consultants? Do you have contracts with your customers? You need to do your financial due diligence.

You need to have all of your financials in order including cap tables. Most investors will take a deep dive look at your technology and will want to understand it, particularly around the IP protection. There will be a strategic fit review with the industry. They’re going to look at your management team. They’re going to do due diligence on your backgrounds.

They’re going to make sure you all work together and understand your history. They’re going to look at your different partner arrangements. If you’re in relationships, they’re not only going to look at your contracts, they’re going to look at the substance of those agreements.

Are they profitable? These are things they will want to retain or change after they come in. They are going to look at your sales pipelines. All these things are involved. As you can tell, it’s a very complex process. That’s going to be done whether it’s an M&A deal, a small angel round or a more institutional arearment.

Let’s turn our attention to M&A. We’ve mostly been talking about investors. Patrick, I know you’re a big fan of helping companies understand and let the diligence trickle out. Talk about that process. You’ve been through the M&A process quite a bit. David, you can jump in there, too. Between the two of you, you’ve bought and sold a lot of companies.

Patrick:     If you’re dealing with a strategic investor or a potential acquirer, it’s a different relationship than you have with a venture capitalist. You should have a non-disclosure agreement. Do not sign a form NDA from a large company without reviewing it. They can put things in there like residual melt.

Even if you write something down but they didn’t write something down, and they remember what you said, that doesn’t fall under the NDA. Have a good attorney that helps you review that stuff. Sometimes you don’t always get everything you want.

That means you have to be more cautious about how you talk about things. You can talk a lot about the “why” and the “what” without the “how” to get people interested. That gets to the market. That gets to the business opportunity. This is what we do. These are our customers. This is the problem we’re solving. You have to share some information.

You should do it under the context of an NDA. Even if you have an NDA, you should still be careful about what you share with someone that is a potential competitor. They’re ripping you off, but they’re doing it legally. I see big companies do this all the time.

They’ll get on an advisory board with a board observer seat. They’re basically collecting information to see if this is a market they want to get into, not necessarily to buy you, but to say, “We can duplicate this ourselves.”

At the same time, you can’t be like the CEO that I was talking about earlier. We tried to do a deal with her for two years. Every time we met, they were holding the information so close. We said, “Can you share a little bit about your roadmap and where you’re going?”

There was no ability to engage. You have to walk a delicate line and say, “In order to get some interest, I have to show them some information.” As you get deeper into the relationship and it looks like there is the possibility that you could do something with them, then you can share more information.

There are two types of NDAs. One is the general NDA. When you get into due diligence, there is a special NDA around that, around not recruiting each other’s employees. That’s another thing. They can come in and suck the braintrust out of your company. They could say, “These are the three people that are amazing. We’re just going to hire them and gut out the company.” I’ve seen that happen before, too. You have to be careful on how you share that information.

Jeremy:     Those are really important points. Just because you signed the NDA with a potential acquirer, especially if they’re a potential competitor, it doesn’t mean that you give them access to everything in your company. They’re going to ask for it and try to get it. You have every right to tell them, “No, this is what we’re going to talk about. I know you need to see my gross profit margin.” Trickle out the information enough so that they don’t walk away.

David:       When I start thinking about M&A, I have two mindsets. One is with private equity firms or VCs where I might take a different approach. If I’m talking about strategics, I like to sit down with the management team and say, “Tell me about your technology. What is truly proprietary here? What is a trade secret? What don’t I want to give away to a close competitor?”

It might be a formula or something to do with the manufacturing. It’s something you do that’s truly proprietary that no one else knows. I’m going to withhold that information. I’m going to be transparent. I go out in a very structured process. I’ll go out to 200 buyers all at once and try to get under NDA. I’ll try to get them to a letter of intent, an LOI. I may not give that proprietary information to everyone until I decide that I get to see the LOI. Then I’m going to give them access to that trade secret. I’m going to say, “You have 45 days to firm up your interest.” Now only one competitor has it, not 10 or 15. That’s the way investment bankers like to do it. It’s a very disciplined, controlled process. Only give out that information to the final one.

For example, I worked on a very well-known molecule called Botox. We used to support that business. We were doing a deal with six Japanese pharmas all at once. I took all six to the end zone. This was on a Thursday. On a Friday, I signed the deal with GSK. This was for the Japanese and Chinese territories. There is all that information and I let it out to GSK after I decided the other five were out.

They fell out for diligence and clauses in the agreement that I couldn’t live with. I gave away that final bit of information on Friday morning. I said, “You have two hours to take a look at it.” They signed. The other five didn’t ever see that information. That’s a technique that you can use, especially when you have a hot asset. You have to control that process. That was with strategic buyers. With VCs, you will have to be very transparent.

Jeremy:     I want to share a horror story while we’re talking about strategics. I had a client that was a medical device company. They were in deep due diligence with a very large medical products company. They were doing a deep dive on the technology. It looked like the deal was going to go, and then the deal died.

Lo and behold, within a relatively short period of time, this very large medical device manufacturer started producing a competitive identical product. We had an NDA, and we even had patents. Guess what? It was a little, teeny startup. How much does it cost to sue great bit, behemoth medical device company for breach of NDA agreement and a patent? It would be at least $1 million. They didn’t have the money.

It was really hard to find anyone to take it on a contingency. They were not able to. The company ended up going out of business. The big medical products company owns the product. That’s a real story. That can really happen. What David and Patrick are sharing with you is really important. Make sure you’re only sharing the most important information when you know you have a deal. You can’t take that risk. Even the agreements, and patents sometimes, won’t protect you because you can’t afford to enforce them.

Patrick:     It’s different around the world, too. There are different countries and different cultures. This is something that you have to be aware of. You have to go into things with your eyes open.

Audience:  The next level of the horror story. Two companies up in Foster City where all the life sciences are in discussions over lunch. They’re in due diligence. They went to lunch together. The founder talked a little too freely. That evening, he was information that a patent application had been filed by the guys on the other side.

They picked up just enough from the free discussion to say, “What a great idea!” They ran out and, because they had the resources, that day, they had a patent application filed. It was trade secret in the startup.

Walt:         What we’ve talked about is good. It’s at the high level. To fish, you need a line, a rod, bait and fish. Let me tell you how this works from the inside of the company. I was hired by a company called Personal Logic that was funded by a really eclectic group of investors. We had an early web application.

If you wanted a dog, a car or a cruise, you could use our selector and figure out what was best for you. The technology was really good. It was a really useful decision guide. They brought me in when they raised Series B. They raised $7 million. On day one when I went in, I had been a CFO before.

I knew that this company was never going to go public. It didn’t have that trajectory. If it was successful, it would be acquired. I said, “How do I plan for success?” From day one of going in there, I said, “Does everyone have an offer letter? Are the offer letters the same? Does everyone have a personnel file? Are there any issues with personnel? What about contracts? What about employee agreements? How about the benefits package? Is everything the same? Is everyone playing on the same level field?”

This is law in California. The CEO can’t have one package with a small company and the other employees have another package. Are all of these things in order? I’m doing this every day during my job. Do the financials come out on time? Do they make sense? If I gave out financials from last year and this year, do they track? Would someone see a coherent picture of the company if we had to do due diligence?

Lo and behold, we had a whopping $500,000 in income two years later with 37 people in the company. That’s not exactly break even. We’re close to being out of money. We’re running on fumes. I have a billion-dollar credit line from a venture financer that took some warrants.

Unlike the banks, they would let me borrow on one. Banks will loan you $1 million if you keep $1 million in their bank. I talk to so many bankers. I have $1 million from a venture financer. We were down to our last 50,000 and our last payroll. AOL came in with an offer over Memorial Day weekend. They were acquisition hungry. They sent a team in from Virginia.

I had everything in order, like the financing, the cap table and the employee agreements. Who are the key people? A big part of the deal was that they wanted the nine people who would guarantee they would stay for a year afterward. I had that all laid out.

Four days later, we went out for drinks. They said, “This was the cleanest due diligence we’ve ever done. Everything was ready.” I thought, “Yes, I didn’t have money to make the next payroll.” But I knew when I started that clean is better. That’s how you want it set up. A lot of young companies don’t understand how important that can be. If you can make payroll, you can still control the negotiation a little bit.

As soon as you can’t make payroll, I can’t say, “AOL, can you loan us $100,000 to make it to next week?” Your negotiating level is gone. From the inside, you want to make sure that someone is taking care of the planning for success. AOL made the acquisition for our half-million dollar a year company.

We got AOL stock worth $30 million. At the time, I was flabbergasted. It was before the internet startup days. Now you see it more often. That was a big deal because AOL tripled in the next year and we were locked up on that stock. You plan for success. You are an “overnight success” after four years of hard work. The same thing goes for a clean company. You’re clean for due diligence when you plan for it for two years.

Audience:  Because you brought it up, doing due diligence, these kinds of issues come out when you have only one or two weeks left to make payroll. Wouldn’t the potential acquirer use that information against you as a leverage point?

David:       Absolutely.

Jeremy:     And the investors, too. That’s why we tell companies not to run out of money.

Walt:         We had deep-pocketed investors. They didn’t want to write another check.

Patrick:     I’ve been in a situation where we were going to buy this company. We went through the process of the proprietary invention agreements. There were three contractors that had worked on a key project. The company didn’t own the intellectual property, so we passed.

We were ready to do the deal. When you start a company, what we call a lifestyle business where you’re going to grow a small or medium-sized business, you’re not going to have an exit. You’re going to have a cashflow business. They’re great businesses. Most of the economy is based on those kinds of businesses.

But you don’t raise outside capital for those. If you raise outside capital, the intent is to either sell the company or go public. If you’re going to do that, you need to have these things in place or you will get to the point where you’re ready to do a deal, and something is going to blow up. Maybe you can recover, and maybe you can’t. I came into a company that we had to sell. This was my second startup. It was a train wreck. Kleiner Perkins was in the deal. Connexum was in the deal.

They said, “We don’t want to put more money in. Can you sell this?” I said, “I don’t know.” We cleaned it up the best that we could but there was stuff missing. There were three employees that didn’t sign agreements. There were offer letters that were never signed. We were chasing people down, trying to get people to sign stuff so that we could sell this company. Fortunately, we were able to do it, but in many cases, as Jeremy said, you can’t get that stuff done.

Jeremy:     These are really great stories. We’re at a time period when it’s so much easier to do this right, and do it right from the beginning. David, talk about data rooms.

David:       If you have the money, spend time on an electric data room. It’s a great way of engaging financial sponsors or investors. It’s a great way of getting strategics involved. Now you’re reaching across either side of the Atlantic or Pacific. Everyone is looking at the same information.

You don’t have to send out a data package or an email and bulk up your servers. Everything is in one place. You’re managing it. Now I can control who sees what. That’s huge. It tracks things like, “Tom just touched this on this page. He sat on that document for 15 minutes.” Who else looked at it? It has “confidential” stamped all over it.

You can limit the ability to print. I don’t want people printing all of my stuff. I can control it. You can have it set to “view only” on the screen. There are ways of doing that. I am a big fan of it. I think it’s a great way of controlling the information. At the end of the day, I want you as the client or investment banker to control the information. I want it going through me.

I want to know who’s touching it and who’s seeing it. If I go out to 200 buyers, I don’t want to send all those emails out. I can’t control that.

Jeremy:     There are a lot of different options. I tell every client and every startup, from the day you start, we’re going to form your company. You have a certificate of incorporation. That goes into an electronic data room. Every single document, every time you sign it, every time it’s final, it goes into that data room. As you just heard, the investors are going to use it. The potential buyer is going to use it.

Imagine what Walt was talking about. Walt, I’m going to call you. Hi, I’m a founder. I just hired David. The buyer is coming in. They want to start doing due diligence. I need you. I need everything ready in a week. And you say?

Walt:         My rate just went way up.

Jeremy:     It could be done. There are resources, money, time and people killing themselves all night. But you will have mistakes. You’re going to find things that are missing. You’re not going to get them fixed in the time period. Don’t do that to yourself.

Walt:         If I came in, I have experience, and I’ve done this kind of thing before, I have zero institutional knowledge if I haven’t been associated with a company and working with you, I don’t know what I don’t know. I can’t possibly catch everything.

In the position that I was in with the company that was acquired by AOL, I should have known everything because I was there for a long time. And I did. If you hire a consultant at the last minute, it’s like saying, “Can you put up this house in two weeks because I’m going to have a party?” It doesn’t quite work like that if you’re building a house, even if you’re an excellent home builder.

This is Patrick Henry, CEO of QuestFusion, with The Real Deal…What Matters.

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