To undertake due diligence (dd) when considering investing in a new project is paramount. However, in reality, to do this well can often be harder that one imagines due both to the amount of time, energy and money required to carry out a full-fledged dd, and also due to the fact that a project’s promoter tends to typically set rather tight deadlines. If not adhering to such, then this “great” opportunity is lost!
To actually bring together the two sides, a project’s management and one/more investors, is, in the end a sign of the project’s success so far. To put weights on relatively similar dd factors from both sides is perhaps the most critical factor to make this happen. Dd congruence is key!
To find a solid and comprehensive approach to the dd execution can be a challenge. On the one hand, there should be enough rigor for the investor to feel reasonably confident that he/she is not taking larger risks than he/she has to. On the other hand, a realistic dd process should be relatively speedy and smooth, and not requiring excessive amounts of resources.
How might one cope with this dilemma? Here is my own experience from S. Ugelstad Invest (SUI). A caveat may be needed at this point, before going further. Smaller, relatively entrepreneurial organizations such as SUI, may find some relevance in what I am about to share. For more, speed is key, but to be relatively rigorous and not apply resources excessively. After all, this ability to move fast may be one of the key advantages of small, non-traded firms. More extensive dd processes tend to be for larger, publicly traded firms. Here too, there often tends to be a “political” dimension at work, namely the “cost” for a hired executive to have to take the responsibility and at times the blame of a particular investment might not work out as hoped. For a smaller, family managed firm, this is typically less of an issue as roles often cross and/or are shared amongst a tight group of executives as in the case of SUI.
My experience has left me with two sets of factors, which for me seem particularly important:
The manager. What about the manager who shall be in charge of running the venture in question? Who is he/she, does he/she hold the required skill sets, strategic and/or operational outlook, drive, etc. to do the job right?
The market side. Is there a set of customers, and is the value-proposition that the venture offers realistic, when seen from the target customer side?
Before discussing each of these two considerations further, let us hasten to add that there shall of course be several other issues that may be critically important, but nevertheless sub-ordinated to the above two. We shall briefly mention serval such factors towards the end of this piece.
A. The Manager
I see a total on seven sub-groups of factors here, all to be raised with the promoter of a given project:
The manager's track record. Has he/she been successful before? Why? If he/she has been involved in past failures, why? Is the manager’s post job experience relevant? And what about his/her educational background?
Is he/she able to inspire other people (employees, customers, …?). In line with this, is he/she a team player, not a super-ego person (“we, we, we” versus “me, me, me”)?
Does he/she have a significant financial “skin in the game”? In other words, has he/she already invested, or committed, as much as he/she can?
Burn-rate discipline. Is he/she planning to run the business in a “lean” manner, at relatively low costs, only planning to scale up when internal successes allow for this? Thus, is he/she able to manage the burn-rate in such a way that break-even might be reached relatively soon? To grow too fast and/or to spread oneself too thinly may hamper the business’s potential success.
Does he/she appear to be relatively flexible? To try to stick to unrealistic initial plans for too long may be disastrous. Does the candidate show sufficient aptitudes regarding learning and revising?
Does he/she appear as “honest”? This includes only asking for relatively modest personal renumeration. And, spending on personal items is certainly out. As this may be hard to assess upfront, one could at least call for tight credit card practices. And is his/her compensation modest?
Is the apparent work ethic of this individual acceptable or in line with owner or company standards? Any issues found in the past, for instance, would count negatively.
Such an extensive set of factors is meant to help the dd assessor to get an overall general view of the manager in question. Does the manager represent something attractive, something unique, an asset? The above should not be treated as a more or less mechanical check list, however. In the end it is the assessor’s consolidated analysis that matters. There is certainly a degree of subjectivity here, and the assessor’s previous experience clearly matters. Nevertheless, to consider the seven factors above may at least give some assurance of objectivity.
B. The Customer Base/Market Side
Here we shall pinpoint a set of five factors that we consider to be key:
Is there already a revenue stream, or is the proposed project nothing more than a “good idea”, i.e. an early start-up? To be able to document a specific cash flow from existing customers is of course important!
How robust is the order book? In my opinion, a lack of an order book, at the extreme, is indeed particularly negative. But also, are we talking about “promised orders”, even wishful thinking by the manager, versus firm orders? And what is the quality of these customers?
What is the attractiveness of the proposition to enter into a purpose from a customers’ viewpoint? It may make good sense to take the time to actually discuss this with several customers.
Are the liquidity reserves sufficient to operate for several months? This does indeed have a great deal to do with whether this particular project is built on a solid revenue stream projection, and also on the manager’s ability to manage the burn-rate, as discussed in A-iv. To aim to grow too fast, and therefore to spread oneself too thinly is often deadly! (“Strategy means choice!”)
Are there some apparent threats, potentially impacting the expected order flow, such as:
Technological developments?
Competitor moves?
Regulation?
Conversely, are there opportunities for scalability and/or to leap on to a “new” technology (e.g. virtual!).
In the end, what matters is to develop an overall view here, and not to treat the above as some sort of mechanical check list.
C. Other Factors that also may be Critical
(As said, almost never as critical as what was covered under A and B).
I have come to believe that there are at least seven factors in this category, now to be discussed. This list is clearly not extensive, however. Others may clearly be focusing on having alternative factors in their dd analysis.
Is the business scalable and/or based on “the latest” technology? We have discussed this already under issue B-v, but here is more. Are there other candidate firms that might be acquired and/or combined with? Is there room for relatively rapid international expansion, assuming that one’s own product and/or service is already fully developed? Is the technology grounded on IT and/or virtuality?
Injection of new capital is almost a certain requirement for most ventures, i.e. future financing rounds. Who is likely to provide this capital? Are there individuals or groups among the present investors that might have sufficient financial strength to be positive to such follow-on investment?
Competition. How are those already established in the target niche likely to react? See B-v.
The project’s valuation. Investments have undoubtedly been made in a project already before it lands on “our” desk, both in terms of funds as well as time spent by the founders. To what extent are these “investments” still valuable? Initial investments that turn out to represent “blind alleys” should of course not count as part of a realistic valuation. And, in general, realistic valuations are central! The promotor’s optimism and enthusiasm regarding this should not allow for a distortion of what might be a realistic project valuation.
Related to the above, financial injections so far is what would count. In my book, so-called “investments” in time and efforts, by the founder and others, should generally not count towards a project’s valuation!
Similarly, salaries and compensation, real as well as options and/or bonus-related, must be realistic, also from the point of view of the investor! See A-iv and A-vi.
Is there a clear exit strategy? Here a typical promotor and/or project manager might tend to take a longer-term point of view; while many investors might look for an exit within a relatively reasonable time. Is there a plan for exit and/or for “dressing the project up for sale” within a reasonable time period, say through growth (acquisitions or internally) as well as sale to identified entity/industries?
The above factors are typically critical indeed, and might be part of a realistic dd. Here too, however, the key is for the assessor to come up with a synthesis, rather that treat each of the above factors as “check list” items.
D. Some examples where projects did not work out as expected – weak dd analysis at the roots?
In the following we shall briefly list seven unsuccessful projects; why they failed in four cases, and in three more cases, why they may be failing. Poor dd seems to be at the root of all of this. For obvious reasons, the names of each specific entity to be discussed has been anonymized. Let us first discuss four projects that might be characterized as total failures.
CO2 Capture Project. We missed out in our dd primarily for these reasons:
The manager was not honest, and for instance, made use of company credit cards for his private use. His annual renumeration was also excessively high.
The potential customers were large corporations, and the product the company was offering was also an expensive one. All in all, for a small start-up to offer such “big” untried solutions was not credible in the views of potential customers.
The product was not operational, and no orders nor revenues had been secured.
Offshore Oil Drilling Project. This project was focused on offshore drilling for hydrocarbons in ocean waters west of Scotland. The project failed, and dd was not done well.
SUI invested in the project based on the recommendations of the promoter, as well as the experience and track record of the manager. Both the promoter and the manager had some of their own funds invested in the project. There was heavy pressure from the promoter that we would have to decide to invest quickly, or, risk losing the opportunity.
Solar Electric Power Generation in Germany. This project was based on using solar panel generated electric energy to be injected onto Germany’s electric grid. The manager was slow and was not able to secure feasible space to install solar panels when there was a “window of opportunity” on behalf of the German government. Later, this opportunity disappeared. The manager was no longer able to raise new capital.
The Beauty Sector Project. This project was focused on developing and running beauty clinics in Switzerland and Germany, including franchising. Also, the company distributed virtually a range of beauty products. The clinics combined focus on hair, nails and skin, and was the largest entity in Switzerland with this combined business. The company failed because of the following reasons:
Ineffective management of burn-rate.
Too little attention to the hiring of the employees by the manager.
A lack of overall focus.
Problematic business projects
Let us now discuss three projects that are still running, and which hopefully might work out fine. However, there were shortcomings with our dd process here too.
The Gourmet Food Projects. This initially focused on filled chocolate medallions featuring a famous classical music composer. Later a line of vegan chocolates was launched. A few other types of specialty products were also introduced. The target market initially was Norway, but gradually other European markets, and the US as well as China were targeted. All production was outsourced. The company ran into trouble for several reasons:
Too wide market focus, ignoring that “strategy means choice”. In general, a lack of focus by the manager too.
Too little market support on each of the key product lines.
Inability to raise more capital. There were no solid investors for follow-on financing rounds.
Perhaps in general a me-too product idea. The first medallions were quite similar to another well-known chocolate with a different shape but similar positioning.
A Consumer Product through the Awarding of Discount Points. This company had developed its own app for consumers to follow in order to qualify for discounts regarding specific products “listed” on the company’s app. The company had problems making its business model work, and the company ran into an acute cash squeeze.
The manager was slow in adapting, seeking ways to combine with others, while the firm would still have its own funds available.
A resistance to an emergency round of financing, implying that present shareholders, including the manager himself, would face a wipe-out.
A Used Book Selling Company. This company is selling used books online, primarily to the Norwegian market, but also to Sweden. The company grew quickly but had yet to show a profit. The company’s situation may be seen as precarious for the following reasons:
The managers negotiated with two industrial players, and risked losing both, but in the end, was thankfully successful. The management team (of two) was too unexperienced, and too greedy!
The company has not yet been able to modify its business model to become profitable.
The raising of new capital, above all, to support the firm’s rapid growth, was seen as difficult, especially if the industrial actor, already significant on the ownership side, might decide not to be ready to invest more.
As we can see, the dd process seems to have been less thorough then ideal in all of the seven examples given. Above all, this seems to be traced back to the way the manager/management team has been going about running its business, as well as a lack of understanding of the specific market in which each firm is operating. The revenue expectation did not come about!
In summary our learnings indicate the serious need for deep dd. Do not try to take shortcuts in your orderly investigation. To have a measure of understanding and prudence can make or break the success of an investment. Remember to be thorough in assessing all the aspects of a potential acquisition (customer/market orientation, the manager, financial, legal, operational, organizational, etc.), but, as indicated, the factors around the manager and the market side may be the most critical, in order to determine the benefits, liabilities, risks and opportunities. We live in a complex world, and a good dd can bring clarity and a more unbiased review of the opportunity at hand as well as to help the investor determine whether proposer assumptions are true and fair, and to discover unknown issues.
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