Investor deal-making: How to verify and close deals

Investor deal-making: How to verify and close deals

Prudent investors have their own ways of separating the good deals from the bad. Most times, investments go through a rigorous process of due diligence and then through several rounds of negotiations before the parties finally agree on mutually beneficial terms for the deal.

Read on to find out how the deal-making process goes and what investors can do to protect themselves from foul investments.

Due diligence as a way to verify startups

If a founder’s pitch strikes a chord and investors are interested in the startup, they notify the founder they’re ready to move on to due diligence.

Due diligence is the research of the inner workings of the business. It serves as a means to manage risks and find ways to add greater value to a startup. For venture capital investors, this is also a way to meet their partners’ expectations.

As an important part of deal selection, due diligence helps establish whether a company deserves a spot in an investor’s portfolio. Investors make their decision by answering these key questions:

• Does this investment align with the VC fund’s mission and goals?
• Is there enough market opportunity for the business?
• Has the product launched and is it ready for delivery?
• Does the team have a proven formula for repeatable sales?
• Is the management team qualified and strong enough to succeed?

The due diligence phase explores these factors further. It provides a deep evaluation of the startup through detailed background checks:

1. Market research

Angel investors endure high risks of putting down their own capital. And venture capitalists are responsible both for themself and their partners. To make sure there’s even a glimmer of hope, an investor needs to establish if there’s a market for the business they’re funding.

During market research, investment analysts investigate the market size and product-market fit, identify the competition, and estimate the startup’s growth potential. An investor needs to determine if there will be enough demand for the product and that the sales will justify the investment.

It’s important to understand that there’s no perfect market. There’s always struggle, so investors need to figure out if a startup has a chance to break through with their support.

Information to gather:

• Market size, trends, and growth
• Competitive landscape
• Sales volume
• Pricing models
• Consumer intelligence.

2. Financial analysis

Financial due diligence weighs in such factors as cash flow, recurring revenue, current financial standing and projections for the future, and the assessment of the startup’s customer acquisition model. The information discovered plays an integral role in the company’s valuation and determining the size of the investment.

Information to gather:

• Revenue and expenses
• Profitability over a time frame
• Debt to equity ratio
• Net assets analysis
• Financial growth prospects
• Customer acquisition cost
• Customer churn rate
• Customer lifetime value
• Earnings before interest, taxes, depreciation, and amortization.

3. Legal review

Another crucial part of due diligence is the review of a startup’s legal and regulatory compliance. The goal here is to spot any legal or contractual obstacles in the company’s day-to-day operations.

The review comprises of auditing contracts, identifying pending legal claims, defining regulatory and compliance issues, and recognizing outstanding liabilities. Anything that would hurt the coming deal.

Information to gather:

• Articles of incorporation
• List of shareholders and equity owned
• Agreements, bylaws, and amendments
• Licenses and permits
• Compliance requirements
• Tax returns and annual reports
• Insurance policies
• Pending legal claims
• Outstanding liability.

4. Product evaluation

Analyzing the product line is a pivotal part of due diligence. This part of the research shows if there’s actual substance behind the founder’s idea and whether it's viable to bring it to market. Analysts need to determine the uniqueness and appeal of a company's products to its target audience.

Quite often, simply coming out with a unique product isn’t enough. The startup needs to have a plan for sustained innovation and development.

The investor needs to learn about the technology behind the product and determine its quality, key features, limitations, and its potential for scalability.

Information to gather:

• Current products and services
• Stages of development
• Methods of distribution and delivery to customers
• Uniqueness and market appeal
• Profitability and market share by product
• Technical documentation on products and services.

5. Business model

An investor needs to learn if the startup founder understands the mechanics of business and how they plan to make money on their idea. Key questions to answer here are:

• How does the company plan to manufacture, deliver, and sell their goods?
• What is the perceived value of the product in the eyes of the consumer?
• Is there a formula and process set up to gather recurring revenue?
• Will the business model be able to scale and adapt to a changing market?
• Have the founders prepared a viable exit strategy and plans for IPO?

6. Founding and management team

Angel investors and venture capitalists should also emphasize a great deal on the skills, qualifications, performance, and track record of the startup’s management team. They also need to figure out if the founder has any relevant experience in the targeted market and if there’s enough founder-market fit.

Investors can take advantage of their vast network of industry contacts and ask if anyone had previous experience working with the founder. If so, an investor can dig deeper and find out whether the founder is a good leader and team player, how they react to unexpected business-related situations, and how well they perform under stress.

Information to gather:

• The organizational chart of the company
• Team’s amount of relevant experience
• Professional credentials and previous track record
• Company’s culture and values
• Company’s relationships with outside contractors
• Disputes with current or previous employees.

Term Sheet as a tool for deal structuring and closing

If the due diligence process went well, it is time to ...

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