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Due Diligence: A 12-Step program

Sometimes you have to get back to basics and today is one of those times. With all of the talk about unicorns and start-ups, how are people to understand why VCs make the investment choices we make and evaluate the companies that get all of this money?

It occurs to me that a crash course in due diligence might be a good place to start, and I am sharing here a lecture I give on the topic each year in my healthcare venture capital class at the UC Berkeley Haas School of Business, plus adding a few highlights below.

Due Diligence Presentation March 2015

“Due Diligence” gets thrown around often but rarely gets defined. To me, it means this: research that tells you whether a specific investment opportunity is a good idea, is a good investment (not the same as a good idea), has the best team able to execute on the opportunity, and has the appropriate balance of risk/reward based on the investment criteria with which you choose to live.

This last bit is important since all investors come with their own set of rules about the kinds of risk they are willing to bear. Some people like to go full cowboy and throw money at wild ideas with no proof of concept; others like to pile money onto proven companies already on the path to IPO and where the only risk is how much MORE value creation is possible.

These decisions are a matter of personal taste and the expectations of those who trust you to invest their money if you are not investing your own. All investors, whether newbies or inexperienced, late stage or early stage, cowboy or mezzanine, can make great money and succeed or fail cataclysmically. Due diligence is one of the ways to help achieve the former and avoid the latter.

The management team of the company targeted for investment should expect you to talk to their customers, their potential customers, their colleagues and competitors, people who love them and people who hate them, their kindergarten teacher and the guy that mows their lawn. In other words, nothing is off-limits in due diligence when you are the one writing a big fat check.

In general, I look at Due Diligence as a 12-step program, not because it makes one want to drink heavily, but because that is about the number of areas that need in-depth attention in an ideal process. My 12 due diligence focus areas include:

• Validity of Idea
• Quality of Team
• Operational Fundamentals
• Sales & Marketing Requirements and Plan
• Regulatory Environment
• Reimbursement Environment
• Financials and Projections
• Legal
• Competitive Landscape
• Corporate Structure
• Capital Structure
• Exit Scenarios & Potential Returns

The presentation linked above summarizes these 12-steps in depth so I won’t here. But I will point out a few important areas of focus where many of the ‘gotchas lay in wait to eat your money:

1. Barriers to adoption: look at the usual, such as work flow and cost, but don’t forget such things as switching cost and inertia, which is the greatest competitor of all.

2. Is there a paradigm shift on the horizon? You may be investing in what you think is the most advanced surgical company on the planet, but if their procedure can be mitigated with a pill that is about to be approved, well, people often prefer the pill. Don’t limit your sights to direct competitors alone.

3. Do you like the management team enough to work with them for seven to 10 years through thick and thin? They may be highly qualified, but if by the end of due diligence you can’t stand to talk to them, this is not the deal for you.

4. Does the sales story make sense? Can one person actually sell as much stuff as they think one person can and how long will that take?

5. Has the company really checked out the regulatory landscape in all the markets it is targeting? Not just the clinical or financial regulatory process but the rules for data exchange? Provider contracting? IP in foreign markets? These may have costs associated with them that could really blow the budget.

6. Who in the world is really going to pay for this? Everyone seems to think if they build it, someone will pay, but nothing could be further from the truth, particularly in healthcare. The healthcare wallet is guarded by some very big artillery and this is the thing that kills more companies than anyone cares to admit.

7. If you think revenue assumptions seem aggressive, you are probably understating the problem. Few get the financial model just right, but paying attention to the potential magnitude of the cash need will spare you a lot of anger management classes.

8. How functional is the Board of Directors? A dysfunctional Board is worse than a dysfunctional family. You can leave your family, but you can be stuck with a Board for years while your money circles the drain due to poor governance.

9. Does the capital structure impede future success? Disincentivize management? Put investors at odds with each other to the peril of the company?

10. And given the apparent discovery that unicorns actually walk the earth, valuation is a big diligence topic that cannot be overlooked. A great company with a ridiculously high valuation is a bad investment: if you pay too much, you can’t make a return on your investment. If no company in the field has ever sold for more than $100 million, it is probably not safe to assume this one will. If it does, yay! When it doesn’t, you will know why I call due diligence a 12-step program.

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