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” 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
• 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.
Photo courtesy of Shutterstock
I think that VCs who really believe that GPs are liars are kidding themselves. If you are in the selling business, you need a thick skin to take rejection and there is no doubt that fundraising is selling.
The “nice guy let down” is a classic tool of all people who deal with lots of salespeople and GPs do this to pitching companies just as…[Read more]
Lisa Suennen wrote a new post, Researchers declare questionable winner in VC battle of the sexes, on the site PE Hub 2 years, 11 months ago
I read an article recently that really set me off. The article, Women venture capitalists underperform men, say Harvard academics, reported on a study entitled “Gender Effects in Venture Capital.”
The researchers’ conclusion was this, and I quote from the article that ran on Reuters, “We find that female venture capitalists significantly underperform their male colleagues,” wrote Paul Gompers, Vladimir Mukharlyamov and Yuhai Xuan of Harvard and Emily Weisburt of the University of Texas at Austin in their study.
[contextly_sidebar id="SeAGU2VtK2fUmBOhyLaFRdndCijmaRRi"]Ok, I thought to myself, if this assertion that men are better investors than women is true, let’s see the data, big or small. Here’s what I found: first of all, the data from the article is so old, most of us would not find it useful as predictive in today’s world. Data were culled from investments made 1975 to 2003.
But lamer yet, the article notes, “the authors counted as successful the investments that led to an initial public offering of the company, or 4,622 IPOs.”
In other words, they left out all companies that exited through merger and acquisition. If you know anything about venture capital, you know the vast majority of companies don’t go public. They exit through M&A. So including only those public companies, which are a fraction of the candidates for measure, skews the data ridiculously.
This is particularly true since there were and remain so few female venture capitalists. About 4 to 5 percent of partners at venture firms are women and it has been hovering in that pathetic range for a very long time. It was probably even lower back in the 1970s and 1980s when much of this data was collected.
On top of that, most venture capitalists have few IPOs in their portfolio since most of their companies exit through M&A. As a result, the number of results being measured per firm partner hardly constitutes a trend, particularly if women haven’t been partners long enough to have many exits.
Also worth pointing out, taking a company public is no proof of value creation for shareholders. IPOs should be considered financing events, not exits. VCs rarely get to exit at the IPO and must wait at least six months, and often much longer, to sell their positions. Sometimes the IPO value six months after the opening ain’t so hot.
For example, out of 187 IPOs in 2014, 66 are underwater today (meaning their current price is less than the price on the day they went public); of these, 31 have lost more than 20 percent of their value. Of the IPOs that are up in value since opening day, 26 are up less than 10 percent, so nothing to write home about. Nearly a quarter of the 217 IPOs that went out in 2013 were underwater at the end of that year and of the balance, 26 had moved up less than 10 percent over their original offering price.
In contrast, as of June 2014 there had already been 16,775 mergers and acquisitions worldwide. The total value of M&A deals to date in 2014 is 44 percent greater than in 2013 even though the number of announced worldwide transactions year to date 2014 is actually down 3.5 percent from 2013.
Yes, some of you will say, but VCs can make money even on failed IPOs since they invested at such low entry prices. And to you I will say, “yes, that is true, but do you really consider it a success if the fund makes money and the company is a failure for its broader shareholder base?” That is exactly the kind of stuff that gives VCs a bad rap.
But here’s my favorite part of the story: the researchers in this weird study blamed the performance difference, in part, on a lack of mentoring by male colleagues.
First, how patronizing. I’m sure the women who reported their success was due to a male mentor meant they were lucky to have a good mentor, who happened to be male. Second, the article notes, “women out-performers often credit a male colleague who took them under his wing.” Well duh. There were almost no women to take other women under their wings, so anyone who served a mentoring role was going to be male. If every firm has, on average, one or fewer females, who else would be there to train them?
Not for nothing, there is a wealth of research out there demonstrating that women make better investors than men. You can look HERE for a good example of some of the contrary research out there, and it is not even mentioned in the report.
Let’s get to the real point: who gives a damn? Some people are great investors and some people are bad investors. Some venture firms make money for their investors and some firms don’t. Controlling for any one variable, whether it is gender or age or whether one drives a red car or owns a dachshund hardly seems to matter. I don’t know what the point is of this endless quest to “prove” one gender is a better investor than the other. Why can’t we all just get along?
Lisa Suennen is Managing Partner at advisory firm Venture Valkyrie. Follow her on Twitter @VentureValkyrie.
Photo courtesy of Shutterstock.
Lisa Suennen wrote a new post, Deaths of the unfit outnumber survival of the fittest, on the site PE Hub 3 years ago
“One general law, leading to the advancement of all organic beings, namely, multiply, vary, let the strongest live and the weakest die.” –Charles Darwin
As you can see from the quote above, I was recently perusing the works of my favorite business advisor, Charles Darwin, after I saw this statistic on Twitter:
429 of the original Fortune 500 companies  are no longer in business today. Adapt or die.
That is some serious survival of the fittest, or a whole lotta’ death of the inflexible.
And it is probably a scary thought, or should be, for those who sit at the top of the healthcare mountain right now. Today’s king of the castle can be tomorrow’s court jester. Look no further than the words of Charles Darwin, who really should have been a management consultant:
“It is not the strongest or the most intelligent who will survive but those who can best manage change.” –Charles Darwin
Half a century ago, life expectancy of a firm in the Fortune 500 was around 75 years. Now it’s less than 15 years and declining even further, according to Steve Demming in an article called “Why Big Companies Die.”
I looked up the original Fortune top 10 and found they were General Motors, Exxon, US Steel, General Electric, Esmark, Chrysler, Armour, Gulf Oil, Mobil, DuPont.
Even though those 10 companies were the giants of their time, there has been pretty significant turnover at the top. The current top 10 are: WalMart, Exxon, Chevron, Berkshire Hathaway, Apple, Philips 66, General Motors, Ford, General Electric and Valero Energy.
As you can see, only three of 10 have maintained their place at the top. Of the seven no longer in the top, their fate was as follows:
• US Steel exists, but no longer in Fortune 500
• Esmark is a mid size company with $400 mm in revenue and no longer qualifies for the list
• Chrysler went bankrupt and its assets were acquired by Fiat
• Armour and Company was sold and broken into parts
• Gulf Oil was merged into Standard Oil, which later became Chevron
• Mobil Oil was merged into Exxon
• DuPont has moved from #10 to #86 on the list
“I think it inevitably follows, that as new species in the course of time are formed through natural selection, others will become rarer and rarer, and finally extinct.”
Here are the healthcare companies that are included in the 2014 Fortune 500:
• Insurance: United, WellPoint (Anthem), Aetna, Humana, Cigna, Centene, HealthNet, WellCare, Molina Healthcare
• Services: HCA, Community Health Systems, Tenet, DaVita Healthcare Partners, Universal Health Services, Vanguard Health, Kindred Healthcare, Express Scripts, Quest Diagnostics, Omnicare, LabCorp of America, Quintiles
• Medical Products: Abbott, Medtronic, Baxter, Stryker, Becton Dickinson, Boston Scientific, St. Jude
• Pharmaceutical: J&J, Pfizer, Merck, Eli Lilly, Abbvie, Amgen, Bristol Myers Squibb, Gilead, Biogen Mylan, Celgene, Allergan
• Wholesalers: McKesson, Cardinal, AmeriSource Bergen, Henry Schein, Owens & Minor
That’s 45 companies, almost 10 percent of the current Fortune 500. And if you go by history, some 86 percent of them are doomed to obscurity or worse if they don’t learn how to adjust to life after the giant asteroid hits earth, also known as the full implementation of the Affordable Care Act.
“It is always advisable to perceive clearly our ignorance.”—Charles Darwin
Many of these companies are making sincere attempts to modernize and modify their businesses to change with the times.
Insurance companies are trying to become technology and outsource service companies selling to providers. The provider companies are trying to become insurance companies or something akin to them. The medtech and pharma companies are trying to adopt technology and services models to augment relationships with consumers or otherwise turn themselves into consumer products companies. The wholesalers are trying to become big data businesses.
Everyone in healthcare is betting on technology as the answer while, ironically, the technology companies like Apple, Google and Oracle and Intuit are betting on healthcare. Whether this results in the tech companies becoming the new healthcare names on the list or, a giant cataclysmic self-cancelling exercise as healthcare and technology giants pass each other in the hallway, remains to be seen. In some cases these former strangers—healthcare and technology companies—are collaborating to find their way onto the road to the future, wherever that leads.
I was recently told by one of the very large entities on the healthcare Fortune 500 list that they were undertaking certain activities (challenges, accelerator sponsorship, etc.) to “check the innovation box,” thus completely minimizing the import of the undertakings.
That company best be looking over its shoulder for a guy with a black hood and a scythe. Actually, if it’s a startup that’s coming to eat his lunch it will probably be a guy with a black hoodie, but you get my point.
“We are always slow in admitting any great change of which we do not see the intermediate steps”—Charles Darwin
I was watching an episode of the sitcom Modern Family the other day and one of the subplots was about one of the kids, Luke, trying to invent the next great kitchen innovation. Among his attempts were a toaster that butters and toasts simultaneously, the coffee-bot (never fully explained), and a self-flipping pancake whose mechanism of action was embedded popcorn. Phil lauded his son’s entrepreneurial spirit and zest for innovation.
And why wouldn’t he? Innovation is everywhere these days, and if you haven’t got an innovation initiative at your corporation or an investment strategy that supports it, you are so five minutes ago.
Unfortunately the term “innovation” has become synonymous with the term “entrepreneurship” and, while often related, they are really not the same thing. Innovation means the creation of something new and different. Entrepreneurship means starting a new enterprise that involves a significant amount of initiative and risk; it doesn’t necessarily mean the enterprise offers something different and unique. It could be a new laundromat or gas station or another Starbucks in a new location. It is only the combination of innovation and entrepreneurship that really moves the wheel of progress forward.
I recently saw Guy Kawasaki, former Apple Chief Evangelist, speak at the Xconomy Napa Forum and he illustrated this point beautifully with a chart (which I have slightly embellished to include the words he used to describe it).
The chart demonstrates how you can have something valuable that is not unique (albeit something that is likely to be sold at commodity pricing); in other words, something that is entrepreneurial but not innovative (see bottom right quadrant). The self-flipping popcorn-embedded pancake would, I am pretty sure, be in that upper left-hand quadrant, aka stupid.
This concept really hit home for me because I am working on a great project for a client that includes a landscape review of all the healthcare-focused incubators and accelerators that have emerged over the last several years. So far I have identified over 60 such entities and I know there are far more. I bet there are more than 100 healthcare-dedicated entities focused on incubating and/or accelerating companies (and that doesn’t even include the tech incubators/accelerators that host the occasional healthcare startup). And that, my friends, is a whole lotta acceleration.
There are as many business models as there are incubators and accelerators. One of the big trends I have noticed is there are some such entities that are designed to solicit any and all unique and different ideas across a wide swath of topics (innovation) and then try to make a market for them. I will call this the outside-in model: It brings ideas from outside and hunts out customer organizations that will take them inside to solve problems. The contrasting and increasingly prevalent model is more of an inside-out one: Sponsoring entities identify the problems they want solved inside their organizations and then reach out to attract people to create solutions, which may or may not be particularly unique (entrepreneurship).
The question this raises is: How big is the overlap in the Venn diagram between entrepreneurship and innovation in these endeavors? Certainly it is not the case that all things evolved in accelerators/incubators are innovative in the unique/different sense of the word. And certainly the business risk is mitigated for so-called entrepreneurs when there are built-in customers asking for a solution. The overlap between the two is the place where great innovation spurs great entrepreneurship and the creation of something new, different, viable, scalable and desired; aka, the Holy Grail.
The challenge is that all of it is called “innovation,” even when it is, essentially incrementalism; and, all of it is called “entrepreneurship” when it is, essentially, opening up a new Starbucks. Knowing the difference is, I suppose, what separates the girls from the women. As large companies continue their march to build innovation centers and appoint chief innovation officers and spin up businesses left and right, it is essential that they are mindful of this difference. Most importantly, they must become especially good at identifying that place in the middle where the magic happens, which is usually just up and to the left of the typical corporate comfort zone.
Hey, this may be an opportunity! Perhaps what we really need is a new accelerator that supports the creation of algorithms to identify which companies have the optimal combination of innovation and entrepreneurship. Now, all we need is a little seed funding…
Photo courtesy of ShutterStock
Lisa Suennen wrote a new post, Big data and banana prices: correlation is not knowledge, on the site PE Hub 3 years, 3 months ago
I recently came across a fantastic website called Spurious Correlations. On it you can pick from myriad of random variables and see how they are correlated with other random variables.
The idea, of course, is […]
Lisa Suennen commented on the post, Hot or not? Why good-looking men get all the funding, on the site PE Hub 3 years, 5 months ago
Alastair, yes most VCs like to work with those they have worked with before, but that is precisely what perpetuates the problem. If we are going to get new blood in, we need to open up the opportunity to […]