Due Diligence: A 12 Step Program

Sometimes you have to get back to basics and today is one of those times.  I was speaking at the Association of Health Care Journalists conference last week (a really high class event).  Chris Seper, Editor in Chief of MedCity News and VP of Healthcare for Breaking Media, asked the venture capitalists on our panel whether there were good resources for reporters to help them get up to speed on key healthcare issues to evaluate the deals we do.  Chris essentially asked us: How can reporters understand why you make the investment choices you make and make their own evaluation of the companies that get all of this money?

It occurred to me that a crash course in due diligence might be a good place to start.  And as luck would have it, I have one of those to offer.  Each year I teach a class in healthcare venture capital at the UC Berkeley Haas School of Business and each year the topic of due diligence gets its own special lecture.  While learning to be good at this task takes years, learning about it is fundamental to becoming a good investor of any type: angel, venture, whatever.  Thus I decided to share my due diligence lecture with you here and discuss a few highlights below.  The lecture can be had by clicking on this link:

Due Diligence Presentation March 2015

“Due Diligence” has become one of those terms of art in the investment world that gets thrown around, but may not often get 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 self-proclaimed 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 yet no proof of concept; others like to pile money onto proven companies that are already on the path to IPO and where the only risk is how much MORE value creation is possible.  There is no judgement about these extremes–they are a matter of personal taste and the expectations of those who trust you to invest their money if you are not investing your money alone.  All kinds of investors, whether newbies or experienced, 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.

As I tell my students and those I advise in the venture world, it is important to look at due diligence with a completely open mind.  It is equally important  that the company to which you are about to deliver a virtual colonoscopy smile and enjoy the ride. 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 and the other person wants it. Credit checks, background checks, Google searches and watching how CEO’s treat waitresses–all fair game.

In order to do your best possible diligence, you may need a team of others to augment the areas you yourself are incapable of analyzing. If you are not an engineer or tech expert, get someone who is to tell you how the code looks; if you are not a financial whiz, hire an accountant to ensure the books are legit; always be sure a lawyer tiptoes through the tulips of the board books and cap table and SEC filings and all that fun stuff.  A  company whose legal and financial house are out of order is always a sign to worry.

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:

1. Validity of Idea
2. Quality of Team
3. Operational Fundamentals
4. Sales & Marketing Requirements and Plan
5. Regulatory Environment
6. Reimbursement Environment
7. Financials and Projections
8. Legal
9. Competitive Landscape
10. Corporate Structure
11. Capital Structure
12. Exit Scenarios & Potential Returns

If you read my presentation that is linked above, I go into each of these categories in great depth so I won’t reiterate all that detail here.  However, I will point out a few places where people really should dwell in their research, as herein is 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.  This is basically where the rubber meets the road on “want to have” vs. “need to have.”
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.  The guy who invested in the last best leech company is not getting good ROI these days.
3. Do you like the management team enough to work with them for 7-10 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. Hang out and socialize because personality and culture fit do matter.
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, really? What is the competitor’s experience and how does it compare?
5. Has the company really checked out the regulatory landscape in all the markets it is targeting?  Not just the clinical regulatory process (FDA, CE, etc.) 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.  For instance, any company that was banking on big telemedicine revenue in Texas, itself another country by some standards, have had a recent rude awakening.
6. Who in the world is really going to pay for this? Everyone seems to think that 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 the revenue assumptions seem aggressive, you are probably understating the problem. And that problem is how much cash it’s really going to take to get to the promised land.  Few get this right but paying attention to the potential magnitude of the problem will spare you a lot of anger management classes.
8. How functional and useful is the Board of Directors?  Again an area often overlooked, but 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?   It is always worth noting who you will be fighting with later and what their bargaining position is likely to be.
10. And given the apparent discovery that unicorns actually do walk the earth, valuation is a big diligence topic that cannot be overlooked.  A great company with a ridiculously high valuation can be a very bad investment.  The product may “make the world a better place” as they say in Silicon Valley and on the TV show Silicon Valley, but if you pay too much, you can’t make a return on your investment. It’s basic math but people get so excited about deals sometimes that they forget that 1+1=2, not 2000.  If no company in the field has ever sold for more than $100mm, it is probably safe to assume this one will not either.  If it does, yay!  When it doesn’t, you will know all too well why I call due diligence a 12-step program.

In the presentation linked above there are some of my favorite due diligence questions and lots of other detail, but here are some parting thoughts that I try never to forget:

• During the diligence process it is critical to keep an open mind and not use the process to validate your own pre-existing beliefs.  In other words, don’t drink your own Kool-Aid.
• Management’s cooperation tells you a lot about their willingness to work with you later.  Don’t invest with people you can’t stand to be around.
• Don’t take the company’s assertions at face value. If you get a bad feeling in your gut, listen to it and exit stage right.
• If you do invest, share what you learned with the company–the good, the bad and the ugly.  Don’t ever violate the trust of those who told you things confidentially during the due diligence process, but be sure that the company learns the key lessons you learned so it can plan to avoid them.
• It’s ok to say goodbye when you’re just not feeling it.  The truth is, there is always another investment opportunity that will come along.  You may miss a good one, but hopefully you won’t have wasted your money on the bad ones.

And lastly, don’t let cynicism rule you.  It is so easy to pick apart opportunities that sometimes it’s hard to see the vision through your dirt-colored glasses.  Never forget that the job is also to see how beautiful it could be if things break the company’s way and the paradigm shift is the one your colleagues create.  Sometimes things do break the company’s way.  Mostly they don’t, but when they do, there’s nothing better than that moment when you get to tell everyone, “I told you so.”