I thought I’d re-post on due diligence given how much more of it we VCs tend to do during economic downturns.  For the uninitiated, due diligence is the process in which a fund decides whether it will make an investment in a particular company and I will include some generic items for consideration later in this post. The earlier the stage of company, the more “art” than “science” there is in analyzing whether to make an investment but most early-stage funds follow the guidelines below to one degree or another. The other aspect of due diligence is often left unsaid, despite the fact it is equally important — the due diligence entrepreneurs SHOULD perform when deciding which fund they would like to work with and whether they want to partner with a particular fund that may have expressed interest in investing in them. It is, after all, a two-way street and both VC and entrepreneur will be essentially “marrying” for the next few years (exceptions/divorces aside).

Deal Due Diligence

Most VCs generally break this down to 1) market; 2) technology; 3) financial; and 4) “operations”. Performing due diligence on a particular market should result in the VC being very familiar (and comfortable) with the size of the market(s) the particular company is targeting with its product(s)/service(s), the direction the market seems to be heading based on historical statistics and the forecast rate of growth (e.g., most funds don’t necessarily like investing in markets that are dying…), the typical sales cycles for the product(s)/serivice(s), and who the players are in a given market (i.e., both the real and potential competition). Technical due diligence depends on what is being offered for sale by the company and whether their success depends on any particular competitive technological advantage (i.e. intellectual property). During technical due diligence, VCs attempt to determine the defensibility of the company’s business, any differentiation, whether the company will have the necessary freedom to operate (i.e., potential patent infringement issues), and any product life-cycle issues. Financial due diligence is essentially two parts: one part is determining how much capital the company will require and whether that fits with the fund’s model and the other part has to do with analyzing the company’s financials (e.g., how much cash they have, their cap table, whether they have any debt, etc.). A part of financial due diligence may also involve determining whether the VC and/or company will be able to pull together a syndicate for larger and/or later rounds of financing. Finally, performing “operational” due diligence involves background checks on the folks involved to determine whether they are the right folks to be able to take the company to the next level based on their past experience and personal characteristics. Operational due diligence also involves making sure the business model is sound, the company doesn’t have any pending or potential legal issues, and the that the general logistics of making the investment make sense. The entire due diligence exercise serves, at a minimum, to identify and mitigate the risks associated with the deal to the extent necessary honor the VC’s fiduciary duties to its LPs. For more information about the types of risks VCs attempt to identify/mitigate, see my Arbiters of Risk post by clicking here.

Fund Due Diligence

A far too often overlooked aspect of the start-up / VC deal consumation is the diligence the start-up should perform on its prospective VCs.    You would be amazed at how much “spaghetti” I get wherein folks are simply looking for funding from anyone and everyone regardless of whether their deal would be a good fit given the stage, size, and investment model of my fund.  So, before I provide more specifics here, do I have all your entrepreneurs’ and would-be-entrepreneurs’ undivided attention???  I thought so…  As sites like The Funded take root, I think you’ll see more transparency in the venture capital industry.  In the interim, here is a short list to get you started.  I started with a list that one of my attorneys, Craig Dauchy, provided for me and added my own items based on my experience as a VC and someone that has raised “OPM”.  So here we go…  Here’s a laundry list of questions you should be asking yourself and/or the VC to determine whether the fund in question is a good fit.:

• What stage fund is it?  Do they invest in your stage of company?
• Where is the fund in its life cycle?
• What is the time horizon for this investment?
• What kind of return does the VC need to make on this investment?
• What happens if there is no exit event providing liquidity by that date?
• What other companies in your sector has the fund invested in?
• Are there any other companies in the fund’s portfolio that would be direct competitors?
•  What deals has this particular VC done?
• On what boards does the VC sit?
• Will the VC be willing and able to participate in the next round of financing?
• Would the VC be willing to work alongside other VCs with whom the entrepreneur is already in discussions?
• Who has the VC syndicated with in the past?
• Are there other funds that the VC thinks should be invited into the deal?
• How has the VC handled management changes in the past?
• Are there any founders in the fund’s portfolio who were pushed aside or pushed out?
• Will the VC introduce you to the founders of other companies the VC has invested in?

For more on fund due diligence and general entrepreneurial advice, I recommend you see my VCs Circle of Life post and spend $45 to pick up a copy of Craig’s book, The Entrepreneur’s Guide to Business Law.  Of the two, his book is better and maybe you can convince him to autograph it for you — just tell him I suggested it ;-)  With that, all you entrepreneurs do your own homework and pick the right partner for the deal at hand and happy venturing.

As for why due diligence seem to take longer these days, there are a number of reasons but they merit their own post so stay tuned…

I thought I’d expand on a post written by Ben Kuo (Venture Capital Booms in the OC) and point out while our county’s start-ups have raised ~$110M in the last week or so, we have also had our recent share of liquidity events.  A very big congratulations to Michael Hajeck and his team at SiliconSystems and to their new parent, Western Digital, as it was announced last week that WDC acquired SiliconSystems for $65M cash!!!  I also feel compelled to congratulate the guys over at Miramar Venture Partners as they were early investors in SiliconSystems.  Looks like a “3-way” win for Orange County to me…

As most of you know, I am a big supporter of almost all things pertaining to the Tech Coast and in helping SoCal grow its venture ecosystem (now #2 in the U.S.)… so today I am excited to announce the launch of:

Southern California Tech Central

Tony Karrer has spear-headed this effort and is off to a great start.  Southern California Tech Central is a community of people in Southern California who have come together to help find and organize the best content from blogs, news sources and other web sites all around technology in So Cal.  The goal is to create a place where it’s easy to find current and highly relevant content.  And perhaps to stimulate new connections.  This site is being sponsored by the Technology Council of Southern California and TechEmpower.  If you are involved in SoCal’s tech scene, you truly owe it to yourself to check it out.

I’ve been spending a fair amount of time lately thinking about the history of California’s “IP industries”, the current state-of-affairs, and where we’re headed as an economy.  All grandiose thoughts to be sure, but for the sake of your attention spans I’ll try to keep this reasonably short.  Intellectual property or “IP” has proven to be a very valuable asset since the original IP laws were created.  If you don’t believe me, just take a look at Intel, Microsoft, Pfizer, Disney or the plethora of other such S&P 500 companies whose businesses are predicated upon the creation, transfer, and protection of IP.  So what is IP and what does it have to do with California?

At it’s most basic levels, IP embodies patents, copyrights, trademarks/servicemarks, and trade secrets and are a set of rights afforded by our legal system to the owners of such “assets” to do certain things with said assets and (often more importantly) prevent others from doing certain things with said assets.  Okay, so what does all of this have to do with California?  Simple.  A very large percentage of California’s GDP comes from companies whose businesses are based on IP.  To put things in perspective, just think about all of California’s tech companies and entertainment companies and you’ll get a very real sense of the magnitude of IP’s importance to our economy.  How many such companies can you name?

Okay, enough of the preamble here.  After thinking through this matter the past couple of weeks, one aspect of this struck me as interesting.  Specifically, how certain “IP companies” make money and how such money gets distributed.  I am referring to “bit media” companies.  Most people are at least aware of the fact that the industry is changing, but most are unaware of just how dramatic the changes have been the past few years or how much more dramatic they will seem in a few years time.  Rather than get into the specifics of these changes right away, I want to let you stew over this for a bit so I will follow up with “part 2″ of this post at a later date.  How’s that for a teaser???

For all you night-owl entrepreneurs who struggle to make it  to our early morning affairs, we’ve heard you and are responding.  Register FAST, this will “sell out” ’cause, what’s not to love???  Booze, food, digital media, and Laguna Beach… 3 of my favorite things.

DATE: Thursday, April 23rd

TIME: 5:30-9:00PM

LOCATION: [seven-degrees] 891 Laguna Canyon Rd. Laguna Beach

At OCVG’s first evening event of ‘09, learn from some of the quickest minds in Digital Media how they’re challenging the powers that be, raising BIG $$$ from VC’s and creating some of the coolest companies on planet earth.  As an added bonus, OCVG will host this mega networking event at [seven-degrees] in Laguna Beach — one of the hottest venues in Orange County.  We’ll have lots of munchies and FREE wine & beer.  Don’t miss out.  Stake your claim and RSVP NOW at www.OCVG.com.Our panelists include:

Dennis Mudd, Founder & CEO, Slacker, Inc. – Slacker creates the perfect personalized radio station for every listener by combining the knowledge of music experts with your preferences..  Since inception five years ago, the company has raised $53 million from “A-list” VC’s including Mission, Centennial, Rho, Austin Ventures and Sevin Rosen.  Before Slacker, Dennis was CEO at MusicMatch, sold to Yahoo for $160 million in 2004.

Jason Feffer, Founder & CEO, SodaHead.com – SodaHead is the premiere opinion-based social community for user-generated Q&A on today’s hottest topics.  Founded only two years ago, the company has raised more than $12 million from savvy investors including Mission Ventures, Mohr Davidow, the Tech Coast Angels and legendary Silicon Valley “über angel” Ron Conway.  Before founding SodaHead, Jason was VP Operations at MySpace.

Mark Kern, Founder & CEO, RED 5 Studios Inc. – Red5 is an independent online game developer led by the talent behind Blizzard Entertainment’s Massively Multiplayer Online (MMO) hit, “World of Warcraft.”  To help fund their drive to become the leading studio for creative, original MMO games for global markets, the company has raised more than $18 million from top-tier Silicon Valley VC’s Benchmark and Sierra Ventures. 

MODERATOR: Bong Koh, Venture Partner, Prism Venture Partners – An expert in starting, growing and selling companies, Bong focuses on digital media and consumer Internet investments at Prism’s Santa Monica office.  With $1.25 billion under management, bi-coastal Prism is a leading investor in digital media start-ups. Before joining Prism two years ago, Bong was a VC at Advanced Technology Ventures.  Prior to this, Bong was co-founder of Mobilocity, a mobile solutions provider he sold to a joint venture of Qualcomm and global ad agency Omnicom. 

May your start-up get funded

and your customers be plenty

May your company be acquired

for a multiple north of 20

May good luck be with you

wherever you go

and your blessings outnumber

the shamrocks that grow!

So far, so good.  We’re averaging 8 entrepreneurs / VCs so I guess I’ll keep this party going and see where it ends up.  This month, we will be meeting March 19th, 9am-11am, at the Pacific Whey in Ladera Ranch at 25672 Crown Valley Parkway (in the Mercantile West Shopping Center).  Hope to see you there.  As always, any last minute changes will be communicated via http://twitter.com/ocvc.

I just returned from a week in Tahoe where I was reacquainted with fear in the truest of senses and thought how relevant overcoming it is for investors in today’s markets.  My first “uh oh” moment was when we encountered a complete white-out on the 50 while driving up to the cabin.  My wife and I had a place in Tahoe years ago when we lived in Silicon Valley so I had driven in snow storms before.  The differences this time were driving on the 50 (narrow 2-lane on a cliff) instead of the 80 and having my wife and kids in the vehicle with me.  I would have simply pulled off until it passed but I could not see the road (AT ALL) due to the conditions and the icing of my windshield and knew the “cliff” was somewhere lurking.  As I said a silent prayer, I was reminded how (for me) faith plays a big part in overcoming fear.  I did not panic.  Nor did I freeze up or suffer paralysis through analysis — I simply persevered and proceeded with caution trusting we would make it through.  One of the lessons I was reminded of during this experience, as it relates to this blog, is that an investor’s visibility if often impaired when making investment decisions.  In such situations one can only trust in the methodical, disciplined approach and make a judgment call based, at least in small part, on faith that the future will occur and that it will be positive.

My second brush with fear occurred while standing at the top of my first run since severely separating my shoulder last February while snowboarding.  My family and friends had been asking me whether I was nervous or scared most of the preceding two weeks and had been making comments such as “I can’t believe you’re going to go after what happened to you last time”.  Well, I have been snowboarding consistently for 10 years (albeit my frequency has gone from ~30 days/year to a pathetic ~3) and I was not going to let the only injury I have ever suffered (from snowboarding) set me back.  I was determined to get back on the horse.  I began my descent a bit timidly and could feel the pit of my stomach tightening up as I gained speed.  Thoughts of wiping out crept into my head and I began to question my judgment in my decision to go…and then I remembered our drive in the white-out, and many of my other experiences with fear, and a strange thing happened.  I relaxed.  I began to “feel” my way down the mountain gaining momentum the whole time until I finally reached a point where I was at ease.  Sometimes life puts obstacles in front of you so that you can overcome them.  Or not.  It really is up to you as to whether and how you proceed in such situations.  So, my advice to you entrepreneurs is to raise your money (despite the economy) and lauch your company.  Things will, eventually, improve so you should ask yourself one simply question:  what position do I want to be in when they do???  Until next time, keep the faith.

This brief post is the result of my jury duty this past Monday and my waiting on hold with a government agency.  I found it ironical that I was finishing Taleb’s The Black Swan while sitting in the jury assembly room wondering whether I’d be called to serve.  (If you haven’t read The Black Swan or its predecessor - Fooled by Randomness - yet, I highly recommend both if you spend any time trying to “predict” anything.  While one of my degrees is in fact in philosophy, I don’t think you need to be a philosopher to understand and appreciate either book.)  I have always believed that luck is where hard work and preparation meet opportunity…but you still need that opportunity to appear for that to be true AND you need to be able to identify and appreciate such opportunity for what it is before you can act.  The question I have struggled with for some time is whether the ability to identify and appreciate such opportunities is simply innate or can it be learned.  While I’ve seen and experienced my fair share of empirical and anecdotal evidence supporting both, I thought I’d open it up to all of you.  So, what do you think???

Well, January has come and gone and the year is off to a “shaky” start in case you haven’t been paying attention to what is going on in the global economy.  Some are faring better…some worse.  In the end, we will eventually pull out of it as life goes on.

Enough luke-warm pep talk.  We had a whoppin’ 6 folks show up for January’s OC VC Office Hours, but since I didn’t know 3 of them I’ll keep this going for the time being and see what (if anything) comes of it.  We had an excellent discussion about what is going on in the local, national, and global VC markets and I suspect this dialogue will continue for most of this year as funding continues to be elusive for start-ups.

The next OC VC Office Hours will be February 12th, 9am-11am, at the common area between Pacific Whey and Starbucks in Crystal Cove (between Newport Beach and Laguna Beach on PCH).  Please join us as we continue to discuss the VC markets and local innovation.