Due diligence

Due diligence scoring - cash flow evaluation

If you’re still with me, these posts were prompted by a member’s question about cash flow. The company we had been working on scored a 0.0 on “cash flow”, on our -2 (terrible) to +2 (amazing) scoring metric. It was the weakest score in the report, and our member was wondering how bad that is relative to other companies we see and to the other criteria.

Cash flow analysis is the second lowest average score across our dataset, at a mean of 0.49 overall. (By comparison, “concept” scores 1.67 – because companies with bad concepts don’t get through screening.) Why is that score so poor?

Startup company cash flow models typically show investment today, “burn” of the capital over 12-18 months, and achievement of a milestone at the end (enough traction to attract venture capital, or, better for southeastern angels, getting cash flow positive or acquired). This is inherently an unattractive profile – which is why banks don’t lend to startups! Most of our members run businesses with a much more attractive cash flow situation, so find it challenging to give positive scores for something that would be a major problem in their businesses. This suggests we don’t do a great job “calibrating” scores on this metric to what we would typically see in early stage companies - something we (as group operators and educators) can improve.

But there is more to it. Positive scores on cash flows require a thorough understanding of opaque concepts. From basic financial concepts (margins, unit costs), to startup-specific company metrics (burn rate, CAC, LTV), to accounting concepts (cash vs. profit), to sophisticated excel modelling – many of which are often lacking from small entrepreneurial teams. These are crucial at the VC level – read Mark Suster’s recent post for example – but angels understand them too, of course.

A slick deck and dynamic team doesn’t impact cash flow score: what does is a robust, convincing short-term projection model; a complete grasp unit economics and sales channel ROIs; and a team clearly focused on making sure the “minimum cash position” never reaches 0. These things are much harder to pick up without training, and almost impossible to “bluff,” so generally scores lower than other areas.

In case you’re wondering, 0.0 was in the bottom 30th percentile on this metric. Low scores appear often when a high burn rate is caused by senior team members taking generous salaries: angels are not thrilled about paying entrepreneurs above average salaries with no guarantee value is being added to the company or that this investment will see a return. Startups companies are high-risk for investors, and should be for entrepreneurs too.

Due diligence scoring - competition

If you read my last post about diligence data, you might remember that “competition” was a surprisingly large determinant of whether SCAN members choose to invest.

Where is “market size”, which so frequently appears on the list of key factors to consider when investing in startups? Well, it’s there, but the "delta" is roughly 10% of the delta for competition. Why?

A couple of potential explanations. First, market size is one of the highest scoring metrics we evaluate – our #2 highest scoring criterion and with little variance. This is because market size is fairly easy to evaluate in the screening and pitching process: if it’s not immediately obvious that the market is large enough to support a company’s growth to a 10x return for investors, the proposal isn’t getting through pre-screening. (Charlotte’s angel fund manager agrees.) We obviously verify and quantify in due diligence, but niche products have been screened out already. “Market” scores are therefore consistent and high.

Competition is harder to evaluate from a pitch. We usually take the presenter’s evaluation of the competitive environment at face value - unless it’s wildly implausible or a SCAN member owns the market leader in the space! But once in diligence, finding your established competitors, recently funded peers (thanks Crunchbase!), or other well-capitalized companies exploring the space is easy. The score can then be pretty good - if the company looks like it can compete and has some barriers to entry - though if the entrepreneur portrayed the situation inaccurately, the score can be very low.

This metric is one of the hardest to score well on. The world is a competitive place generally – and for startups it’s hard to avoid the question “why can’t I and $100,000 replicate what you have in two months” because that’s often essentially what the entrepreneur did. And if you describe your business as “the facebook of {soccer moms, cyclists, families, pet owners, or college students (yes really)}” it will be hard to score well on competition.

Due diligence scoring - what criteria are important to SCAN members?

What are the key factors that SCAN members consider when deciding to invest or not? In our April CSR Angels meeting, a member asked a perceptive question about our due diligence scoring system relating to evaluating a company’s cash flow profile. The question prompted me to dig back into our scoring data to see if what we tell people about our investment criteria is supported by our evaluation and investment activity. (More on that cash flow question in a future post.)

Some quick background: VentureSouth groups conduct due diligence on companies that pitch and report the results through a standardized scoring system based on 10 criteria. Without boring you with the details, we’ve scored dozens of companies using this system – both companies we’ve invested in and those we’ve passed on - which allows us to calibrate the relative attraction of an opportunity against others we have seen.

If you’ve seen any of us present on panels or on Crowdr, you can probably guess that we say the three key criteria in deciding to invest are (i) quality of the management team, (ii) size of the market, and (iii) ability to exit.

Does the scoring of candidate companies and our investment decisions support that position? Well, yes but not completely.

I looked at the criteria with the biggest difference in score between companies we’ve invested in and companies we haven’t. The top three are “management team,” “competition,” and “deal terms.”

Quality of the management team is therefore without doubt the most important thing we analyze. Actually, what we are evaluating is suitability: can the team presenting this plan deliver on it? If members believe they can, we invest; if not, we don’t.

“Competition” came as a surprise to me: more on this in another blog post.

On “deal terms,” if the valuation is too high, the deal too complex or lacking opportunity for oversight, or has some other atypical feature, the scoring is much lower - so we pass. It is notoriously difficult to value early stage companies – as Matt’s last education session showed. And yet, investors must remain disciplined on valuation – otherwise the “winnings” from the investment “wins” cannot make up for the inevitable “losses.” So it was particularly encouraging to me to see that detailed reflection on deal terms from the members – and willingness to pass on investments that look appealing but are overpriced – is evident in the behavior of our diligence volunteers.