Due Diligence

December 23rd, 2019

Reflex CapitalBlogDue Diligence

Due diligence serves, or should serve, to identify the risks in the company (legal, financial and commercial). However, some investors use due diligence to get an extra advantage and a way not to comply with the terms agreed in the term sheet.

The plot goes usually like this: a suite of junior lawyers, analysts and consultants, who are not so much interested in the company’s own business, seek to dig out every minor detail, regardless of whether it has any practical meaning or not, as they:

1) want to prove their analytical abilities and get noticed with chances of being promoted one day,
2) want to find as many problems or “problems”, to have the due diligence report as long as possible and for their employer to invoice as much as possible for due diligence.

And the investor then uses those long lists of identified issues as a tool for a popular sport called “hammering down”, knowing that the founder is already exhausted after many weeks of negotiating through the process. Founders want this to be over as soon as possible, so that they can start dedicating time to their business again, so most founders give a few concessions to finally conclude the transaction. The prospect of starting over with another investor is just grim.

We at Reflex Capital look at it a little differently. When we like the people and their business, everything else is less important. We will also perform a simple due diligence, because we do not want a particularly large skeleton to fall out on us from the closet, but as we also had our own businesses, we know very well that in every startup there is a lot of garbage. That’s how the things are done when you bootstrap. It is normal that a contract cannot be found or that balances are off a few thousand. We do not take this as a bargaining ammunition, for us it is more like a To-Do roster of what all needs to be addressed post-closing.

Likewise, in startups, it is normal for financial management to be seen as a bank account look at “how much do we have”, that external accountants process accounts only to perform a tax return, and that the founder’s “annual contact” with accounting and finance reports looks something like this:
Accountant: “Hey, why am I calling you… I am filing yearly accounts here and am seeing there was a big loss last year.”
Founder: “Dude, really? … And how much? ”
Accountant: “Over 200 grand.”
Founder: “Two hundred? How is it possible?”
Accountant: “Don’t ask me. Perhaps you should know that. I’m just adding up what I get from you. Did you send me all the invoices issued?”
Founder: “Issued by who?”
Accountant: “I say issued, that means those you issued. The invoices you receive are received.”
Founder: “Ah. Well, I guess… I didn’t notice there was anything else going on … ”
Accountant: “Did you forget to invoice something?”
Founder: “Perhaps not. We have a few acceptance delays for a few customers, but it won’t come to 200 grand… ”
Founder: “And.., like…, 200 grand? That’s nonsense… we’re negotiating an investment, and we can’t show such a loss to the investor. He would run away. Is there anything you can do about it?”
Accountant: “Well … perhaps there is way to capitalize the cost of developing your software?”
Founder: “Uh, capitalize? What’s that? ”
Accountant: “Well, that’s like activation accounting… Wait, not like that … like, you put labor to capex… wait… you wouldn’t understand, anyway. Just for the sake of simplicity, imagine that you will make an asset out of your costs.
Founder: “Costs become assets? That’s good, we could do that more often. Why haven’t you told us earlier? … we could’ve already had a lot of property.”
Accountant: “Hey, slow down. That’s not that simple, because … but I will not even try to explain that to you. ”
Founder: “Don’t explain that to me. I also don’t explain to you how to run bits and algorithms. So we are agreed to turn 200 grand of cost into assets?”
Accountant: “Look, dude, don’t be fooled… You’ve only got 300 grand of these costs per year, and half your sales are services. And don’t forget that the IRS is at it. And of the cost of people, only half are staff … the rest are subcontractors …”
Founder: “So how much?”
Accountant: “I’d say no more than 100 … even that’s a bit risky. But if your investor isn’t completely stupid, it would still be clear to him.”
Founder: “Oh yeah … okay … so then the loss will be how much?”
Accountant: “You’re really dumb or something … when it comes to over 200 grand and one hundred sweeps, just over 100 grand … maybe that’s logical, isn’t it?”
Founder: “Maybe for you. I have other worries than those stupid numbers. But yeah … so do it. Loss just over 100 grand will hopefully do.”

The founders of technology companies cannot be expected to be masters of legal and accounting stuff and it is quite logical that after the founding of a company they devote all their efforts to the business itself and they do not have time for these “bureaucratic matters”. The legal, accounting and tax history can then be cleaned up. It usually only costs some effort and a some money.

But if the founder has some personality defect, has no vision and ambition, lives outside of reality or his product targets a non-existent market, nothing can be done about that. No investment can cure that. The worst thing is when, in the context of due diligence, we find that the founder has consciously concealed something. Then we lose trust and trust is everything. You cannot restore that with a discount.

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