DUE DILIGENCE

Due diligence is an absolutely necessary step in the investment process. As investors we usually base our initial impressions of a deal on how it is presented. During the due diligence process we check the facts to test our initial assumptions.

The following list of questions can help you frame your inquiry. This is a long list, a detailed list; but, you will find, it seems, never long enough. As you encounter unforeseen traps and blind alleys in your deal making you will add considerably to the list of facts you will want to know before money leaves your pocket.

Use only those questions that seem appropriate as you explore each of the primary areas of management, personnel, marketing, production and finances. The degree of detail you examine in each unit will depend on the stage of development of the business, how much you know about the industry, how well you know the entrepreneur, and many other factors. If the research goes well, a pattern will emerge confirming your preliminary judgment. If not, you will thank yourself for avoiding likely future problems.

Asking questions, how you ask and whom you ask, is a science in and of itself. Use references and source material the entrepreneur provides, then go further to find confirming data. The key is getting unguarded, unvarnished, non-vested input from a variety of people who have experience, from different vantage points, with the principals, the market, the products, etc. For instance, a visit with a past employee or co-worker of the entrepreneur, when both were in a previous company, can often provide a useful perspective.

Many of the following questions assume that the business enterprise has been around long enough to build some kind of track record. In seed investments, however, many of these questions are unanswerable. Nonetheless, this gives you a template to follow.

MANAGEMENT

Most venture capitalists say people are the most important part of any good investment. "Good management" are the watchwords of investors. But whether management is "good" hinges on performance. That is, if the management team has made lots of money for the venture capitalists, then they are considered "good management." What is it that makes a venture capitalist believe a management team will succeed and therefore be good? What makes a good entrepreneur? Well, a billion pages have been written on these subjects in every type of publication imaginable, from psychology journals to popular self-help magazines. Judging people will be one of your most difficult tasks. Here are some questions to help you start thinking about the key people.

A. Chief Executive Officer

1. What achievements has the chief executive had in prior business? In personal affairs? In general? What makes you think the CEO will achieve the established goals in this business venture?

2. What other business ventures has this entrepreneur been in? How successful were they? Why were they unsuccessful?

3. What is the style of leadership of the chief executive? Will that style be effective in this business?

4. How does this person perceive his or her role relative to other members of the management team? Is the emphasis on one individual or on the team effort?

5. How well does the chief executive understand the details of this business? Is the entrepreneur a detail-oriented or a concept person?

6. Does the CEO know the details of the day-to-day operations of the business?

7. Is the CEO knowledgeable about all parts of his business - marketing, production, finance, etc.?

8. To what extent does the CEO rely on subordinates or other managers to analyze business operations?

9. Does the chief executive take a lead role in the company's planning efforts or rely on others to do the planning?

10. Is the chief executive innovative in dealing with existing or potential problems?

11. Characterize the CEO in terms of behavior, attitude, and approach to life? What behavior traits does the CEO have?

12. Is the CEO honest?

13. Does the entrepreneur have integrity?

14. Is the CEO knowledgeable about the industry?

15. What is the reputation of the CEO in the company, in the community, and in the industry?

16. What is the net worth of the CEO? Is he or she wealthy outside this business?

17. What is the age of the entrepreneur? Does he have the energy to run a small business?

18. What is the health of the CEO? Is the CEO insurable?

19. What kind of home life does the CEO have? Is it stable? How will it effect his ability to run the business?

20. What does the CEO want to make in capital gains from this business? How much in salary?

21. There can be only one final decision‑maker in any company; is this CEO the final decision‑maker? Is the CEO in control of the decision‑making process?

22. Is there a natural successor for the chief executive? Would the company be able to function smoothly without the CEO?

23. Does this entrepreneur need to achieve?

24. Is the CEO competitive?

25. What achievements are in the CEO's background?

26. Does the CEO have a high energy level?

27. Does this CEO give you straight answers to questions?

28. Does this CEO have a need for autonomy?

29. Does the entrepreneur seek independence?

30. Does the CEO need to dominate every situation?

31. Is the entrepreneur self‑confident?

32. Is the CEO persuasive?

33. Does the CEO have a high tolerance for ambiguity?

34. Does the CEO change?

35. Is the CEO able to perceive risk well?

36. Does the CEO take excessive risk?

37. Does the CEO have good verbal ability?

38. Does the CEO have a good personality? Is the CEO easy to get along with or a difficult person to live with?

39. Is the CEO a leader or manager?

40. Does the CEO have a broad and deep knowledge of the industry or the market?

B. Number Two and Three in Management

1. Would the people in second or third command be able to fill the shoes of the CEO if the CEO should die or be disabled? Why do you believe this?

2. Are there any disagreements between the top executives? What kind of friction exists between them? Can they work as a team?

3. What are the backgrounds or the second- and third-level executives? How do they fit together as a team? Do their backgrounds complement each other? Does each have a specialty?

4. Ask the same questions of other key people as you did for the CEO above.

C. Management as a Team

1. Obtain an organization chart and job description indicating present management areas of responsibility.

2. How does management experience in the past and the responsibilities of each person in the team compare with present job requirements? How does salary level compare?

3. Are there any gaps in the present management structure? What are the company's plans for remedying these deficiencies? Should they be remedied before an investment is made?

4. Why do you think this team of managers will be successful? Have they worked together in the past?

5. What percentage of ownership or potential ownership does each member of the management team have? What was the amount of his cash payment for shares held? How significant is each person's investment position in the company relative to his overall financial resources?

6. Are there any loans to or from management or key stockholders?

7. Does the company have the right to repurchase shares held by employees if they leave or are fired? For how long does this right continue? Can the company repurchase share at cost?

8. What are the present salary levels of management?

9. Are there any kinds of incentive compensation?

10. Is there any employment contracts?

11. Have key employees signed non-compete agreements?

12. Is there presently any litigation or other potential liability resulting from management's previous relationship with another company?

13. What changes have there been in the management group in the last three years?

14. How is coordination between members of the management team achieved?

15. How do other members of management feel about the chief executives and their leadership style?

16. Does the company have a management development program?

17. How often is performance by members of the management team reviewed? By whom?

18. Is there a strong team spirit in top management? Is there esprit de corps?

19. Is there a strong work ethic? Do they work long hours?

D. Organizational Structure and Decision‑making

1. Who exercises the principal authority?

2. What are the relative powers of the president, chairman of the board, vice president of marketing, etc.?

3. Are there any functioning committees? What functions do they perform? Who sits on them? How often do they meet? What records are kept?

4. Who are the members of the board of directors? What recent changes have there been in board membership? What are their backgrounds and qualification? What compensation do they receive? What actual or potential stock ownership positions do they have?

5. Who are the people on the board of directors? What role do they play in the company? Do they attend board meetings?

6. What is the relationship between management and the board of directors?

7. What role do investors now play in the company?

8. What is management's attitude regarding the function of the board and the investors?

9. What other outside interests influence management's decision‑making?

10. What are the individual duties, responsibilities, and authorities of each member of the management group? Who defines these? Do written job descriptions exist?

11. Are the basic rules of good organization being adhered to, such as delegation of authority, defined authority limits, defined responsibility limits, simple and flexible organization, separation of line functions, and staff functions?

12. Are successful and proven management personnel available to carry out plans, or does everything depend on one or two key persons? What happens if a key employee is not available for an extended period?

13. Is there a blend of youth and experience, or are most employees the same age and do they have the same experience?

14. Are there cohesive lines of authority and communication? Do all parts of the unit work closely together? Is there an integrated approach to all major problems?

15. Does any one individual excessively dominate operations and planning?

16. Have development plans been established for key managers and high potential employees?

17. What is the strategy for filling key positions? Can internal development alone meet the requirements or will inter-company transfer or outside hiring be required? Are outside consultants used? What has been the company's past experience?

18. Are local laws prohibiting discriminatory hiring and advancement practices being complied with?

19. Is the compensation plan being administered so as to attract and retain top-quality personnel? Are salary levels competitive with industry norms?