What Investors Look for During Due Diligence
Before getting an investment, a company has to go through Due Diligence. This process involves an investigation into the business affairs of the company for finding out whether it is worthy of investment. Though the due diligence can differ according to the nature and size of the company, there are some common check boxes that every company has to tick.
If you are planning to raise capital, knowing beforehand about what investors look for during due diligence will help you prepare better. So, let’s find out what VCs and private investors are looking for in their next investment.
Incremental Revenue is the additional revenue generated during a time. This time period can be annual, quarterly, or half-yearly. Investors like to see a growing curve of incremental revenue. This is a sign of a healthy business. This means that the company is gaining traction and will be able to generate more revenue in the future. The importance of this factor in your funding will depend largely on the stage of your business. If your business is at a very initial stage, then investors will pay high attention to this factor. This is because it shows that your business idea is working and there is an actual need for your product.
If your business is in the growth stage, investors will look for this to find out how fast you are acquiring market share. This would provide insight into how much of the total market share you will acquire in the future. So, make sure that this is an upward trajectory.
Correlation of Sales and Marketing Expense and Sales
Investors not only want to know how you earn but also how you spend. Ideally, you should earn Rs. 1 for every rupee spent on advertisement. So, the magic number is 1. This ratio provides insight to investors about how well you know your customers, target segments, their pain points, and the gap that your product or service is trying to fill.
If you are an early-stage company, investors may compromise this magic number to be less than but near 1. Still, they would look for a strong correlation between your company’s marketing expenses and sales. If you are in the growth stage, then, 1 is your qualifying number for funding. In the long term, investors expect this number to increase. The sales of the company should be more than Rs. 1 for every rupee spent on advertisement. Investors love it when the growth in your sales is more organic rather than overspending on advertisements.
Gross Profit Margin
During a pitch meeting, most of the founders try to draw the attention of the investors through their revenue, customer reach, active users, repeat orders, etc. No matter how much you impress investors with these flashy numbers but all these numbers would only make sense if your gross profit margin is high. If you are a SaaS company, investors expect your gross margin to be at least around 50%. This not only shows the quality of your revenue generated but also your cash generation capacity. It is your profits that are going to generate cash for your business. If you cannot generate enough cash, most probably, you could go out of business. Investors would not like to invest in such a company.
Now, you can employ different pricing strategies. Some businesses employ a penetration strategy where they keep their margin low just to capture market share. Some businesses employ a skimming pricing strategy where they keep their margin high and sell their products to elite customers initially.
So, if you are going by penetration strategy and compromising your margin for high sales volume, two things are going to justify this for investors. First, how big is the market that you are targeting, and how big your company can become in that market? Second, After acquiring a considerable market share, will your company enjoy pricing power in the future. If the answer to these two questions is decent, then the investors would be willing to compromise for a low gross margin.
Now, even the skimming pricing strategy has its own risk. Though, the customers are willing to pay a premium price, how long are they willing to pay it? Once, your innovative product is in the market, others will try to copy it or could launch a better version of your product. Investors would like to invest in a company that can sustain its gross profit margin in the long run.
Balance Sheet Review
The Balance Sheet shows the overall fate of your company. Investors analyze the Balance Sheets to track how money is allocated to different asset classes and most importantly, your current capital structure. In this review, a series of balance sheet ratios are analyzed like debt-equity ratio, asset turnover ratio, current ratio, cash conversion cycle, working capital turnover ratio, and so on.
All these ratios combined will point out one thing i.e. Company’s survival. Let’s understand how investors interconnect these ratios. Firstly, the debt-equity ratio will tell investors how much debt is there in your capital structure as compared to equity. This would point out how much money you are going to need anyhow to pay interest. Now, be it equity or debt, investors would want to know how well are you using this money. This can be found in the asset turnover ratio. The capital that you brought into the company has been used to purchase assets that will generate income for your company. So, how well your assets are used to generate revenue is measured by Asset Turnover Ratio. Now, a normal logic would be that this ratio should be more than 1. After all, every rupee in the asset should generate a rupee of sales. But, this is not always ideal as it depends on the nature of the industry. For a capital-intensive business, this ratio is generally less than 1. Investors compare this with the industry average to find out if your asset turnover is justified. For a retail business, this ratio is generally expected to be more than 2 as companies are required to keep fewer assets.
While calculating the above ratio, total assets were used. This included both fixed assets as well as current assets. Now, the investors want to find out how liquid is your balance sheet. Investors evaluate liquidity with at least a perspective of the coming two years. This means your company has enough capability to generate cash for at least the next 2 years. This liquidity can be measured from the Current ratio which is Current Assets divided by Current liabilities. So, after finding out that your Balance Sheet contains some liquidity, investors would like to measure how well you use this liquidity to generate sales. This can be measured by the Working Capital Turnover Ratio.
This ratio shows how well the company can manage its day-to-day operations to generate sales. Again, investors use the industry average as a benchmark while analyzing this ratio. Working capital basically covers three aspects viz. Debtors, creditors, and inventory. If the company has low debtor days, high creditor days, and low inventory days, the company is safe from a cash crunch.
So, overall if investors read all these ratios together, they would find out how you allocate your cash and how well you make cash.
Management and Overall Team
So far, we have discussed a lot of financial metrics. When investors bet their money on a company, they not only just look at numbers but also the people behind those numbers. For any company having experienced management and a good team is a must. Investors generally read the profile of the management to find out their experience in a particular field. Also, they evaluate the capital allocation decisions of the CEO of the company. Capital Allocation tells about the business acumen of the CEO. Whether he reinvests, acquires products, launches new products or the founders withdraw the money. The top management of the company is the people who have the highest information about the company. So, investors monitor their past actions to draw the overall scope of the company.
The Next most important evaluation is the Teams of the company. In this, the investors evaluate whether each team is working efficiently and is there a need to downsize the company. The Investors also look at the attrition rate, especially if you are a tech company. A high attrition rate would lead to increased costs and also points out that there is something fundamentally wrong with the working of the company.
Whenever an investor is looking to fund a company, it craves for next Google or Amazon. Something that has the capacity to solve a bigger problem. This can be analyzed through the business model of the company. The Kirana store near your house and Dmart, both sell groceries but both have way different business models. This is the difference that a business model creates. Sometimes the product or service may not be unique but the business model is what proves to be a competitive advantage for a company. Investors like business models that have low operating cycles, which include expanding distribution networks and that create a brand.
Competition in Industry
‘Never stop learning from your competitors’. Investors take this quote seriously. The Competitors in the industry provide a rough idea about the scope of success in that particular industry. Investors refrain from the markets that are highly saturated or if there are many substitutes and no pricing power in the industry. These all can be analyzed by looking at the competitors that provide an idea of how big a company can become. They also analyze what competitive advantage you hold against your competitors and how are you going to acquire market share from the existing players. Investors also analyze what problem you address in the market that would make people shift towards your product.
We have recently viewed many examples in the stock market about how deceiving the valuation of a company can be. Many new-age internet startups got listed at a very high valuation and soon, their stock prices fell tremendously. So, valuation is highly subjective. The results which are ascertained from the above due diligence are used to confirm the valuation that you quote. If your business works on an asset-light model, then the investors could use an income-based approach. This means that they would value business according to the future business income and projected cash flows. If your business is at a very early stage, then, the investors may go for a market-based approach. This means that they will value your business according to other similar businesses in the industry.
Entrepreneurs face many types of risks in the business. Investors keep a close eye on all such business risks and consider this even during business valuation. While the financial risks get identified from the Balance Sheet, some other business risks are hard to put in a box. These risks include competitive risks, market risks, legal risks, political and economic risks, etc. So, having a plan or having a risk mitigation strategy adds a plus for investors. Investors often go through the footnote of the Balance Sheet to identify contingent liabilities that may arise in the future. While preparing a budget, you should take into account these risks to present a more realistic plan before investors.
So, due diligence is a comprehensive process. Investors also consult with industry experts to understand the dynamics of a particular industry. As an entrepreneur, you should consider the above-discussed factors so that the company’s due diligence tells a compelling story.