Due Diligence for VC and PE- India Venture Capital Association

Due Diligence for VC and PE investing Indian Venture Capital Association,New Delhi,IndiaDisclaimerThese materials and information contained herein are provided by Deloitte Touche Tohmatsu and are intended to provide general information on a particular subject or subjects and are not an exhaustive treatment of such subject(s).Accordingly,the information in these materials is not intended to be relied upon as the sole basis for any decision which may affect you or your business.Before making any decision or taking any action that might affect your personal finances or business,you should consult a qualified professional adviser.These materials and the information contained therein are provided as is,and Deloitte Touche Tohmatsu makes no express or implied representation or warranties regarding these materials or the information contained therein.Without limiting the foregoing,Deloitte Touche Tohmatsu does not warrant that the materials or the information contained therein will be 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firms,and their respective subsidiaries and affiliates.Deloitte Touche Tohmatsu is an organisation of member firms around the world devoted to excellence in providing professional services and advice,focused on client service through a global strategy executed locally in nearly 140 countries.With access to deep intellectual capital of approximately 165,000 people worldwide,Deloitte delivers services in four professional areas audit,tax,consulting and financial advisory services and serves more than one-half of the worlds largest companies,as well as large national enterprises,public institutions,locally imported clients and successful,fast-growing global growth companies.Services are not provided by the Deloitte Touche Tohmatsu Verein,and,for regulatory and other reasons,certain member firms do not provide services in all four professional areas.As a Swiss Verein(association),neither Deloitte Touche Tohmatsu nor any of its member firms has any liability for each others acts or omissions.Each of the member firms is a separate and independent legal entity operating under the“Deloitte”,“Deloitte&Touche”,“Deloitte Touche Tohmatsu”,or related names.2ObjectiveTaking the audience through the step by step process of a Private Equity(PE)and Venture Capital(VC)deal in all stages starting from considering to invest stage to exit stage with focus on due diligence.3Due Diligence for VC and PE InvestingAgenda for discussionPrivate Equity-RecapStages of a Private Equity dealFocus on Due DiligenceKey takeaways4Private Equity recapPE and Venture Capital(VC)firms usually raise capital from theirLimited Partners(LPs)and invest in Yet-to-be-formed companies,Newly formed companies,Private companies not listed on stock exchanges,and Public companies that are listed on stock exchanges.VC/PE firms charge their LPs a percentage as management fees for the assets under management and retain an additional percentage of profit from the initial investment provided by their LPs.5Stages of a PE deal6Due Diligence for VC and PE InvestingDeal EvaluationConsideringtoInvest&Target IdentificationStage IStage IIStage IIIStage IVStage VStage VIStage VIIStage VIIIValuation&NegotiationDeal Approval&TermsheetDue DiligenceReviewDeal ClosureManaging the InvestmentExiting the investmentStage I:Considering to invest&target identificationA PE firm can explore opportunities either by approaching interested parties or being approached by themInvestment criterion based on a number of parameters such as:Sector:PE firms may have a list of sectors they invest in as specified by mandate with their LPs.Investment sizeLocation Stage of growth(mature Vs start up)7Due Diligence for VC and PE InvestingPrivate equity(PE)investors are now diverting their attention to sectors such as energy,telecom,infrastructure,education,media and entertainment as these sectors are largely dependent on the domestic market and not foreign countries.Sectors where maximum activity is expected in the next 6 monthsSource:Deloitte PE Confidence Survey June 200810%Media6%IT&Telecom7%Infrastructure23%Education6%Pharma/Biotech12%Consumer/Retail11%Real Estate/Construction 7%Engineering&Manufacturing 9%9%Financial ServicesPower/Energy/Mining 8Due Diligence for VC and PE InvestingStage I:Considering to invest&target identificationTimeRevenuePrototypeRoll-outGrowthMaturityExpansionEarly stage financingSeed Start-up First stageSecond stage financingFoundersThird stage financingMezzaninePIPEAcquisition financeExitInception9Due Diligence for VC and PE InvestingAs per Deloittes PE Confidence Survey 2008,PE players are increasingly differentiating on a number of parameters and these differentiators are undergoing a radical change in terms of relative weightage in the portfolio.Stage I:Considering to invest&target identification35%22%22%14%16%11%11%8%14%19%11%22%16%8%5%5%Market regulationHigh ValuationsHigh levels of competitionOpaque tax rulesQuality of investee managementRecognition of private equity benefitsPolitical stabilityInfrastructure bottlenecksEconomic downturnShortage of SellersInsufficient capital in the marketHigh cost of basesInvestor herd mentalityInadequate corporate governanceOthersh2 2007h1 2008Source:Deloitte PE Confidence Survey 20088%8%5%5%25%Stage II:Deal evaluation10Due Diligence for VC and PE InvestingIdentified targetsMove to Stage IIStage of GrowthInvestment SizeSector11Due Diligence for VC and PE InvestingDeal evaluationBusiness Plan(BP)/Information Memorandum(IM)Stage II:Deal evaluation12Due Diligence for VC and PE InvestingStage II:Deal evaluationBusiness plan/Information memorandum It is the document that details your business history,current standing and future plans.It is a basic management tool that helps guide the future direction of your company and a mandatory document if you plan to seek business financing.It provides a considered and logical framework to set out a businesss short term and long term plans,shows how these plans can be achieved,and demonstrates that the plan addresses the requirements of the target audience.13Due Diligence for VC and PE InvestingStage II:Deal evaluationBusiness planInternal Uses Planning business growth Monitoring and managing performance Keeping operations aligned Allowing benchmarks to be set Committing the management team to common goals Anticipating changes in a structured wayExternal Uses Bank Financing and Investment Funds Strategic Alliances Mergers and AcquisitionsKey sectionsExecutive Summary,The Business and Strategy,The Product/Service,The Management and Organisation,The Market and Competitors,Marketing and Sales,Financial Information,andAppendices Other sections may include:Risks/Contingency Plan,Design/Product Development Plan,Legal/Regulatory Compliance etc14Due Diligence for VC and PE InvestingStage II:Deal evaluationBusiness plan/Information memorandum 15Due Diligence for VC and PE InvestingStage II:Deal evaluationBusiness plan/Information memorandum In sum,a Business Plan quantifies an entrepreneurs vision in a realistic way right from the macro to the micro level.Each projection is backed with hard numbers and valid assumptions.An Information Memorandum on the other hand,gives a snapshot and qualitative feel of the opportunity envisioned and invites an investor to have a look at the numbers behind the vision.Underestimating the strength of ones competitors,Not clearly explaining the opportunity,Unrealistic and simplistic projections,Overstated managements strengths,Miscalculation of market size and achievable market share,Disorganised,unfocused or even poor presentation,Lack of risk assessment and contingency planning,andDeficient description of a viable exit strategy.16Due Diligence for VC and PE InvestingStage II:Deal evaluationPitfalls to avoid 17Due Diligence for VC and PE InvestingStage II:Deal evaluationAn investors preference spectrumMany investors will focus on specific attributes to screen the idea!Revenue streamMarket protectionCompetitive advantageIntangible models“First-Mover”No other competitorsTransaction feeBrand EquityLower Cost OperationsProduct SalesHigh Switching CostsUnique operationalProcesses or technologyLeast attractiveMost attractiveSource:GE 393 RLP-Business Plan Workshop for Technology EntrepreneursStage III:Valuation&Negotiation18Due Diligence for VC and PE Investing Valuation Basics Valuation Methodologies The Venture Capital Way Value Drivers Investment Case Modeling Negotiation in PE Parameters that are NegotiatedStage III:Valuation Basics19Due Diligence for VC and PE InvestingTimeRevenues/EarningsStart-up or Idea CompaniesRapid ExpansionHigh GrowthMature GrowthDeclineRevenue/Current OperationsOperating HistoryComparable FirmsSource of ValueNon-existent or low revenue/negative operating incomeRevenue increasing/Income still low or negative Revenue in high growth/Operating income also growingRevenue growth slows/Operating income still growingRevenue and operating income growth dropNoneVery limitedSome operating historyOperating history can be used in valuationSubstantial operating historyNoneSome,but in same stage of growthMore comparables,at different stagesLarge number of comparables,at different stagesDeclining number of comparables,mostly matureEntirely future growthMostly future growthPortion from existing assets/Growth still dominatesMore from existing assets than growthEntirely from existing assetsEarningsRevenuesStage III:ValuationBasics Why?20Due Diligence for VC and PE InvestingPurposes of valuationFunding(VC/PE)AcquiringMergingRestructuringBuying You need to know the value of asset under consideration Maximizing Shareholders wealth Investment principle Financing principle Dividend principle.an assetStage III:ValuationToolsUnderlying Asset Approach Book value basedReplacement cost basedLiquidation valueIncome Approach Past earnings basedFuture earnings basedRelative ApproachMarket multiplesTransaction multiplesContingent Claim Approach21Due Diligence for VC and PE InvestingStage III:Valuation PE/VC Valuation methodPE/VCs primarily use multiples(Relative Valuation)methodValuation linked to exit horizon Discount rateStaged investment22Due Diligence for VC and PE InvestingEntrepreneurs valuation Business value:Cash flows over explicit 10 year forecast+Continuity value.Take into account high growth and stable growth period Suitable for entrepreneur who does not plan to exit in 10 years Discounting using long term capital structure and WACCPE valuation Deal value:Present value of investment realisation on exit less investment made in Yr 0.Does not take into account stable growth period.Exit when the business is set to capitalise on its growth potential.Valuation horizon:Exit time frame Higher discount rate reflects high riskStage III:Valuation In sum23Due Diligence for VC and PE InvestingStake DilutionFund RequirementValuationKey Concerns of Investee and InvestorThough the value of a business can be objectively determined employing valuation approaches,this value is still subjective,dependent on the Investees and Investors expectations and subsequent negotiations.24Due Diligence for VC and PE InvestingInvestment caseWhat is an investment case?Perhaps you areproposing a large project to senior management,getting approval from finance,or working through a corporate funding process,or proposing new funding for your start-up venture.Either way,youll need a clear investment case,and Defensible revenue and expense projections.25Due Diligence for VC and PE InvestingInvestment plan documents need to address the key issues succinctly.Clarify decision-maker interests early in the process.Clarify roles Be strategic when approaching standard processes.Building truly useful financial models is truly as much art as science.Investment case When designing the revenue or expensemodels for an investment case,weconsider the following:Make the model as readable as it is accurate.Identify the main drivers early on.Base all assumptions on defensible present-day data.Option valuation can be an invaluable tool to realistically evaluate some projects.26Due Diligence for VC and PE InvestingInvestment case definition27Due Diligence for VC and PE InvestingTypical items incorporated in an investment case summaryElementFunding Stage Purpose of fundingCurrent and other proposed funding routes Key shareholdings Company description Tangible assets Intangible assets(inc IPR)Market size and growth Market driversSpeed of market change Key risk elements Downside potential(break up asset value)Cost base Break even Forecast EBIT period end Dividend policy Speed of market change Global potential Seasonality,long term cycles Pricing/market profitability Management team Extent of project development Business model Business strategy Competitive advantage Main competitors Barriers to entry Key performance indicators Valuation at period end Investment sought Interest cover Gearing Equity share offered Exit potential IRR/NPV Investment case modellingInvestment Decisions-Making the best decision calls for an easily understandable case that captures all the costs and all the business benefits,including those that are hard to measure in financial termsBusiness Case Solution for investment decisions includes:Complete case building project managementCase-building project planning and industry analysisSelection of the case-building teamRecruitment and management of a Business Case Advisory GroupEasily understood and comprehensive cost modelSolid and complete benefits rationale,validated by stakeholders and managementComplete cash flow statement projections Financial metrics,including return on investment(ROI),net present value,etc.Rigorous risk and sensitivity analysis Confidence interval estimates for net cash flow and other financial metricsImportant contingencies that must be managed to target levels Major risk factors and their probabilitiesRecommendations and conclusions Comprehensive business case report,summarizing and interpreting the above analysis28Due Diligence for VC and PE InvestingFirst step in developing the model Estimate the costs and benefits of the project,combining the project budget and sales volume ForecastsGuidelines for constructing the base case:Model should be kept simple and direct.All assumptions should be made carefully.Assumptions about the costs of development,marketing,production etc.need to be as accurate as possible.Change the assumptions at any time throughout the modeling,depending upon the results achieved.Modelling is a team exercise and it is essential that all the people involved in the construction of the model understand both the variables and the assumptions that are being used.All the necessary information should be sourced from the people responsible for that particular business activity.Maximum possible input from the management will improve the accuracy of the numbers,which in turn will validate the assumptions.29Due Diligence for VC and PE InvestingInvestment case modellingStage III:Negotiation-Parameters30Due Diligence for VC and PE InvestingDealNegotiationDeal structure/termsValuationOther parametersStage III:Negotiation Deal structure parametersType of security Liquidation preference,conversion,automatic conversion redemptionVoting rights,board/observer rightsChange-of-control,transfer-of-control clausesOwnership,capitalisation tablePosition in Capital StructureAbility to Stage CommitmentsRestriction on asset salesAnti-dilution protection31Due Diligence for VC and PE InvestingCommon Deal StructuresMergers&AcquisitionsInbound(Overseas company acquiring an Indian company):Cash,Cash&Stock,EarnoutsOutbound(Indian company acquiring companies overseas):Mostly cash/Adjustments/earn-outsWithin the Country:Cash,Cash+Stock,Stock,earnoutsPrivate Equity/Venture CapitalStockConvertible PreferredConvertible DebentureWarrants32Due Diligence for VC and PE InvestingStage III:Negotiation Deal structure parametersStage III:Structuring instrumentsSome of the usual reasons in an Indian context why a foreign investor would prefer an instrument other than equity shares are outlined below.The investor may wish to get a preference on dividend or liquidation or both.Prevailing Indian exchange control laws do not permit foreign equity investment beyond a certain level in certain sectors.The investor may wish to get disproportionate voting rights on its investment in return for the strategic value such investor may bring to the table.Indian corporate and securities laws may place certain restrictions with respect to equity shares which may not suit the commercial understanding between the parties.The investor may seek liquidity in overseas markets and the maximum flexibility in terms of exit options.33Due Diligence for VC and PE InvestingStage IVDue Diligence process34Due Diligence for VC and PE InvestingWhat is Due Diligence?Analyses and validates the financial,commercial,operational,and strategic assumptions underpinning the company through:Historical financials Contractual document provided by the company Publicly available industry and competitor information,and Due diligence is linked to the investors corporate strategyTarget companies should also perform transactional due diligence on the investor35Due Diligence for VC and PE InvestingTypes of Due Diligence Financial and Legal Due Diligence Commercial/Market Due Diligence Intellectual Property Rights Due Diligence Human Resource Due Diligence Information Technology Due DiligenceGoal of due diligence is to determine whether a transaction with a given target is in line with the investors corporate strategyDue Diligence The VC viewpoint!36Due Diligence for VC and PE InvestingThere are two main types of venture capital due diligenceBusiness Due DiligenceA review of the market for the product of the company A background check on the founders and key management team The competition for the company Discussions with key customers of the company An analysis of financial projections for the business A review of any holes in the management teamLegal Due Diligence Legal Due Diligence:Key contracts for the business Employment agreements Minutes and consents of the board of directors and shareholders Confidentiality and invention assignment agreements with employees Corporate charter and bylaws Litigation-related documents Patents and copyrights,and other intellectual property-related documentsReviewing and readying the documents on basis of above points will help expedite closing a deal.Due DiligenceFirst LookInvestment sizeIndustry Rapid sustainable growth,critical mass,exceptional profitsGeographical location of the InvesteeStage of development of the Investee companyActive Interest/ValuationBusiness Model Sustainable competitive advantageCompanys exceptional market position/track record of successVision of the promoterExisting Management Experience,maturity,creativity,commitment,leadership37Due Diligence for VC and PE InvestingScalability of the current businessCurrent and projected revenue and profitability levelInflu