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CTAN Due Diligence Guide

Appendix A (Deal Screen Worksheet) Appendix B (Due Diligence Red Flags Worksheet) Appendix C (List of Potential Information Requests) Appendix D (Due Diligence Outline)

OVERVIEW

A great way to start a heated debate in an angel investment group is to ask “how well do we do due diligence?” Aside from the politically safe response of “we can always do better,” there are no easy answers in this critical task of assessing, investigating and evaluating investment opportunities. Hindsight can make the answers appear simple: successful investments had enough due diligence, while failures missed key issues. Unfortunately, it is never simple before an investment is made. Particularly in a cautious investment climate, potential investors can squander the most precious resource—time—by stretching the diligence processes well beyond reason. Fear of potential risks can drive investors to near endless questions and long checklists, but are those substitutes for quality? And, how do creating file boxes of documents help either the investor or the entrepreneur when so much rests on the assumptions about the future? Or to put it another way, “Don’t forget the difference between precision and accuracy.” As teams of industry experts and business leaders, angel networks can be a welcome friend to entrepreneurs by doing effective and efficient due diligence. CTAN’s strength lies in applying practical, operational experience. Our weakness, however, lies in having no full-time resources to investigate and monitor investments. This document outlines a framework to pursue a balance of sufficient quantity with high quality. Remember, the diligence process never ends. There is a visible and necessary process around the time of investment, but periodic updates, investigations and interactions also help avoid future problems as well as take advantage of emerging opportunities. Process Due diligence has both informal and formal processes. The informal often occur before an investment opportunity receives official consideration and after the investment has been made. These include how the company and CTAN were introduced, feedback that led to the company receiving formal investment consideration, and reactions and specific comments of each CTAN member. There often is valuable information and perspective across these processes, so we have found the following tools useful in managing the process: • Angelsoft. This relational database helps track and maintain a record of details and comments concerning CTAN deals.

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CTAN Due Diligence Guide

• Obtain a Champion. Filtering deals also in and of itself is part of the diligence. Within CTAN, a potential investment needs to have a champion, a lead angel. If there’s not one up front, we assign one through the deal flow process (see below). If we cannot find one, it may be a sign that our angel group is not a good fit with the company seeking investment. • Record Notes During Discussions. Designate an angel group member or staff person to record comments during the evaluation and screening process. These notes identify the concerns for subsequent formal diligence and may elucidate key insights. • Evaluation Sheets. Creating a rubric for scoring companies with room for comments gives angels a way to express observations and share expertise. They also create a quantitative metric for making comparisons between or across companies. See the CTAN example in Appendix A. For the formal process, CTAN selects a leader who will be responsible for coordinating the diligence—and for refereeing the process in cases of disagreement either among the angels or with the entrepreneur. Remember that individuals with great market or otherwise relevant knowledge will speed diligence and be more respected by references, other investment group members, coinvestors and the entrepreneurs. The diligence process often serves to sell the deal. Having highly experienced and engaged individuals working closely with the company can give your group a competitive advantage against other potential investors and/or greater ability to negotiate favorable terms. The decades of experience and industry insight from experienced angel investors can help foster mutual respect and a strong working relationship. CTAN also encourages entrepreneurs to do their own due diligence on the investor group and will provide references when appropriate. This kind of reciprocity helps develop a relationship with the investors and provides independent views on the best ways to work together. Finally, before launching into the formal diligence progress, CTAN will establish shared goals with the entrepreneur. We recommend highlighting the major areas of focus in advance, outlining what diligence materials will be requested (See Appendix C), and setting dates for accomplishing each step. Due Diligence Areas There are many checklists for conducting due diligence (See Appendix D), but each tends to boil down to five or six areas of risk: 1) People on the management team 2) Product or service offered 3) Market 4) Competitors current and future 5) Financial requirements and return

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CTAN Due Diligence Guide

6) An additional occasional risk is the role of governmental regulations or similar industry standards that could impede the venture or foster competition.

Before you begin investigating these areas, CTAN recommends that each investor look for potential red flags (See Appendix B). People. A common phrase among early-stage investors is “we invest in people.” One might respond, “That’s probably because it’s all you have right now!” Without a finished product, clear market, known competitor or tested financials, there is not much else to investigate. If you have limited time and can only focus on one area of due diligence, this would be it! The future of the venture rests on the management team, and this process not only tests their abilities, it also serves to identify opportunities for the members of CTAN to provide assistance and coaching to help the venture succeed. While checking references, conducting background checks, interviewing past employees and employers all give insights into the management team’s strengths and weaknesses, we also recommend trusting your instincts. CTAN members’ own affinity for the team can often judge the potential for success. A statement like “I like these people, they remind me of when I was starting my first venture” from an investor who has been a successful entrepreneur is often a good sign; get 10 people to say that and you likely have identified the next generation of industry leaders. Product/Service. “Does it actually work?” may be a tough question for an early-stage venture, particularly one on the cutting edge of technology. We have seen many new companies, particularly in biotech and materials science but also in software and telecommunications, give great promises only to discover later that surprises lay in completing or scaling the product or service. If your organization lacks people who have tried similar or analogous things before, this is likely a time for syndicating the investment. Finding people with complementary technical or market skills can help make the investment decision and can provide assistance to the company in years to come. Market. Are customers ready to buy? Who are they and how do they purchase this type of product or service? Answers to these questions not only will help you make your investment decision and but also help the company refine its sales strategy. Knowing the market size and the industry dynamics also are critical elements for estimating the company’s prospects. Competition. This is perhaps the great unknown, particularly for early-stage ventures. Current competitors may be small and hard to identify; others may not have yet emerged in the market. Truly innovative technologies may have no immediately apparent competitors, but customers always have alternate ways of spending their money. Understanding customer alternatives (even if the customer’s choice is to simply “do nothing”) is key to helping the company hone its value proposition. Having a large network of investors with industry experience gives CTAN a competitive advantage

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here. You may already know who could be a future threat, and you may already understand the mindset of the potential customers. Brainstorm among the group to create lists of companies, organizations or people who could be competitor. This same list may also elucidate business development and recruiting opportunities, so view the exercise as one for both risk management and opportunity creation. Financial. In addition to reviewing financial projections, consider the consequences of the overall capital requirements for risk in cases of both success and failure. Model the capital table through the company’s likely stages of investment to exit. This will help you address how much money you will need in reserve during the life of the investment and how you will make money. Some angel investors view acquiring a large venture capital round as a sign of success, but having that as part of the financial plan may create the risk of diluted ownership and lower returns. Of course, one of the largest risks is running out of cash or going out of business after a large investment. Documentation. After assessing each of these risks, we recommend compiling the comments into a written report. Doing so takes more time and effort than just giving a verbal presentation at the next angel group meeting, but it also forces review of each of the above areas and whether they have been considered adequately. Including quotations from members and sources also gives color commentary that helps other investors get a better perspective than just providing a list of data. Verbally reviewing the key findings with the company’s management team can also help created shared expectations or illustrate key differences. Be careful not to provide a written copy of the report that should have been confidential or allowing management team members to focus overly on particular points relevant to them personally. After the Investment The due diligence process is like dating and an engagement; you are evaluating each other and seeing if you want to tie the knot. After the wedding, however, it is hard to get divorced. Rather than wake up one day and realize you no longer know your business partner—or have found they have been running with what you view is the wrong crowd—regular check-ins help maintain the relationship and strengthen both parties. Look around the market. Designate several official advisors to the company, who periodically go on sales calls. Interview and meet with members of the management team other than the CEO, while still respecting their leadership role. Ask your industry contacts about the company and its reputation. In Conclusion These are some of many steps. Pick the ones most appropriate to a particular venture, mark them on your to-do list, and report back to the rest of CTAN because other members may have suggestions and insights that could also help the opportunity.

Appendix A

CONFIDENTIAL

Deal Screen Worksheet

Company Team Product / Service

Market Financials Total Vote to Present

Key Concerns

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Yes No

Appendix B-1

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CTAN Due Diligence Guide

DUE DILIGENCE RED FLAGS WORKSHEET

Company Name:

Entrepreneurs Involved:

Presentation Date:

QUESTION: CIRCLE ONE NOTES

1. Have the founders invested their own money?

Yes No

2. Are there numerous inexperienced small investors (i.e. friends and family)?

Yes No

3. Does the company have only one product or a single-application technology that would limit the available market?

Yes No

4. Are there claims of “no competition”?

Yes No

5. Would any potential funds be used to cash out earlier investors or pay liabilities?

Yes No

Appendix B-2

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CTAN Due Diligence Guide

6. Does prior financing have greater protection and/or more favorable terms?

Yes No

7. Is there a history of failure by the management team?

Yes No

8. Is this a family business where nepotism and family drama may create unfavorable dynamics?

Yes No

9. Are multiple licenses required for practicing technology that may limit margins due to license fees or even threaten patent infringement?

Yes No

10. Is the company carrying a disproportionate amount of debt that may signal poor financial management skills, or an unfavorable sign about the company’s worth?

Yes No

11. Are key assumptions missing in the company’s financials?

Yes No

Appendix B-3

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CTAN Due Diligence Guide

12. Is there a board of advisors and/or directors that provides external participation?

Yes No

13. Does the entrepreneur want total control?

Yes No

14. Is there an unrealistic valuation of the company that is unlikely to be resolved?

Yes No

15. Are there any other concerns you may have about the entrepreneur, the company, the market, etc?

Yes No

TOTAL

Yes No Circle interest in investing: Highly Likely Likely Undecided Unlikely Highly Unlikely

Appendix C-1

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CTAN Due Diligence Guide

LIST OF POTENTIAL INFORMATION REQUESTS

Below is a checklist of the extensive amount of information that entrepreneurs may be expected to generate prior to the authorization of funding. Additional documentation may be required, but the following should offer a starting point: 1. Corporate Documents:

Articles of Incorporation

Bylaws and operating agreements

Shareholder agreements

Minutes of Board of Directors and Shareholder meetings

All documents furnished to shareholders and directors, to include newsletters

Certificates from all states and jurisdictions where the company does business 2. Previous Securities Issuance:

Copies of stock certificates, warrants and option agreements

Complete Stockholder contact information

Number of outstanding shares, dates of issuance, and percent ownership

All outstanding preferred stock, including covenants

All outstanding options, warrants or convertible securities

Employee stock benefit programs; stock options, stock purchases or others 3. Contracts and Agreements:

List of Bank and non-Bank lenders

Joint venture and partnership agreements

License and purchase agreements

Liens, equipment leases, mortgages or any other outstanding loans

Insurance contracts and agreements

Contracts with suppliers, vendors and customers

Any additional agreements or contracts of relevance (confidentiality, consulting, etc)

4. Financial Information:

Audited financial statements since inception

Income statements, balance sheets, cash flow statements

Records of all changes in equity position

Accounting methods and practices

Company prepared monthly or quarterly statements

A three year budget and financial projections

A complete and current business plan

Accounts receivable aging and accounts payable aging

Product or service pricing plans and policies

Revenue and gross margins by product or service

Appendix C-2

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CTAN Due Diligence Guide

Extraordinary income or expense details

Explanation of any material write-downs or write-offs

A summary of all bad debt experiences

Details of any outstanding contingent liabilities

Accountant report on the company's financial condition 5. Tax Status:

Federal and state income tax returns for the last three years and details of any tax audits

6. Governmental Regulations:

Copies of all permits and licenses

Copies of reports made to government agencies

Detail of any inquiries made by any local, state or federal agencies 7. Litigation:

Description of any current litigation including potential damages

Description of any potential litigation including potential damages

Settlement documentation 8. Products and Services:

Detail of product offering including market share by product line

Inventory analysis including turnover, obsolescence and valuation policies

Backlog analysis by product line including analysis of seasonal issues

List of all major suppliers including dollar amount purchased per year 9. Marketing:

Solution the company provides in its sector (What is the opportunity?)

What is the company’s strategy to take advantage of the perceived opportunity?

List of competitors and detail of market share

List of major clients

Analysis of pricing strategy

Current brochures and marketing materials

Sales commission structure

Sales projections by product line

Any pertinent marketing studies conducted by outside parties

Potential M&A players and any relevant M&A activity 10. Management and Personnel

Management organizational chart and bios of senior personnel

Detail of any labor disputes

Employee compensation plans including pension, options, profit sharing, deferred compensation and retirement

Appendix C-3

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CTAN Due Diligence Guide

Management incentive plans including pension, option, profit sharing, deferred compensation, retirement and any non-cash compensation

Number of employees, turnover, absentee problems and hiring projections

Employee HR, benefits, and insurance manuals

List of all principals, managers and directors

Credit history and/or investigation reports on all principals, managers and directors

Resume verification on all principals, managers and directors 11. Property and Equipment

An appraisal of all equipment and fixed assets

List of all real property owned by the company

Copies of titles, mortgages and/or deeds of trust

Regulatory issues

Detail of any easements or other encumbrances

Leases and sub-leases and any company space expansion plans

IP ownership: Patents, trademarks and other intangible assets 12. Research & Development

Detail all research and development in progress

Commercial analysis of R&D efforts, to include expert opinions

Documentation policies including examples 13. Other Company Information

Copies of all past and planned company press releases

Existing articles relating to the company and its industry

Appendix D-1

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CTAN Due Diligence Guide

DUE DILIGENCE OUTLINE I. Executive Summary

a. Key Judgments i. Investment characterization and quality ii. Nature of the venture and outlook

b. Next Steps i. Financial requirements (this round and subsequent) ii. Team requirements iii. Additional documentation requested (See Appendix C)

II. Team Analysis

a. Management team’s resumes b. Current board of directors c. Advisors d. Professional services e. Reference checks f. Comments on their ability to support this venture g. Willingness to accept outside guidance, direction and changes

III. Product/Service Evaluation

a. Description b. Strengths, weaknesses c. Benchmark against nearest competitor d. Complimentary goods, inputs

IV. Market Analysis

a. Size, scope i. Estimated by company ii. Analysis/critique

b. Key customers i. Interviews with current ones ii. Important future clients and steps to acquire

c. Pricing d. Selling strategy e. Revenue model

V. Competition

a. Current (include stage, market share, funding and strategic outlook) i. Direct ii. Indirect (including substitutes)

b. Future i. Direct ii. Indirect (including substitutes)

Appendix D-2

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CTAN Due Diligence Guide

VI. Operational Critique a. Company structure

i. Form and local of incorporation, if any ii. Current shareholders, amount invested iii. Existing securities, classes of stock, restrictions

b. Organizational structure i. Current positions filled ii. Additional personnel needed and strategy to acquire them iii. External partners, suppliers and complimentary organizations

c. Production i. Process of providing good or service ii. Operational analysis

VII. Financial Evaluation

a. Pro forma financial statements (from company) b. Planned use of CTAN funds c. Key assumptions and variables d. Follow-on funding requirements e. Timetable for fundraising and potential exit

VIII. Overall timelines

a. Critical deadlines/timing i. Internal (e.g., product, recruiting, financial) ii. External (e.g., market, seasonal sell cycle)Product/Service

b. Overall schedule, key milestones

IX. Critical Risks & Problems a. For the venture

i. Team ii. Market iii. Product/Service iv. Financial

b. For CTAN i. Company ii. Financial

X. Next Steps

a. CTAN assistance b. Board seats c. Potential synergies with other companies and/or strategic partners

XI. Conclusion and Level of investment