Introduction
The story is about a startup company at the Massachusetts Institute of Technology (MIT) in the USA. The startup approached an Energy and Construction Company, where I was the Foreign Investment Director reporting to the Board, to invest in their technology concerning the mobile and small capacity system that converts poultry litter into oil, gas, and charcoal. The Energy and Construction company was already in the waste-to-energy business and found it exciting and complementary to what they are doing and considering investing in.
The narrative below will briefly explain a generic due diligence process and then share information on the process we followed.
Due Diligence
Due Diligence dictionary means "(Merriam-Webster) "law: the care that a reasonable person exercises to avoid harm to other persons or their property" or "business: analysis and probing of an organization or company done in getting ready for a business transaction (such as a merger, acquisition, investment or purchase of securities)."
Due diligence (DD) is widely used in business. For example, a VC, buyer, angel investor, broker, or dealer requires due diligence before closing a deal to know what they're getting into. Primarily, it is the investigation, audit, or review performed during an investment decision, merger & acquisition processes, and internal analysis of corporations or stock in a stock exchange and other corporate entities via a thorough examination of components or finances of the target unit or before entering into a proposed transaction with another party.
The due diligence process starts by using readily available public data. The following stage also covers the confidential data concerning the target company/unit/stock, depending on the purpose of the due diligence report prepared, which will be available for a decision process by the interested party of the investigation, audit, or review requested.
Angels and VCs both make investments in private companies. However, angel investors invest their wealth (or pool it together and invest as a group), whereas VCs invest the funds provided by third parties and others and managed by the VC. Angel investors can also be friends and family members. Due to investing their funds and not having the same benchmarks and economics as VCs, angel investors invest smaller amounts in earlier-stage companies and take a lower risk.
Due diligence has become common practice in many countries regulated by law; for instance, securities dealers and brokers of stock indices or stocks are responsible for fully disclosing the information about the instruments they sell. In those countries, according to law, dealers and brokers are liable to disclose information concerning the target company or stock to potential investors; the opposite is presumed to be a criminal offense.
Depending on the purpose and the target company type, such as private, public, or startup, there are many objectives and contexts for the due diligence process.
Due diligence captures the nature of the target company's business, assets, capabilities, and financial performance attributes. In detailed terms, these are (1) pre analyzes the plan of the business case, (2) the current status of the target corporation/startup (legal, assets, administrative/operational, finance, HR, market capitalization/customers, commercial, production, intellectual properties, environmental, taxes), (3) future state of the target entity, risk analysis, and (4) how well cultural adaption is possible in case of M&A of entities that they will merge and become a single entity and (5) A particular case on due diligence is startup DD.
A pre-analysis plan of the business case is a document outlining the technical details of a study conducted. It includes the project description, project objectives/rationale, type of data required and its source, the methodology, unit of analysis, definition of the target entity, corporate attribute (legal, assets, administrative/operational, finance, HR, market capitalization/customers, commercial, production, intellectual properties, environmental, taxes.)
Also, due diligence aims to examine the target corporation's current status concerning its legal, assets, administrative/operational, finance, HR, market capitalization/customers, commercial, production, intellectual properties, environmental, tax-related properties, risk, and complications in the case of the M&A process. This is an extended study of the target entity in detail, depending on the purpose.
Besides, it may look at the prospect of target corporation activities, changes in market capitalization, customer portfolio, cultural and internal process adaption of two entities, a merger of departments, reduction in the workforce, and how these will affect merged organizations and their businesses.
Also, depending on the nature of the target entity, a different type of due diligence may be required. One such process is startup due diligence. Startup investment due diligence requires examining the business plan, business model, financial plan, market, market potential, intellectual property and patents, competition, management qualifications, etc.
Startup funding rounds are (1) seed round, (2) angel round, (3) Series A, Series B, Series C rounds, and so on. Then, mezzanine finance rounds, bridge loans, and other debt instruments are used, depending on the appetite of founders, funding a startup between venture rounds (given above) or before its initial public offering stage.
Besides, investors might consider the future value of the target entity. They might require risk analysis, which is finding out how well the target entity is positioned to achieve what they aim to succeed.
The Story
The target company developed a mobile and small-capacity system that converts poultry litter into oil, gas, and charcoal. The products are used in the energy sector or local businesses that need to augment the energy gap with low-cost (supposedly) oil, gas, and charcoal-type resources.
The technology offered is plasma pyrolysis for thermal degradation (pyrolysis) of carbonaceous waste to produce synthetic liquid fuel (oil), carbonaceous residue (charcoal), and hydrocarbon gas (syngas). These are either used directly to meet energy requirements in the market or refined into gasoline and types of diesel, hydrocarbon gas, and process residue, such as charcoal.
The investment offer came through the organization due to the board members' connection with MIT, and I took responsibility for managing the due diligence process. The startup shared a presentation and an Excel sheet concerning the financial side of the business plan and samples of product outputs from their mobile plasma pyrolysis system. We verified the startup's claims via lab analysis of gas, oil, and charcoal. Our team created several reports on the chemical characteristics of the oil and charcoal, their similarities to oil and gas standard products, and potential energy content per unit.
A presentation described the business model but no particular business plan. Instead, an Excel sheet gives a perspective on financials.
Our study showed that the presentation had not emphasized the market conditions, i.e., the market requirements, circumstances, competition, and farmers' nature.
The farmers are the potential buyers of the technology. They were also competitors in the competition for raw materials to keep raw materials to burn for heating the facilities. The startup company has not given any attention to the competitor role of farmers – hidden competition. Besides, the presentation mentioned a strategy that could help farmers supply alternative ways of making better use of energy sources via mobile poultry litter to the energy system.
The presentation did not examine the market well. We found twenty-six product-wise competitors in the market; four were direct competitors, and only three were mentioned in their presentation.
Financials are supplied on an Excel sheet. The product price is given in a broad range between 1M USD and 360K USD. The price calculation had no substantial rationale supporting it while calculating in the Excel sheet. Therefore, it is difficult for a reader to grasp its meaning and verify if it makes sense.
Operator salaries are considered high, and energy consumption was not part of the Excel sheet.
The process output is 40% oil, 40% charcoal, and 20% gas. From the revenue viewpoint, the most value comes from oil or gas due to their relatively high market value but not from biochar; therefore, 40% of charcoal production is high, meaning lost revenues.
We found (1) Mean Time Between Operational Failure (MTBOF), (2) Mean Time Between Maintenance (MTBM), (3) Mean Time Between Malfunctions (MTBM), (4) Mean Time Between Overhauls (MTBO) may not be accurate for a system using heat and pressure according to our referral sources.
Overall, we requested additional studies in light of the information in the conclusion and advised the reconsidering business model, operating, and market strategies to review our investment options again.
The actual report is kept confidential.
Conclusion
Due diligence is an essential tool for evaluating investment options. Both sides must fully understand their responsibilities and choices regarding the opportunities driving the due diligence. The process can take different forms and contexts depending on the attributes in target concerning the entity in consideration, investment objectives, and the round of investment concerning startups. The higher the investment round, the more complicated due diligence becomes, and it takes time and effort to gather data for the report.
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