Startup Companies – Five Due Diligence Considerations for the Entrepreneur

One of America’s greatest strengths has been how readily it promotes and fosters the formation of startup companies. Entrepreneurs looking to take the plunge and capitalize on a new idea, product or service may want to consider five issues in their due diligence.

New business founders soon find out that the landscape for new business formation offers several legal options. Each of the most common startup formation options, including the ‘Doing Business As’ (‘DBA’) format, as well as the Sole Proprietorship, Partnership, C Corporation, S Corporation, and Limited Liability Company (‘LLC’) structures, carry their own set of initial filings and annual costs. Each format also includes its own rules for State and Federal tax treatment, as well as varying levels of personal liabilities and risks for the owners. While each choice includes its own level of paperwork, advantages and disadvantages, the newer hybrid LLC format has grown increasingly popular in recent decades. LLC statutes vary by state, but the LLC format frequently offers an attractive combination of ownership & finance flexibility, tax treatment & expense deductibility, and also personal liability shielding from third parties.

Due Diligence Considerations in Startup Companies

Thorough ‘due diligence’ therefore is important not only with the startup company’s basic business plan and marketing concepts, but also with regard to its legal form of enterprise. The preferences of commercial banks can be very important to keep in mind for many reasons down the road. Lenders and credit card companies often appreciate when a startup company has exercised good discipline and paid the dues of undertaking a thoughtful form of business structure. While various internet sites may offer enticing quickie paperwork solutions for startup companies, a smarter view is often to save both money and time over the longer run by reviewing new business formation decisions in advance with competent legal and accounting professionals.

Five Due Diligence Considerations for Entrepreneurs
One of America’s greatest strengths has been how readily it promotes and fosters the formation of startup companies.

However, before signing up for any new business format, the entrepreneur should take a very deep breath and invoke as much common sense as possible. Does the new idea, service, or product really have what it takes to be successful? Just being better than the competition is rarely good enough. Even the smartest business people often misjudge pricing, markets & buyers. Competitors can also be underestimated, and so the failure rate of startup companies is high. Unless he/she is a writer or theoretical physicist or is producing a solo work product, the successful entrepreneur will need the advice and input of dozens of people along the way. Openness to honest discussion and ‘best practices’ suggestions are often the difference between success and failure. In addition, oftentimes the dedicated but quieter employee comes up with meaningful ideas and solutions.

Not all startup company entrepreneurs recognize that for a new physical product to have a good chance of enduring success, that the final selling price often must be at least 4X the all-in manufacturing cost including in-bound shipping, raw materials, labor, packaging and all marketing costs. Yes at least 400%. Stated differently, this means that if it costs $25 to make it, box it, and market it, that the product reliably needs to sell in stores and on-line for at least $100 (net of discounts) in order make a long-run successful company.

Why? Because profits allow for proper rewards to staff and they also finance growth. However, profits also attract competition. Therefore, the 4X pricing model also accepts and embraces the base profit incentives that friendly intermediary parties must have themselves to ensure even wider distribution of the product. This 4X pricing concept is known as the ‘keystone’ rule of thumb in the retail world, and it constitutes the sum of the practical experience of thousands of entrepreneurs and products before us. Many stronger startup companies look for niches where they can sell at an even higher final markup than 400%. The necessary profit margins for non-manufacturing service, software and fee-based businesses can be a bit less daunting than 4X, but a truly healthy profit margin can rarely be dismissed among the top priorities for any startup success.

Management Styles in Startup Companies

At its best, a good startup company is one where its customers absolutely cannot get through a day (or a week) without using the product. In most cases, a successful product or service should be well marketed in multiple venues and it must find and fill a vacuum of practical need. One successful five-time entrepreneur wrote: ‘If you are in a startup company environment, you have to accept that you will make mistakes. No matter how much you plan, you will usually overestimate demand and you will underestimate costs. Stuff happens. A strong profit margin is often the best cure for the multitude of mistakes and delays that you will experience as you get off the ground.’ A self-made billionaire based in Los Angeles addressed his assembled staff at a new company some years ago with a surprising theme and approach for success. In both a humble and aggressive manner, he was able to convey several ideas: ‘Let’s all check our egos at the door when we come to work every day. Success is about addressing opportunities and facts; it is not about going with the flow or the status quo. If you are not asking questions and making a few mistakes here and there, then you are not trying. I promise not to fire anyone here who takes a thoughtful and agreed risk, which may not succeed. However, I do promise they may not be here very long after that if we don’t all learn from our mistakes and correct them quickly. Now let’s all get to work.’

There are many different paths to success for startup companies, and just as many different successful management styles. Selection of the best legal venue, thorough due diligence, focused marketing, keystone pricing targets, and making adjustments toward goals are common themes witnessed in many successful startup company environments.

Doug Johnston is an expert witness and investigative business consultant specializing in Commercial Banking & Lending, Private Equity, and Due Diligence. Early in his career he was named as the youngest bank president in Texas, and thereafter he established multiple bank offices in both Texas and California. Expanding into Corporate Finance and Mergers & Acquisitions, he became EVP-Finance and a ‘Founding Father’ of the largest private company in Los Angeles. As a C-Level executive, he has ‘hands-on’ due diligence and documentation experience with lenders, investors, buyers and sellers involving hundreds of businesses engaged in the technology, service, commercial real estate, entertainment, and manufacturing sectors across the US as well as in Europe.

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