What is Due Diligence?
Due Diligence (DD) is a significant phase in the investment process and offers investors insight into the viability of an investment. At its core, DD is an investigation of a potential investment confirming all facts provided are fully accurate and not misrepresented. In other words, DD is essentially an audit of an investee company affairs to ensure an investor has all the facts needed to make an informed decision about next steps in the investment process.
For individual investors, due diligence is considered voluntary (with some investors simply going on gut and instinct) however, most investors would regard it as vital and therefore, will implement a sufficient review of a business before making any formal commitments. It is worth noting that entrepreneurs do not have to agree to giving you everything you are asking for during the DD phase, but it is advisable to exercise caution when something you feel is important is not readily available to you. In addition, investors should be aware that due to the nature of early-stage investing and the age or business stage of a company, they might not have all the items you are looking for so DD might look different on a transaction-by-transaction basis.
What does the DD process look like?
The DD process starts once an investor(s) decides they would like to invest in a business. The process takes into consideration a variety of factors, some of which are based on an investors’ personal experience, but typically will look at things like the viability of the technology or product/solution, intellectual property, competitors, the management team, risks, and more, enabling a deeper look into the business so investors have all the facts needed to make an informed decision.
The process is very much dictated by the lead investor’s DD checklist and what they deem necessary to move forward (or turn away). This checklist will vary depending on the investor(s) and the experience or expertise they have in the sector or space in which the business is operating, as well as the stage of the business in question. Whatever the case, DD does not follow a specific structure or time frame and is executed on a case-by-case basis.
When a group of investors begins DD, they will likely split the workload up among them since there can be a lot to investigate. It is worth noting, most businesses that angel investors will be looking into will be early stage and therefore, will not necessarily have an excessive operating history or large scale team. When an angel investor is backing a business that is operating with an excess of £2m in revenue, there is likely to be a large-scale group or VC leading the round who will have a team in place to drive DD and take the workload off the angels, since it can be substantially more the further along the business is in their growth stage.
Key areas: what should investors be focusing on when looking into a business in the DD stage?
Due diligence is about ensuring the investment an angel plans to make is sound from a business, financial, and market perspective. Therefore, an investor should look at a variety of factors that will come together to help inform and determine the investment potential of the business in question.
Early-stage companies are inherently high risk, so what an investor needs to look for during DD are a few critical risk areas such as: the deal size, financials, the organisational structure, market competition, technology and IP, and legal matters. Once you have looked at each of these areas, it is recommended that you rate them on a scale of low to high and those that rank high, require a bit deeper digging.
The Deal
- Deal size: Does the amount and kind of funding requested make sense? After digging into the financial model do you understand key assumptions and near-term milestones for this current round of financing?
- Terms: How do the deal terms, funding strategy and exit opportunities combine to produce a reward that justifies the risk of an early-stage investment?
- Funding Strategy: What is the model for the long-term funding strategy of the company and how will different strategies impact the early investors?
Financials
- Statements: Can they provide you with items like financial statements, a balance sheet, year to date income statements, filings, income and expenses?
- Projections: Do they have budget forecasts in place and do their plans for the future, including 5-year projections, check out? Does the business demonstrate it has the capacity to cover their bases should a costly emergency arise?
- Financial Arrangements: Does the business have financial arrangements, borrowings, agreements, or convertible instruments in place that can impact investors and their shareholdings.
Structure
- Management Team: Reference checks on the leadership team are key to understanding them, their background, work and leadership style etc., but notably, also how you gel with them.
- Organisation: How does the structure of the company align with their key objectives? Do they have the right people in leadership roles to help the company grow or do they have a clear strategy for appointing individuals to fulfil open roles?
- Legal Structure: Is the legal structure of the company correct for receiving equity investment?
The Product
- Technology: Does the company really have a breakthrough technology? Is it trademarked/patented? Have they protected their technology IP? Is it proven and validated?
- Intellectual Property: How do you evaluate the importance and strength of the company’s Intellectual Property? Have they built any significant barriers to entry with IP or any other means?
- Solution: How do you evaluate whether customers really need the company’s product? Is there validity in their claims that they are addressing a market problem and if so, does the market size and need add up?
Market
- Market Opportunity: What is the long-term potential for the company based on the addressable market opportunity today and in the near future? Are they solving a problem that is ‘trendy’ or ‘of the moment’ or are they addressing an issue that will enable them to continue to scale.
- Competition: What is the competitive environment including but not limited to the set of competitors that the company identifies? What will it be in 5 years?
- Go-to-Market Strategy: Does the company have the right initial strategy for selling to the customer and a plan for doing it at scale? Are they entering the market at the right time or are they too early or too late? Further, is the market they are entering sustainable and match with their strategy?
Legal
- Regulation and Contracts: Investigate such areas as regulation, IP, pending (or previous) litigation, employment contracts, patents, trademarks, and material contracts that might impact the value of the business.
- Incorporation: Is the company incorporated and is their filing history clean?
- Ownership: Look at things like who owns the IP, is it the founder or the company? Does the company own property and occupy it? What do the ownership terms look like?
Alignment:
- Exit: What are the exit opportunities for the company? Who will buy this company and why? Does their strategy make sense and align with your expectations?
- Goals: Finally, how do you make sure that the goals of the investors and the company founders are in alignment? Or in the case of impact investors, are the goals of the company in alignment with the goals of the investors and the desired impact?
Completing Due Diligence
There are many other aspects that you might deem necessary to investigate, which of course is completely up to you and your fellow investors. You might be the kind of investor that wants to collect customer feedback and obtain testimonials, you might also want to test a product out yourself so you can attest to the user experience. Whatever your approach, it is important to find a balance between gaining confidence from doing your due diligence and being overzealous and asking for granular details that might not be necessary and can be time consuming.
During the due diligence phase, you are essentially looking under the hood of the business and determining if the risk is worth the potential reward. Take your time with this and make sure that at the end of the process, you are satisfied with the information you have uncovered. After all, it is your responsibility to protect yourself and your investment, so if you decide that something doesn’t add up, you can back out.
