Due Diligence for Angel Investing – Part 2

Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.

Continued from last week

Red Flags

As you grow more familiar with investing and the due diligence process, you’ll likely evolve your own list of red flags. These warning signs serve as indications that investment in a venture is very possibly not a good idea. Any particular investor’s set of red flags will differ from another’s and your own experiences will guide you in determining your own. These sample red flags constitute an excellent starter set:

  • Founders are not invested in the company: When those individuals who ought to be the most invested in a company aren’t, it raises serious questions. Are they truly as dedicated as they seem or as they wish to seem? Do they really believe in the fundamental value proposition of their product or service?
  • No one is working full-time on the company: If the venture isn’t a priority for the principals, why should it be for you? When investing, you need to be confident that you’re entrusting your money to good hands. An uncommitted team doesn’t inspire much confidence.
  • Asking for too much money without clear plans for it: Some founders may get ahead of themselves and believe that the more investment capital they raise, the better. That doesn’t bode well for the future. You need to be sure that your investment is being properly managed and effectively utilized to grow the business. If a team is asking for too much and doesn’t have a clear plan for how they’re going to utilize the funds, question them in much greater depth and be prepared to walk away.
  • Not aware of the market or other competitors: Too often, business people are shortsighted and state that they don’t have competitors in their region or industry. This is almost always demonstrably false. Whether a product of willful ignorance or mere oversight, this statement should give one serious pause. Of what other critical details is this team ignorant?
  • Team lacks industry knowledge: Those involved in a venture must be industry experts. They have to be able to explain why their product or service will function and how it will impact the industry as a whole. If their industry, market, and/or audience knowledge is lacking, then there’s a major problem. Further background research on the principals is absolutely required.

Methods for Researching

While your preferences on how to complete the due diligence process may vary from other angels’, it’s important to utilize a range of research methodologies in order to achieve a valid impression of an opportunity and to reduce your risk accordingly.

Q&A Sessions and In-Person Meetings

Being in the same room with someone is often the most effective way to get a feel for their character. Angel groups often schedule Q&A sessions to facilitate potential investors getting to know a particular entrepreneur and his business. Individual angels should also set up entrepreneur meetings for the same reason. Be sure to do your research beforehand so you’re ready to ask questions and make the most of the opportunity.

Internet Searches

The internet makes it effortless to examine so many different areas that were previously inaccessible. You can research an individual, a company, or a product. You can check reviews or investigate a principal’s social media presence. Time spent wisely online has greater potential to uncover investigative gold than perhaps any other area of inquiry.

Networking

Former partners and coworkers of the entrepreneur and management team you’re investigating can provide useful insights into how those individuals work and whether they possess the skills and knowledge to make a success of the company. Ask each team member for references and follow up! Speak with former customers. Locate individuals who may be acquainted with the team principals and ask to speak with them. Some of the interviews you conduct should be with the team’s supplied references, but it’s also important to speak with people who’ve worked with the principals and not been offered as references. This can help to create a more balanced view of the parties involved.

Document Requests

Making requests to see particular company documents is absolutely a given. The information conveyed by the documents listed above can paint a picture of an exciting opportunity or of a startup destined to fail. To be able to read the signs, ensure that you remain organized and examine every piece of information with a critically objective eye. Maintain a written record of questions as you examine the documents supplied and be sure to secure answers to every one before moving forward with the opportunity. The documents should clearly illustrate how the company functions, how it intends to make money, who it views as its audience, how it plans to scale, and its plans for the future.

Making Due Diligence Easier

The process of conducting due diligence does get easier with practice. These further tips should help to ease the burden of your initial research activities:

Due Diligence with an Angel Group

If you’re involved with an investment group, you may find that sufficient due diligence is completed by the group and that you don’t need to do much additional work yourself. According to the Angel Resource Institute, groups tend to spend 50-100 hours on due diligence. In this case, your due diligence process will likely consist of a meeting and Q&A session with the company principals and a thorough reading of the company’s documents. Your main focus will be to ensure that the company aligns with your investment goals and that none of your red flags are present.

Investing in Your Industry of Expertise

For angels investing in their industry of expertise, the due diligence process is slightly easier. The expert knowledge and insight gained from years spent in a particular sector renders it a relatively simple matter to conduct due diligence of startups within that industry. Additionally, angels who invest in their industry of expertise tend to experience a higher rate of return.

Working from a Checklist

Utilizing a checklist can help you to remain on track as you gather documents, check references, and research the company’s industry. Plus, it can serve as a valuable reminder of your personal criteria, especially when you’re excited about an opportunity. A checklist can aid you in maintaining a level head as you complete the due diligence process. This comprehensive checklist is from the Angel Capital Association.

Invest in the Same Sector

If you continue to invest in the same sector, you’ll gain more knowledge of that industry over time and your need to conduct industry-specific due diligence will decrease for successive opportunities, reducing your overall workload.

Dealing with Unresponsive Companies

It should go without saying, but if you request information from a company and their response is incomplete or non-existent, be wary. Any company interested in receiving angel dollars should be extremely forthcoming and very willing to share information with potential investors. If you find that a company is withholding information, providing incomplete data, or not responding to your requests, move on to a different opportunity posthaste.

Relationship Building

As you’re completing your due diligence, definitely keep in mind that the company is also investigating you. Investment creates a bilateral relationship. Respect the entrepreneurs you meet. Provide them with helpful feedback. Be honest and open. Don’t overpromise – be realistic. An entrepreneur can decide that they don’t want to work with you, just as you can decide not to invest in their business.

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Due diligence helps you to best understand the potential risks of any investment opportunity. It provides a way to achieve insight and to verify that the company in question aligns with your goals. While the process may generate excitement, it’s important to keep a level head and to always proceed with caution. While the amount of due diligence you complete will likely vary by opportunity and/or investment platform, the goal is always to determine whether you’re comfortable investing in a particular company. With time, you’ll craft a process that best suits your own needs. Be prepared to learn along the way and always keep your eyes and mind open.

Sources:

Returns to Angel Investors in Groups: http://www.angelcapitalassociation.org/data/Documents/Resources/AngelGroupResarch/1d%20-%20Resources%20-%20Research/6%20RSCH_-_ACEF_-_Returns_to_Angel_Investor_in_Groups.pdf

Issues to Consider in Due Diligence: http://www.angelcapitalassociation.org/data/Documents/Resources/StartingaGroup/1b%20-%20Resources%20-%20Starting%20a%20Group/8%20Angel_Guidebook_-_Due_Diligence_Questions.pdf

Checklist: http://www.angelcapitalassociation.org/data/Documents/Resources/StartingaGroup/1b%20-%20Resources%20-%20Starting%20a%20Group/9%20Angel_Guidebook_-_Due%20Diligence_Checklist.pdf

About the Author

Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).

Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.

Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.

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