Due Diligence for Angel Investing – Part 1
Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.
The amount of due diligence, or investigation, that you complete prior to making any investment is entirely up to you. Research shows, however, that spending at least 20 hours on due diligence can reduce losses by one-third and increase returns by a factor of 5. How much time you spend researching any particular opportunity will be determined by whether you’re part of an angel group, are leading a due diligence team, or are working alone.
What is Due Diligence?
‘Due diligence’ is a catchall term referring to all of the research completed on any given investment opportunity. It should be thorough and cast as wide a net as possible in order to ensure that all pertinent information is discovered prior to an investor writing a check. Thanks to the Internet, this now requires considerably less time, though frequently generating even more data than was previously possible. This wealth of data provides investors with the invaluable opportunity to discover details about companies, their teams, and the industries in which they’re positioned within the market. At the same time, it’s vital to winnow unnecessary information in order to keep the process manageably focused on the task at hand. For example, you may uncover a treasure trove of information on an entrepreneur’s college musical performances. However interesting that might be, it’s clearly of dubious relevance to the possible investment. It’s also important to note that a lack of available information is at least worthy of further investigation if not actually suspicious, in and of itself.
The goal of performing due diligence is to determine whether a given investment merits your risk. It affords you the opportunity to discover issues that might exist with a business plan or to learn whether the executive team is up to the challenge of executing their plan and successfully developing their idea into a going concern. Due diligence yields direct improvements to your investment outcomes and is an absolute requirement for all investors.
What Needs to Be Researched?
What should you be researching during the due diligence process? Everything! This is your opportunity to delve into a company’s inner workings.
Prior to expending valuable hours on research, take time to ascertain that the investment opportunity meets your basic criteria. Is it in an industry of interest to you? Do you believe in its mission? Is it located in a geographic region in which you prefer to invest? As you begin to expand the scope of your research, be sure to periodically compare any newly discovered information with your personal investment criteria to ensure that the opportunity remains valid for you. If at any time you find that your goals or ideals don’t align with those of the venture under investigation, don’t hesitate to move on.
Before beginning the process, create a due diligence plan or locate a published due diligence checklist that appeals to you. Having a plan in mind will streamline the entire process, as it’ll help to keep you focused on the items you’ve deemed important. Refer to your plan consistently to ensure that you remain on track.
Your due diligence plan should include investigation of the team, the business plan, the industry, other shareholders and board members, and the terms of investment.
Investors are generally attracted to a company, initially, by either an innovative idea or an entrepreneur with a history of success. Once one or both of these has caught your eye as a potential angel investor, it’s necessary to dig deeper. You need to determine whether or not the idea and the company are a good fit with your basic criteria. Investigating the company’s core ideas, their legal documents, and their products, etc. can help to paint a clear picture of a healthy business – or one more wisely avoided.
During your due diligence process, you should confirm that a company in which you’re interested is financially viable and that it’s on sound legal footing, especially with respect to patents and licensing. You’ll need to request a range of materials, including:
- Business plan
- Incorporation documents
- Credit reports
- Criminal reports
- Contracts
- Employment agreements
- Patents (filed, pending, and granted)
- Insurance
- Customer contracts
- Previous financing agreements
- Leases
- Tax filings and related documents
- Minutes (from shareholder and board meetings)
- Capitalization tables
- Term sheets
The Team and Values
A good team is an essential component in making a business successful. For many investors, the team in place is an enterprise’s pivotal selling point. The entrepreneur(s) leading the venture should be committed and excited about their project. Their initial team should be completely capable of driving the project forward. In order to verify that the team is up to snuff, you’ll need to research:
- Past work experience: Does the entrepreneur have the skills and experience to lead a successful endeavor in the industry? Has he surrounded himself with people knowledgeable about the industry and market? Is his past work and business experience applicable to the current endeavor?
- Background checks: A check into the financial and legal history of the company principals can help to determine whether there are (or have been) any legal actions taken against them, as well as any relevant judgements. Be wary of investing in teams who have criminal or civil convictions, tax problems, or pending suits.
- Reference checks: Ask the entrepreneur for both professional and customer references. Be prepared to solicit independent references in order to verify the entrepreneur’s standing in his community and industry.
When researching a team, you must assure yourself that they’re honest, passionate, and hardworking. Reflect critically on your interactions with them and take nothing at face value. If you’re not satisfied with what their references have to say, seek out additional references until the situation clarifies.
Business Model
Poring over business plans and legal documents can be exciting for investors. Be prepared to apply a critical eye. Ensure that the executives are well-suited for their positions. Look for gaps, omissions, and errors as you dig through financials. Question the value propositions and any assumptions made in the business plan. Learn whether the product is ready for market and identify the intended customers. Investigate the required cash flow and how the company has spent money to date. Is the business scalable? Does it have a clear path to profitability? With all this in mind, make a determination of whether you’re looking at a sound plan or at a set of documents that raise more questions than they answer.
The Market & Industry
Although the documents provided to you by the company may yield some insight into the market and industry in which it’s situated, you’ll likely need to conduct your own research. This will help to provide you with a more objective viewpoint and to better determine whether there’s truly a market for the company’s product or service. You’ll want to reach a conclusive determination on whether the assumptions made in the business plan truly represent the market and if a sufficient demand exists for the company to reach profitability. Additionally, you’ll need to research potential competitors and market risks that went undisclosed in the business plan.
Fellow Shareholders and Board Members
It’s also essential to consider a project’s other investors and board members. These individuals can greatly influence the progress of a venture. If you disagree with a fellow shareholder and/or board member or have had issues with one in the past, carefully consider whether this opportunity is right for you. If you’re unfamiliar with the other investors or board members, thoroughly investigate their past endeavors and be sure that you’re comfortable with them before proceeding.
Terms of Investment & Exit Strategy
Not all term sheets are created equal. After examining the term sheet, you’ll need to determine whether you wish to continue with the opportunity. Are the terms competitive and sound? Do they meet your investment criteria?
Depending on your angel investing goals, you may want to articulate your exit strategy. It’s never too early to begin considering your exit. Having a plan in place can serve to both set your mind at ease and also enable you to better balance your overall investment portfolio.
To Be Continued
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
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.
Categories: Angel Investing