What is due diligence?
What is due diligence?
Due diligence is the process of gathering and evaluating information before making an investment decision. Investors use this process to assess the risk of an investment. They do this by looking at a company's financial data, comparing it over time, and comparing it to competitors to determine the potential for growth.
Shows like Shark Tank give a glimpse into the conversation that happens between startup founders and investors, but in real life, due diligence is a more serious and organized examination of a business since investors look at every detail of the company.
How long does due diligence take?It depends! If you’re a professional venture capitalist or investing at later stages (Series A, B, and beyond), due diligence can take several weeks and involve complex financial modeling and legal diligence. For earlier stage companies (pre-seed and seed), due diligence could be done in a couple of days depending on the efficiency of the team, how well the investing team already knows the industry of the potential investment, etc.
In practice, angel investors’ diligence is usually 1-2 meetings, a deck from the founder, and their own research of the relevant industry. Occasionally, depending on the size/maturity of the company, there’s access to a data room. This is for a few main reasons:
- companies are usually not eager to share information with a lot of people. Information is considered sacred, and the more people it’s shared with, the more likely it is to land in the wrong hands (i.e. competitors)
- angels, compared to professional VC’s, don’t usually have a ton of money or time to dedicate to legal resources or professional expert networks
- founders’ time is limited, and therefore, it’s less likely to have a founder spend significant time with an angel (who’s typically writing a check infinitely smaller than ones coming from much bigger institutions) than with a VC
Due diligence for startups can take anywhere from 2 to 12 weeks, depending on the complexity of the company and how quickly the documents can be gathered. However, due diligence is a continuous process and not a one-time event. As an angel investor, you have to be constantly updated and aware of the company's performance and the market trends that might affect your investment.
When is due diligence performed?
Due diligence happens mostly during your conversation with a founder and potentially in follow-up materials after. You’re also encouraged to do your own independent research - reading, research reports, talking to friends/experts in the relevant industry, etc.
In reality, angels get limited time to do due diligence, which is why many angels opt to only invest in industries they already have a strong understanding of. Especially in deals that move quickly and are about to close, you may only have a few days to make a decision.
The due diligence process starts as soon as you start talking to a startup founder, although it is somewhat informal at that stage. You should be asking basic questions to get an idea of the company. Once you and the startup agree on a term sheet, you can send a list of information you need (more details on this further down).
A due diligence checklist:
When considering investing in a startup, there are many risks and elements to consider:
Market Opportunity: Evaluate the company's potential based on the addressable market today and in the future.
Technology: Understand what makes the company's technology unique.
Product/Solution: Evaluate customer demand for the company's product.
Intellectual Property: Assess the importance and strength of the company's IP and barriers to entry.
Funding Strategy: Assess the company's plan for long-term funding and how it affects early investors.
Alignment: Make sure the goals of the investors and the company founders are aligned.
Go-to-Market Strategy: Evaluate the company's plan for reaching customers and scaling sales.
Competition: Assess the current and future competitive landscape.
Financials: Understand key assumptions and near-term milestones for this round of financing.
Exits: Evaluate the potential exit opportunities and who may be interested in buying it.
Deal Terms: Consider how the deal terms, funding strategy, and exit opportunities align with the risk of an early-stage investment.
What should an angel investor look for in due diligence?
There are 5 main areas angel investors need to consider:
1. The Product
The diligence of product varies depending on the type of company you’re investing in, and it’s fine to invest in companies so early they might not even have a product, but it’s important to know what you’re investing in! For consumer companies, you might be interested in how easy it is to use, its differentiation vs competitors, how well it works (which reflects the execution abilities of the team), etc. For hardtech companies, you might be doing more industry research to understand the viaibility of the underlying investments vs personally seeing or evaluating the product itself. Other considerations include how the product can grow, its monetization potential, the existence or importance of intellectual property, etc.
When assessing whether a startup will be great to invest in, you need to look for certain things in the product or service, such as the ability to grow, protection of the company's intellectual property, potential profit margins, and how the product is made.
2. The Market
When examining a company, you also need to research the market. Make sure to ask the founder questions about how the company fits into the competitive landscape, and how they perceive the current and future size of the market. Related to this, you also want to understand the company’s go-to market plans and plans for growing/expanding.
3. The Team
Remember that when you’re giving money to a startup, you are forming a business relationship. You need to trust the leaders and team of the company and take into account their past experiences, skill, and integrity. If you don’t trust or believe in the team, you’re better off not investing in the company even if the company appears to be a good investment opportunity. Angels tend to have the least information rights in startup investments, so if this is a team you feel like you’d need to monitor or constantly question, an investment might be more stressful than positive.
4. Financials
When you’re giving money to a startup, you need to trust the startup and its founders enough to use it well. Financial diligence in the early stage might just be a projected financial model (vs true financials). When evaluating, you can expect the startup's predictions for the company's future to be optimistic, but it’s also important to consider whether they’re realistic. It’s also important to ask about use of funds - what are the founders planning on doing with the money and how will they use it to reach the next milestone? It would be expected and common to change, so it’s less about the precision of the answer and more about whether it reflects thoughtfulness of the founders.
5. Equity Structure
What terms are you investing on? What valuation? What information rights do you have? Startup investing is risky, so you want to understand the underlying ownership structure and potentially who else is involved (early investors, co-founders, other angel investors, and VCs). Pay special attention to any restrictions on debt and special rights of the preferred shares.
A few additional things to keep in mind when investing in startups:
When thinking about investing in a startup, you’re taking a wild bet, especially if it’s an early stage startup that doesn’t have a history to analyze. Below are some crucial factors for startup investors to consider:
- Plan on losing all of your money. Ideally you have a return, but never create plans around the assumption of a return on your investment.
- Think about working with a partner to share the risk.
- Look for startups with good products that are likely to make a good return on investment over 5-10+ years. Angel investing is a long game.
Extra Resources on Due Diligence:
Books:
The Angel Investment Process by David S. Rose - This book by angel investor and entrepreneur David S. Rose provides a comprehensive guide to the angel investment process, including due diligence.
Due Diligence for Angel Investors by John May - This book by angel investor John May provides a step-by-step guide to due diligence for angel investors, including practical tips and case studies.
Articles:
https://www.ycombinator.com/library/3h-series-a-diligence-checklist
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