What is Due Diligence?
‘Due diligence’ sounds awfully serious.
When it came into use in the mid-fifteenth century, it simply meant ‘reasonable care’. It became a specialised legal/business term in the 1930s when the US government passed a law to ensure that securities brokers disclosed sufficient information when selling to investors.
It is now used as a general term for the process of verifying information.
The level of due diligence required and the level of due diligence possible varies depending on the information being checked. Naturally, a high-level corporate merger would require extensive due diligence.
When it comes to investor due diligence on early-stage companies and startups, the due diligence need not be overly laborious. It is necessary but should not be daunting, even if it’s your first investment of this kind.
So, for the remainder of the post, I shall refer to it as DD. It’s less daunting that way. (And easier to type!)
Why is due diligence different for early stage companies?
Any sort of institutional or corporate investment requires sophisticated and extensive DD.
Investment institutions tend to invest in companies who are well past the proof-of-concept and early growth stages. As such, they can examine substantive data in their assessment and check its validity. They also need to check it so that they can justify the investment to their own shareholders.
It’s only when a company has achieved a certain level of tangible traction that you can reasonably run analytics on it in the hope of predicting the eventual outcome and the risks involved. The later stage the company, the more data, the more due diligence, the more predictable the outcome.
Early-stage companies accepting investment from private investors tend to have less tangible evidence available for checking because the company simply hasn’t been operating long enough. This means that the checks an angel investor carries out are mostly formulaic.
Due diligence at the level of early-stage investments is predominantly about checking the claims of the company in their documents/
This does not mean you should carry out minimal DD. Evidence suggests that investors who spend longer on DD get higher returns (UKBAA research has shown that at least 20 hours due diligence has a positive impact on the likelihood of a multiple investment return (Siding with Angels; Robert Wiltbank, Nesta-UKBAA)).
Correlation or causation, it doesn’t really matter. You should carry out thorough due diligence.
But the point is that it is not a complicated process. People making their first skirmishes into angel investments are sometimes put off by the idea of DD. They think that they don’t have sufficient experience to do it properly and as a result, they’ll be throwing away money.
They think like this because they have the expectation that their DD ought to be as rigorous and detailed as that carried out by a private equity firm, for example.
But this is an unfortunate belief. It’s naïve to think that the same level of DD should be carried out – there is not enough information on early-stage companies. Because they are early-stage!
If there was more information to check, then the investment would probably not be open to private investors. Nor would the opportunity for the huge returns possible for early-stage investors be available because the risk quotient would be so much reduced.
It’s important to remember the reasons why we choose to invest in early-stage companies:
- We want to bring our experience and network to bear so that we have an active role in helping the company grow and succeed.
- We want to take a calculated risk to help a team of founders we believe in to achieve something cool.
- And in so doing, we want to make a good return on our investment.
The early stage means that we have the opportunity for all those things but, naturally, the risk is larger. Proper due diligence is your armour against this risk.
Is there an optimum way to carry out due diligence?
DD research can be divided into six principal sections as set out in the following section.
But how should you approach them?
It’s simple enough to work systematically through each, but this can be time-consuming and, human as we are, we are all prone to mistakes and oversights.
It can make the process less burdensome and pressured if undertaken with one or more investment partners. You can divide the labour, check each other’s research and discuss to form an opinion.
If you then all decide to invest, it can make the process even more enjoyable and less pressured.
What DD should you carry out on early-stage companies?
Your DD should cover six main areas (I have written a downloadable checklist for each):
1. Team & Management
Early stage investment is often said to be in people rather businesses. This is because it’s the execution that counts…
This checklist will help you form an impression of whether you think the team has what it takes to execute.
2. The Business
Do you believe in the idea?
This checklist will help you work that out.
3. The Market
Market research is the process of finding out information about demand, trends, size and competition in the target market. It’s an important process for gauging sales volume, pricing and ultimately whether there is sufficient opportunity to develop an idea into a lucrative business. Entrepreneurs will present you with certain claims about their market – your DD should aim to verify their claims.
This checklist will help you decide whether the company has identified a viable market opportunity.
4. The Technology/Product (if applicable)
The team is often considered more important than the starting product. But it’s still essential to check the product is a great solution. A great team with a great product ticks a lot of boxes!
This checklist will help you assess the tech.
5. Finance & Tax
When entering into an investment agreement, you need to be aware of any information that may increase or decrease the risks involved. Financial DD ensures that you are aware of all the existing assets and liabilities.
This checklist will help you assess the company’s position.
It’s a good idea to send a legal enquiries check sheet to any company you are interested in. Use this template drawn up by Tony Littner at Harbottle & Lewis LLP, Jon Gill at Eversheds LLP and Sandy Finlayson at MBM Commercial LLP for the UK Business Angels Association. (If you’re looking at a company based outside the UK, it should work for you too.)
These checklists are in no way exhaustive. Your DD questions will vary according to the type of business you are evaluating. But these should serve as a useful starting point. And they should indicate the level of due diligence required for these types of investments.
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*Thanks to the UKBAA whose own due diligence checklists were the inspiration for this article.