Due diligence in the venture industry refers to the process of investigating and analyzing an investment opportunity
to determine whether it meets the investor’s criteria for funding. This process is important for both angels and venture capitalists because it helps to mitigate investment risk by gaining a better understanding of the company and its business, as well as assessing the suitability of the investment for the investor’s portfolio. According to the research from Angel Capital Association, we can learn:
Key aspects of due diligence
One of the key aspects of due diligence is identifying the risks associated with a venture. Even in the best-case scenario, there are many factors that must align for a venture to succeed. For example, management must be capable and motivated, market demand must be as expected, production must be scaled up as planned, the competition must be held at bay, liability, and litigation must be avoided, the company must have sufficient capital, and existing customers must be able and willing to pay. However, if any of these risks are not assessed correctly, the probability of success can be significantly reduced.
As an example, the case of Hitsgalore.com in 1999 illustrates the importance of due diligence. Hitsgalore, an internet company whose market value soared from $53 million to $1 billion in three months, did not disclose that its founder was accused of cheating customers at a previous job. When this information became public as a result of a lawsuit, Hitsgalore’s shares plummeted by 53%, cutting the company’s market worth by $534 million. This could have been avoided with proper due diligence.
These issues are even more critical for angel investors than for venture capitalists, as early-stage ventures bear a greater risk of catastrophic failure. While most deals that venture capitalists see are fairly far along, angels and angel groups often invest in very early-stage ventures, where the risks are higher. Therefore, due diligence is an essential process for all investors in the venture industry to help mitigate investment risk and maximize their chances of success.
When to Start Due Diligence
The timing for starting due diligence in the venture industry can vary based on the criteria for investment established by each angel investor. For instance, some may require that the investor has a defensible plan to reach $100 million in ten years, while others may be more interested in a scalable concept that yields revenues of US $100 million by Year 5. In some cases, investors may want to see evidence that the business is likely to grow rapidly and reach at least $15-30 million in revenues in the next 3-7 years.
Before beginning the due diligence process, there are some additional considerations to take into account. One is whether the angel investor feels comfortable with the management team of the company being considered for investment. This is important because successful investments require a good working relationship between the investor and the entrepreneur, and any lack of trust or integrity can quickly sour that relationship.
Another important consideration is the number of potential deals that are being considered. Ideally, the investor should narrow down the field of potential deals to a manageable number, perhaps one or two per month. Trying to do too many deals at once can spread investors too thin and result in subpar investment decisions. Additionally, it may be helpful to have at least one member with experience in the relevant domain who can take the lead in conducting the due diligence process.
Creating a Due Diligence Plan
When creating a due diligence plan, the first step is to identify the assumptions that need to be validated in order to confirm an investment. Some of these include the viability of the intellectual property, the demand for the new technology, the existence of a market for the product, and established customer relationships. It is important to separate elements that may not be confirmable from deal breakers that must be confirmed.
Investors should also define acceptable risks and potential deal breakers beforehand. They should be prepared to shoulder the cost of the due diligence process, which may include legal fees, hiring industry experts, and travel expenses for site visits.
Avoid common pitfalls
To avoid common pitfalls in the due diligence process, it is important to ensure that patent applications are filed in a timely manner and that the legal scope of claiming patentable inventions is not too narrow. Additionally, it is important to consider the risk of patent infringement “willfulness” exposure. Investors should also confirm that customers are experiencing pain from an unresolved problem and have the ability to pay for the product.
Professional market research firms can provide a more rigorous analysis of the market, and having established customer relationships is vital. The due diligence team should determine what aspects of the venture will not be deal breakers if they cannot be completely confirmed.
Non-Disclosure Agreements
Non-Disclosure Agreements (NDAs) are a topic of debate in the angel investing industry. Some entrepreneurs include an NDA when sending a plan to an investor, but many investors are reluctant to sign them. Some investors believe that they are unnecessary and that investors are not looking to steal ideas. Others believe that a specific NDA can be signed if there is a need to disclose confidential information. It is recommended that entrepreneurs should consult with their lawyers and avoid using NDAs unless it is necessary and they have legal guidance.
Reasons Deals are Rejected
The venture industry looks for a range of factors in a potential deal, including the management team, the market, the competition, and the firm’s business model. In terms of management, investors consider whether the team has the necessary skills and experience to lead the venture, as well as their honesty, integrity, and leadership ability. They also look for a growth mindset and the ability to work hard and make tough decisions. Market-related risks, such as a lack of understanding of the market dynamics or competition, can also be deal breakers. Investors consider the market size, market dynamics, and competition, as well as any potential barriers to entry. Finally, the firm’s business model must create value for both the firm and its customers, and there must be a viable distribution strategy.
Final Thoughts
Due diligence is a process of research and analysis that investors conduct on a potential investment opportunity to determine its value and risk. The process includes examining the business plan, vision, business model, marketing plan, financial plan, organizational culture, office, and employee environment, and talking to management, employees, customers, advisors, and competitors. Investors can also use tools like LinkedIn to find out more about entrepreneurs and conduct background investigations on senior management. Moreover, they should talk to other investors and check their references, check the credibility of advisors and customers, and use their network to get information about competitors. Site visits are also important to observe the firm and its operations. By conducting due diligence, investors can assess the feasibility of an investment opportunity and make informed decisions.