Conducting Due Diligence

Due diligence is the most important aspect of startup investing. Without it, you won’t have the slightest idea of how successful (or unsuccessful) a venture is likely to be – you might as well be throwing your money into the wind.

Due diligence requires a bit of digging, especially as its trail is often hard to find; complex regulations and fear of putting off potential investors mean that the facts may be hidden beneath layers of flowery (and imprecise) language. Having a lead investor in on the round can help, since they will do some digging before pledging their own money into the round, but regardless of what anyone else says, always be sure to carry out your own research before investing.

When conducting due diligence on a target company, your goal is to thoroughly evaluate its affairs in order to make an informed decision as to whether to proceed with an acquisition. After completing a preliminary overview investigation of the company and signing a letter of intent or term sheet, it’s time to dig deep into corporate data. This will include finances, sales figures, customer data, ownership of assets, personnel records, and customer data. Keep in mind that some proprietary information may be staged for later in the due diligence process when it’s warranted by the seriousness of your intent.

Broadly speaking, there are five main things you should definitely consider. Below is our due diligence checklist

• The Team
  • Ask any experienced investor and they’ll tell you: the founders matter. While opinion is split over whether or not it’s a make-or-break factor, there is general consensus that you shouldn’t overlook the team behind the idea.
  • So, what should you look for in a startup team? For founders, having relevant experience is important, but so is motivation and vision. What is their reason for creating the startup? Are they reliable? Trustworthy? Do you get along with them? A founder can tick all the right boxes, but if you can’t stand to be in a room together then you’re unlikely to have a good business relationship.
  • It is very unlikely that you will find all the characteristics needed to run a successful startup in a single person; that’s why you’re far more likely to come across co-founders than entrepreneurs pitching solo. The ideal team will be made up of people with complementary skill sets who are enthusiastic and able to turn their hands to whatever’s needed.

• Review the Company’s Business Structure and Practices
  • The company’s organization documents should include articles of incorporation, bylaws, names of board members, board meeting minutes, names of shareholders, a list of all the states and countries where the company does business, and an organization chart. It is also important to review corporate records for partnership agreements, vendor and supplier relationships, and agreements to purchase securities. The data room should include licenses, permits, and letters of consent, as well as articles and press releases about the company.
  • Naturally, it’s also a good idea to look into the product or service the startup is offering. Is it innovative? Is it easily replicable? Has it been trialed? If so, was it well received? Does the company hold any patents? If you’re investing in an early-stage business, it’s likely its product will not be fully developed and the degree of risk will be higher.
  • Conduct research on the competition and find out what’s worked for them, and what hasn’t. If a similar product has recently flopped, it may be best to sit this one out.

• Traction
  • Traction is any kind of forward momentum, but the bigger it is, the better. A company’s traction gives you an idea of how well it’s been executed to date. What you want to see is a steady growth in metrics month on month, with no big drops or plateaus.
  • Here are some measures to look at when evaluating a startup’s traction:
    • Growth – How many customers do they have? At what rate is this figure growing?
    • Revenue – What’s their track record like? How many sources of revenue have they planned for?
    • PR – How is the startup scaling its metrics?

• The Market
  • Look at the market to gauge whether the product/service is likely to do well. Assess the market size, competition, and potential acquirers. How ‘hot’ is the sector?
  • The acquisition value of a company can be calculated using a multiple of annual revenues (or expected annual revenues) – listen to this Angel Insights interview with Peter Cowley, Fellow at the Cambridge Judge Business School, for a few tips.
  • If you’re going to invest, you should be sure that the market is large enough for the venture to achieve healthy revenues and a healthy return. At the same time remember that, unlike a VC, you don’t need to wait for an opportunity in a billion-pound market since angels come in much earlier on in the process.
  • And then there’s the factor that everybody forgets about…

• The Investors
  • When deciding whether or not to invest in a startup, it’s crucial to know who you’ll be investing alongside, and yet this is one consideration that isn’t immediately obvious to many aspiring investors.
  • Will you be investing as part of a syndicate? What industry or financial experience do the other investors in your group have? Who will be leading the round – you, or someone you can trust?
  • Investing as part of a group or syndicate has many benefits, not least among these being due diligence. Two heads are better than one, and ten inquiring minds are even more likely to poke holes in a sub-standard business plan. You can learn a lot through camaraderie.