“Diligence is the beginning of brilliance.” – Indonesian Proverb
BusinessDictionary.com defines due diligence as, the “duty of a firm’s directors and officers to act prudently in evaluating associated risks in all transactions.” Due diligence is a process not only to be completed when evaluating investing in a company; but, should also be conducted for all follow-on rounds to ensure positive investment viability. According to the Angel Capital Association, due diligence should focus around 7 things. In this post, we cover what these 7 topics are and why they are inherently important in making investment decisions.
While we will drill down on several aspects of due diligence the biggest mistake angels make is circumventing their own diligence processes. Too often “gut” or “good judgment” are used in place of disciplined procedures. Angels historically are their own worst enemy. Too often they project their own vision of what the company seeking financial support could be rather than listening to what the founder intends the company to be.
How, when and who should conduct diligence on potential investments are a huge business decision which can make or break any company’s portfolio. The process for BlueWater Angels begins when companies apply for investment on our website, then our portfolio manager conducts an initial review to determine if the company aligns with our investment portfolio’s objectives, if a company passes the initial review a screening committee then meets to review the company’s representations and documents. It’s important to note that initially we begin with the claims and representations are all from the company. To provide and determine the viability for investment it’s essential to de-risk the deal by accessing data sourced outside of the company’s claims.
After the initial reviews are complete, we invite entrepreneurs to attend one of our pitch events where they are given 10 to 20 minutes to present their venture and address Q&A with our investors, this event helps us to determine our investors thoughts on the company and willingness to invest.
If a company is approved by a base group o investors, a term sheet is put into place and a much more in depth round of diligence is undertaken primarily focused on customers or third-party references.
If all goes well with the investment capital calls are made to investors.
The first thing we review is the structure of the business and the advantages and disadvantages this poses to us as investors. For example, corporations typically require a board of directors which can be extremely helpful when making difficult business decisions; but, can also slow progress if stuck in deliberation.
We then determine the deal structure requested and what the structure will be for shareholders including costs and ownership in the company. Other topics we cover in Governance and Business Structure include, executive wages, dilution from investment, liquidity options, and organizational structures.
During due diligence, financials are regarded as a main priority determining the current cost structure and revenue base, as well as future projections and profitability. Companies that have limited or no revenue are reviewed to determine the viability and sales projections, companies with revenues currently are evaluated to determine expanding sales projection.
Financial reviews also determine the cost structure and ways to increase efficiency of the company, a huge plus in cultivating profitability. This process also includes completing a current valuation of the company, an important step in determining the price of shares.
Market research provides the size and location of available buyers for products and services, an essential tool in determining the viability of an entrepreneurial venture and its potential profitability. Evaluating the market of start-ups determines if the entrepreneur is currently targeting the right demographic and if business operations need to adapt to better suit the target market. Not only does market research determine who best to target, it determines the total volume of potential sales. Additionally, market research is a great way to evaluate competition and determine how to outperform them with marketing and product differentiation.
A solid management team is a necessary tool to execute a successful business plan and can greatly determine the profitability of a company. First, management should have a vast array of skillsets, experience in new ventures, outgoing personalities with diverse leadership skills, vision to lead, and passion. Evaluations can be conducted by reviewing resumes, conducting interviews with past employers, business partners, and subordinates, and completing reference checks.
Intellectual Property and Technology assessments determine if products or processes have been patented, copyrighted, etc. These assessments are an essential tool to ensure that no patents or copyrights have been breached, intellectual property of the entrepreneur and team are protected, and the viability of the product or service. Technology assessments are completed utilizing field experts to determine the viability and use of the product and whether adopt-ability is possible and/or likely.
Operational plans dictate the daily tasks of an organization and carefully explains the roles of employees. Leoisaac.com list an operational plan to include allocation of resources, specific activities and events, day-to-day management, and reference of strategic plan. An Organizational plan should be entirely adaptable as business needs change including the allocation of resources, financial planning, and marketing plans.
Due Diligence is a highly valued advantage of Angel Investment groups in which Angel
Investors idealize the choice to take a front or back seat in the process; but, reap the benefits either way. The Angel Capital Association provides a detailed Due Diligence Checklist Table, a useful printout for angel groups and individual investors including:
- general corporate materials,
- compliance with laws,
- employee matters,
- real property,
- intellectual property matters,
- debt financing,
- other agreements,
- financial information,
- tax matters,
- public relations,
- press releases and clippings,
- and miscellaneous other topics.