What is Investment Due Diligence?
Angel investing can be an exciting, fulfilling, and profitable experience, but how can would-be investors identify worthwhile startups? This can be a challenge even for seasoned investors, meaning it can be even more daunting for first-time investors. What steps can an investor take to find those diamonds in the rough? Learning about angel investor best practices can help you identify those potential unicorns while avoiding startups that are unlikely to provide a return on your investment.
What is Investment Due Diligence?
“Due diligence” refers to the practice by which each party of a transaction takes steps to confirm that all information disclosed by the other party is accurate. Investors practicing due diligence effectively audit a company by researching its financial situation, the product, service, or technology it offers, and any other aspect of a business relevant to them. There are many different ways an investor can perform due diligence. Each angel, fund, or group typically develops their own methods and recruits specialists to their group to perform the various tasks including financial, market, technical / engineering, legal, etc. The Angel Capital Association recommends a minimum of 40 hours of due diligence per deal (company) to do the work properly.
Why Is Due Diligence Important?
Startups are inherently risky places for investors to put their money, as many fail before fully launching or don’t live up to the great expectations of their founders or backers. This means investors need to be fully aware of the risks they are taking on be placing their money in a startup before making a commitment. Conducting your own research about an investment opportunity can provide you with added protection and may alert you to dangers or opportunities a startup’s owners may have missed. Investors who don’t conduct due diligence before making a commitment can see a low ROI or even a total loss of their investment.
How to Do Due Diligence as an Angel Investor
While there isn’t a set process by which you need to conduct due diligence, there are a few key areas you’ll want to check before making a decision to invest in a startup.
Is It Proprietary?
A startup might make a good coffee, but if their intellectual property isn’t proprietary, there’s nothing stopping another business from selling the same thing. Check out competitors, if there are any, and find out how the startup in question’s product or service differs from them. You’ll also want to ask the startup founders as much as you can about their product to determine if it can be easily replicated by another company or if it would be protected by copyright.
Check the Financials
One of the most important things to do is to ask about the financials of the startup in which you wish to invest. Not all startups are alike, and a promising startup in its early stages might have negative cash flow, whereas one that has moderate potential might have a robust balance sheet. You’ll want to consider how much risk you’re willing to stomach and what kinds of financials you’re willing to accept. If a startup lacks sufficient cash flow or is excessively leveraged, it could fold under financial pressure before you ever make a return on your investment.
Interview the Startup Founders
You can learn a lot about a startup’s prospects for success by simply interviewing the founders of the startups you want to invest in. If there is only one founder, do they have the skills to build a team that can see their vision to completion? For startups with multiple founders, how well do they work together and complement one another, and what are the contingency plans should some of them decide to exit? When you invest in a startup, you’re investing in the people at the top, so you want to have the utmost confidence in their ability to deliver.
Conduct Market Research
You might be enamored with a startup’s product or service, but that doesn’t mean others are. How strong is the demand for what the startup is offering? You could find that you struck gold, or you might find that the founders are over-optimistic. Once you have a better sense of the demand for the product, you can get an idea of how capable the startup is in scaling to fulfill it.
Ask About Their Marketing
Even if the startup has a dedicated team of founders with a product that has massive potential, they still need to be able to sell it. What are their plans to market their product? Do they know who their customers are, and do they have an effective strategy for reaching them? What is their plan for scaling to meet demand should business take off?
Talk About Long-Term Plans
Your relationship with the startup today might be on solid footing, but where will it be in six months, two years, five years, or even ten? What can you expect as a return on your investment, and how will the entry of more investors affect your position? What exit opportunities are there for you or the company, such as potential buyouts? You’ll want to make sure that your long-term vision is aligned with the founders before investing.
Angel Due Diligence Checklist
Here’s a list of things that you should expect to do during the due diligence process:
- Review the company’s financials, including their cash flow, debts, and any other expenses
- Interview the startup founders/owners to learn more about their vision and relationships
- Conduct market research on potential demand and competitors
- Inquire about what sets the product or service apart from others
- Ask about long-term plans for scaling and exit opportunities, such as a sale
- Set clear terms for your investment
If you’re serious about angel investing, download our 60+ point due diligence checklist to better evaluate potential startups. StartUpNV is Nevada’s only state-wide business incubator, and it’s our mission to connect aspiring angel investors with experienced angels and promising start-ups. You’ll learn how to determine a startup’s feasibility and how to measure its progress toward a successful, scalable launch. With this information, you’ll have a tested rubric by which you can evaluate potential business partners and act on opportunities as they arise.
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