I’ve been asked to join the panel at a London Business Angels investor club night this week. The event will focus on the topic of due diligence. To get the juices flowing, I’ll focus here on some key aspects:
Staged due diligence is vital
The amount of time and effort put into gathering information needs to be staged to be fair to you and to the prospective investee. In stage 1 we simply evaluate the business plan, presentation or other initial interaction. In stage 2 we ask more questions but take the answers at face value. At stage 3 we seek to reach a detailed conclusion as to whether we would like to invest in the company. This is the main stage at which we take the technology, product/service and market apart and seek to understand them thoroughly. Finally at stage 4, we seek to ensure that the legal and financial terms are fully acceptable. Our experience is that the decision to pass from one stage to the next should be taken seriously and with regard to the time and implied commitment involved.
Decide how much to do before agreeing terms
We’ve varied in our approach to the amount of due diligence we do before agreeing investment terms. On one hand a greater degree of upfront research will indicate areas for further discussion and investigation. It will also uncover issues that change our views on valuation or our interest in investing. On the other hand, an early term sheet shows commitment and gains exclusivity.
The company seeking investment should provide the information
When I started investing, I would spend a lot of time undertaking my own research into the market prospects for potential investments. Whilst we still do this on occasion, it’s far more valuable to understand what the company knows. Our approach now is to provide the company with a set of headings for the main due diligence, and expect them to populate a dropbox folder with their information. This has the twin advantages of helping us to understand the depth of the company’s own understanding and providing the basis for the warranty disclosure letter at the end of the process.
Talk to customers
An invaluable part of the diligence process is a series of calls to current and prospective customers. Are they happy with their interactions with the company? Does the product perform? Do their projected orders correspond with the company’s sales projections? A few structured calls undertaken by a market research professional can be illuminating.
Don’t overdo it
It’s possible to overanalyse a prospective investment. This can result in wasted time and thus deflate the return on investment. With early stage technology businesses, especially those that are pre-revenue, some questions cannot be rigorously answered and the decision will come down to your personal judgement. I always ask myself the questions “will this piece of research contribute directly to my investment decision” and “do I think that the management team will find the answers post investment”.
Undertaking a structured due diligence process is a super way of learning about the business and its management team. Executed properly it leaves me with the confidence to entrust the company with my investment, or to walk away from the deal safe in the knowledge that ‘this one’s not for me’.