Imagine a startup owner standing before a group of investors to pitch his idea. The investors listen patiently throughout the presentation. Then they start asking questions. It turns out they are planning to compile a set of due diligence reports, including a startup valuation report. They intend to do their homework. They want to know if the business owner has done his.
It has been our experience that entrepreneurs working on their first startups are often caught off guard by the due diligence concept. They expect to have to prove the value of their companies from the ground up. They don’t realize investors will do their due diligence after being pitched.
They Need to Know the Risks
Angel investors rely heavily on due diligence to protect their own financial interests. The top concern is risk. Investors want to know all of the risks associated with a given project before they commit. Identifying risk is just one part of due diligence. But it is a big part.
As a due diligence provider, we may identify more than a dozen things we believe investors need to look at. Those investors might prefer to distill all of the risks down to the top three or four. Then again, they may choose to look at each one in complete detail. It is really up to them to determine how detailed the risk assessment should be.
Assessing risk ultimately leads to more questions. Those questions are compared against current performance data, future projections, and even the answers entrepreneurs gave during the pitch. Only when investors are satisfied do they stop asking questions.
They Build Investment Models
Another key component of due diligence is building a business model. Just like the entrepreneur starts out with a business plan and accompanying mission and vision, investors do something similar. They put together a model of what their investment could look like under certain circumstances. Some investors build multiple models to account for different scenarios. Due diligence plays a role here as well.
Proper due diligence looks at a long list of factors covering everything from financials to management team experience. These factors influence investor models. One model might account for strong financials but an inexperienced management team. Another might focus most heavily on industry competition. All of the models combined help investors wrap their heads around where a startup might be headed.
Assessing risks and developing investment models requires making assumptions. This is the riskiest aspect of angel investing. Remember that in business, there are no guarantees. Some of the most promising ventures have crashed and burned in short order. By the same token, there are well known multi-billion-dollar corporations that started as a project in someone’s garage.
Some investors refer to assumptions as things that need to be believed. In other words, investors must believe that X, Y, and Z are true in order to proceed with the investment. If just one of them is not assumed to be true, everything stops. The tricky thing about assumptions is managing them properly.
Poorly managed assumptions can turn the light out on a deal that would have otherwise proved quite profitable. They can also encourage investors to make unwise decisions they end up regretting later on. Due diligence plays a role by providing the necessary data to manage assumptions. The more data provided the easier assumption management is.
Due diligence is critical to angel investing. Whether entrepreneurs know it or not, investors will go to great lengths to protect themselves before investing in any project. That is what due diligence is all about.