10 Due Diligence and Do Diligence
Several months ago I met with a group of younger angel investors, and I explained how I try to confirm some of the things in the pitches I hear. They looked at me with amazement and said, “Oh, you’re one of the old-style angels.”
Frankly, I couldn’t believe my ears. “What do you mean?”
“Oh, we roll in a new way,” they said. “We think due diligence is a waste of time. We’re good judges of these things. If we like the idea and like the team, we give them money.”
Since then I’ve met many angels who share this point of view. Why bother verifying a lot of stuff on résumés or who owns what intellectual property, when the real issue is the idea and the intelligence of the team, details that can be validated just by talking to people? It’s also true that due diligence takes time. On average, angel investors spend seven hours on due diligence per investment. That can seem burdensome, especially if an investor wants a diverse portfolio.
But I think if you’re going to be an angel, then you should invest the time and energy to do it well. The research is absolutely clear on this: there is a direct link between investment returns and the length of time you spend on due diligence. According to a 2007 study for the Angel Resource Institute, “Returns of Angels in Groups,” Robert Wiltbank of Willamette University found that angel investors who devoted less than 20 hours of due diligence per opportunity received portfolio returns of ×1.1 as compared with the ×7.1 returns by those who spent more than 40 hours on due diligence. It’s clear there’s a positive correlation between the time spent on due diligence and portfolio returns.
I know that many founders dread this step. Frankly, the words “due diligence” frighten a lot of entrepreneurs. I find the term “discovery” less threatening.
By any term, the concept is very simple. It’s an investigation or audit of a potential investment. It is completed before a startup receives an infusion of equity capital from the investor. The goal of the process is to give investors an objective look at weaknesses, potential liabilities, and other exposures so they can better assess the risks of the investment. Due diligence is all about mitigating risk.
There’s risk in every investment; no startup is perfect. It’s always easy to find a reason for saying no to any opportunity. I’ve met a lot of angels who put so much effort into due diligence that they hesitate to invest in anything. It’s analysis paralysis.
Due diligence becomes a trap if it’s applied only to identify reasons not to invest in a startup. I believe the process should equally be applied to identify reasons to invest with enthusiasm. I call this process “do” diligence.
Other angels use do diligence to give themselves “permission to believe,” a concept I discussed in Chapter 4. Mature angels understand that risk can’t be eliminated. Due diligence can go a long way toward mitigating avoidable risks. And do diligence underscores the fact that every startup offers bright, shiny opportunities for profit. It’s a question of balance.
In the United States, regional differences in due diligence further complicate matters. No one should be surprised to learn that the conversation I recounted at the beginning of this chapter occurred in California. Silicon Valley angels are more laid back about everything, including due diligence.
The kind of due diligence an angel engages in reflects his or her experience. On the East Coast, angels tends to come out of the finance world, and they often want to do what I call “spreadsheet due diligence.”
The proponents of relaxed or no due diligence believe that the numbers underlying the presentations are fantasies anyway. Due diligence consumes a lot of time for what is often, from the angel’s perspective, a small investment. In such cases, it’s more meaningful to have a conversation with the team about how they intend to go to market.
Adam Dinow, a partner in the New York law office of Wilson Sonsini Goodrich & Rosati, is deeply involved in the New York technology community. He serves on the board of directors of NY Tech Meetup, the nonprofit organization at the heart of the New York Angels tech community, with over 30,000 members. Adam represents businesses at all stages of their life cycle, from incorporation to exit, with an emphasis on working with entrepreneurs and fast-paced, rapid-growth enterprises. You’d figure he has a clear opinion of due diligence, and he does.
“The numbers mean nothing; legal due diligence means nothing,” Dinow says. “I’ve worked with investors who go through excruciating due diligence and those who write checks on a whim. The most critical piece is to get comfortable with the entrepreneur and their values, to know he or she is sharp enough to know when something isn’t working.”
Dinow’s main point is that the investing world is moving too fast for due diligence overkill. “When a company can’t bring in $400,000 on an angel round because the due diligence takes too long, that’s a problem. In this game, angels are either doing it or not; they can’t stretch these companies out for too long,” he says.
Some angels ignore due diligence and then try to protect their investments with indemnifications and warranties. Basically, angel investors and startups make representations and warranties to one other in the acquisition agreement. The startup’s representations and warranties provide a mechanism for the angel to walk away from or possibly to renegotiate the terms of the investment if, between signing the term sheet and closing the deal, the angel discovers facts that are contrary to the representations and warranties.
“I don’t believe an angel investor can legislate due diligence,” says Dinow. “Indemnifications and warranties cannot be a substitute for determining up front who you do business with.”
Alain Bankier, introduced in Chapter 5, got his start as an investment banker and applies his quantitative skills to every opportunity, so you’d expect him to incline toward the rigorous end of the due diligence spectrum.
“I am very far from the guy who meets a smart entrepreneur and immediately whips out my checkbook,” Bankier says. “On the other hand, I am not a due-diligence-to-death guy, either. The research is pretty convincing that angels dramatically increase their chances of return when they apply some measure of due diligence.”
One problem is how to do meaningful due diligence on prerevenue startups. Bankier has evolved a process that looks more like competitive analysis. He wants to have decent confidence that Microsoft, as far as one can tell from available information, is not going to roll out something similar to the product of the startup he’s considering. Or even worse, there’s already a better mousetrap out there in beta. He also scrutinizes the startup’s market projections, to see if they are realistic.
For example, if a startup in a multibillion dollar market indicates it intends to have $20 million of the market in year four, that’s a red flag. “Why are they shooting so low?” Bankier wonders. The reverse is also true. “It makes me nervous to see a startup claim $100 million share in a $1 billion market,” he says. “Really? You expect to grab 10 percent?”
We are now seeing angels outsourcing due diligence to entities they assume will do it better. In one case, the entity is Y Combinator, the elite accelerator. Yuri Milner’s DST Fund and Ron Conway’s SV Angel fund recently announced that they will invest in every single startup coming out of Y Combinator. The seed rounds will provide $150,000 to every single one of the 40 startups that wants it, without any due diligence on their own part whatsoever. The capital is in the form of convertible debt with no cap and no discount. The loan will convert when and if the startup raises a proper angel or VC capital round at the same valuation that’s set in the round. Most convertible debt has a valuation ceiling and also gets a discount on conversion. The angels are banking on the premise that Y Combinator, in vetting the startups it stewards, has performed satisfactory due diligence.
Milner has effectively shut out any other angel investors by offering such attractive terms. It’s almost free money. I’d be surprised if any of the 40 startups in each Y Combinator class decline such an offer.
Knowing that it’s coming, why not anticipate due diligence questions and address them before the angel asks? I promise you, angels will be impressed.
It takes a lot of time to prepare for these questions properly. But you’ll actually save time over the long term, because you will be asked for this information often. Most investors will want details about your team, stock ownership, other investors, IP, etc. If you have this information available, don’t wait until you are asked for it.
David S. Rose, the CEO of Gust and founder of New York Angels, has raised over $50 million from venture capitalists for companies that he has founded. His approach to due diligence is proactive: before he even meets with an investor, he has already taken a complete list of items that VCs often request during due diligence and compiled them all into one big binder. That way, when a potential investor starts asking about the details, David can simply hand him or her the binder, and say “here you go!”
And if there’s some negative information that’s going to come out anyway, volunteer it. For example, if there is a dispute about your IP, don’t wait for the angel to find it. If you volunteer the information, you project confidence, and you and the angel have an opportunity to discuss the issue. Such conversations are much less agreeable if the angel learns about the problem elsewhere first.
Don’t be one of those startups that screws up the due diligence step. It’s not enough to assume that the business plan documents and financials speak for themselves. Yes, the business plan and all supporting documents must be up to the minute, synchronized, and in the hands of every founder. And the entire team must be on the same page. Every founder must know the startup’s strengths and especially its weaknesses (because that’s where angel attention will be focused) and practice responding to potential objections.
It’s not just the investor auditing the founder; the founder gets to audit the investor. Far from being insulted by having questions turned on me, I welcome it. I expect it. I’m actually disappointed when a startup fails to do its due diligence on me. I’m not the right investor for every opportunity. I want the entrepreneurs who approach me for funding to be absolutely clear that they want me as an investing partner. I like to see a certain peer relationship between the investor and the entrepreneur. A reciprocal due diligence dance keeps the partnership in balance. Most investors welcome a reasonable level of due diligence from entrepreneurs. If an investor resists, that’s a bad sign. I suggest the founder look elsewhere.
Jay Turo, CEO of GroupThink and an angel investor, uses social media to conduct due diligence on entrepreneurs. “You’re naked out there,” Turo says. The good news is that entrepreneurs can turn the same social media tools on angels. Appendix C describes five indispensable tools for entrepreneurs to use as they conduct due diligence on angel investors: LinkedIn, Gust, AngelList, TechCrunch, and Quora.
Early-stage equity investors approach due diligence in different ways, but here are a handful of common issues on which entrepreneurs should always expect to be scrutinized:
• The team. Convene the team to discuss due diligence. This is a perfect time for the CEO to present the final investor charts and answer any questions. Everyone on the team needs to know what his or her role is for the due diligence. Every team member will likely be separately interviewed. Investors want to determine the commitment, talent, strengths and weaknesses, and management style of each team member. For many investors, the “chemistry” of the team is the number one issue, because we know that a firstrate team with a second-rate idea will always outperform a second-rate team with a first-rate idea. Make sure all résumés are up to date. Give listed references a heads up that the startup is being scrutinized. If due diligence uncovers signs of a team member who doesn’t carry his or her own weight, a naysayer, or a dysfunctional team, most investors will back off.
• Validation of product. I’m interested in your technology, the current state of your product’s development, and customer satisfaction. How ready for market is the product or service? The answer to this question comes from a process called “technical due diligence.” Before I invest, I generally spend a day or more with the individuals responsible for engineering, development, and product marketing. I want to evaluate the quality of the startup’s development processes as well as the products themselves. Is what you have to offer something consumers need or simply want? Does it work? Is it ready to ship? Are there any issues or certifications that need to be resolved? If the product is in customer hands, I’ll ask for a list of customers. I need to have confidence that the product is ready for release and actually has all the features detailed in the presentation.
• Customers. Now would be a good time for you to contact key customers and vendors. Explain that they may be called, and use the opportunity to gauge their satisfaction with your company and your product. If there’s a problem you can’t fix, tell me yourself. You don’t want me to be surprised. Customers are key to success. I can be a pretty good resource for a startup, but I can’t make customers buy anything, and without actual customers eventually parting with their money in exchange for a good or service, there is no business. So I will ask for lists of potential customers to call. I’ll start with your (undoubtedly well-rehearsed) reference list but will quickly try to get them off-script and go from there. I will also try to ascertain the sustainability of the market. Does the startup enjoy key differentiators or significant barriers to entry? If not, even the best markets can be poached by new competitors.
• Size of the market. A great product or service is critical, but it’s not enough. One of the criteria for a good investment is a large and fast-growing market. I’ll determine the actual size of the potential market and the market share you can reasonably expect to capture. I’ll examine the sales and marketing strategy you expect to deliver that market share. This will involve an analysis of your distribution channels, promotion, and pricing strategy. I need to get an independent reading on barriers to entry, competition, and price sensitivity.
• Intellectual property. I need to be confident that the startup’s claims to its intellectual property (patents, trademarks, copyrights, etc.) are legally sound. For many startups, the intellectual property is the sole basis for the valuation of the company, so investors need to be confident that it’s real.
• Business integrity. Every entrepreneur, every startup, leaves a trail of business transactions in its wake. As much as I am able, I like to trace that trail backward to determine how well the team has met its previous financial and business milestones. Does the record show evidence of meeting commitments and obligations? Or is the trail peppered with unpaid bills, disgruntled landlords, active lawsuits, or bankruptcies? Any one of these is generally a deal breaker for me.
Why should due diligence be so threatening? If I were a founder, I’d be suspicious of an investor who is willing to write me a check on the basis of a single pitch. I’d expect the investor to conduct an objective check of my business model, talk to a few of my customers, and verify that the product or service, team background, and revenue projections are as represented. If the results do not match the representations, a conversation needs to follow.
I speak from experience. There is no substitute for due diligence, as I think the new generation of angels will discover to their dismay. I’ve been burned many times by making bets solely on the basis of my initial judgment, only to find out later that my investment was squandered by founders without integrity. There’s really only one way to determine an individual’s integrity: to consider how that person acts—or has acted—when he or she thinks no one is looking. That’s what due diligence does. In a disciplined way, it looks at an individual’s achievements and behavior, both good and bad.
I personally pay more attention to some things than others. Integrity is of paramount importance to me. I want to confirm that the educational credentials on the résumé are as represented. I also think the way an individual handles money is hugely revealing. I want to see if the founder has handled debt with integrity or if he has left a trail of landlords, merchants, financial institutions, and other investors holding the bag. In the stock market, we are reminded that past results do not guarantee future performance. But when it comes to character, past behavior is the most reliable predictor of future performance.