The dos and don’ts of due diligence for investors
Investors backing early-stage start-ups might struggle to know where to begin when it comes to due diligence. A lot of the usual advice on checking past company performance and financial records doesn’t yet apply. So how do you ensure you’ve dotted the i’s and crossed the t’s before diving into a new opportunity?
With early-stage start-ups, a lot of the due diligence steps you can take are about assessing the opportunity and looking for synergy between what you both believe in.
Yes, due diligence is about checking if it’s a sound financial investment and making sure the business stands up legally. But it’s also important to consider wider points like diversity and ethics.
If you’re on the cusp of investing in a start-up, there’s a lot that you can do to help you enter into the relationship with confidence. Here’s our checklist of dos and don’ts to tick off before you make the final decision.
Do… understand the opportunity
The pitch deck is the first stage in getting to know your start-up properly, so assess it carefully. Make sure it covers all the basics:
Executive summary – this is the overview that you evaluate first to decide whether you want to see the founder’s pitch. It should be brief but clear. Does it explain the business idea well and make you want to know more? If not, don’t waste your time calling them in.
The problem they’re aiming to solve and their proposed solution – this is the crux of their business idea and you need to feel strongly about it to be properly invested in the business.
The team and their background – what expertise and capabilities are the founders bringing to the new business? How will they use their past experience to drive the business idea forwards? This is an important marker to help you determine future success in very new businesses.
Finances – it can be tricky for early-stage start-ups to nail the finances in a pitch deck. But even if the business is yet to make sales, founders should be able to show you a three-year plan with projected costs, profit margins and income, and explain how these will change as the business grows.
Traction – another difficult area for young businesses. However, any founder asking for funding should have validated their idea in some way. This is a chance for you to investigate their creative approach. For example, have they built up a group of early adopters to help them launch, or developed key partnerships to improve their route into market?
The market opportunity – They should have a good understanding of the current market size as well as any opportunities for market growth in the near future.
Competition – Have they fully assessed the competition and carved out a clear USP that sets them apart from the rest?
Do… be clear about potential risks
Now it’s time to flesh out the potential risks involved. It’s likely that the business has very little trading history, few accounts and no employees – so how do you carry out a risk assessment?
The first stage is trusting your instinct. What are your first impressions and what red flags popped up during the presentation that you need to investigate further? The business founders will have a well-rehearsed presentation, so it’s up to you to drill down further into the finer points.
This might involve a Q&A session at the end of the presentation, but if you don’t get the details you need, press them for a follow-up call to explore things in greater depth. Compose a list of key questions and refine these to no more than five that you want to explore.
You can use a due diligence checklist to help you work through the most important questions to ask at this stage. Make sure you’re crystal clear on what the opportunity is for you as an investor:
Do you understand the proposition and what you’re investing in?
Are you investing in the right founder?
Is there a real opportunity here?
If there are still unanswered questions after this process then it’s probably time to walk away.
Do… look for common ground
All businesses should strive to raise investment that has a deeper meaning than a simple transaction of funds. But that works both ways. Investors also have a responsibility to fund businesses they are aligned with.
It’s your job to look for a business you believe in, rather than one that will simply make you money. Not only will this lead to a more successful investment on your part, it will also go some way to addressing the shocking levels of inequality in the world of investment.
Consider the facts: 79% of angel investors are White British and 43% of VC seed investment goes to founding teams with at least one member from an elite educational background.
So, part of your due diligence as a funder is to invest in a more equal and diverse future. Make a start by asking these questions:
Is the start-up taking a scattergun approach by talking to a very broad range of potential funders?
Why do they want you specifically to fund their business?
Are they deserving of your capital?
Do they represent a group that resonates with you? For example, are they trying to solve an ethical problem you care about?
Can you see that they would benefit from certain areas of expertise or experience that you could help provide them with?
Do… get advice from angel groups
If you’re investing as part of an angel group, lean on one another’s strengths when carrying out due diligence.
Look for other funders with key strengths in different core areas, like legal, finance, marketing and operations. That way, you can make sure you have a strong foundation of different skills between you.
Of course, many investors that are considering early-stage start-ups will be investing as individuals. If that’s the case for you, look within your wider network of professional contacts, friends and family, when you need a second opinion on aspects of the business that you’re not an expert in.
If you already work with a good solicitor or tax advisor, then it’s also worth running the opportunity past them first.
Don’t… invest just because your peers are
Heard about an exciting new business that your peers are investing in? It’s not uncommon to invest based on the fear of missing out (FOMO).
This is a bad idea for three reasons.
First, just because a start-up is the right fit for another funder, it doesn’t mean it’s the right fit for you.
Second, it’s all too easy to assume that the other investors have done their due diligence. After all, they are astute business people who you know and trust. The problem is, they may have a different outlook and set of criteria to you. If you don’t follow your own process of due diligence, this could unravel later down the line.
Finally, this approach can lead to a cycle of unconscious bias. This is where we make decisions based on ingrained views and beliefs, rather than doing robust research.
The result? An investment landscape that continues to lack diversity by elbowing out minority groups.
Don’t… invest just to get a tax break
As an investor, it’s crucial that you can expect to see a sound financial return in the near future, but don’t fall into the trap of investing for the sake of it.
The tax reliefs for investors who fund start-ups can be high – and that’s appealing. It’s not surprising that most investors want to take advantage of one of the government’s schemes to benefit from the tax relief they offer. These include the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS).
Investing in start-ups shouldn’t be seen as a way of solving a tax problem, though. Follow all the due diligence points covered in this guide first and see tax breaks as a nice extra.
Don’t… forget that it’s not a level playing field
Remember that some founders from underserved communities may not have access to these types of services when developing their business. This could be the very reason they need investment – to find individuals with the right expertise to help them.
If this is the case, try to judge the business opportunity on what it could become with the right input, rather than what it is now.
Be prepared to have a frank conversation. Can you see a profitable idea if the founder can access the right support? Are you in a position to help them grow the network they need? You aren’t running a charity, but you may be able to add value to help the idea move to the next stage.
Taking a balanced view of due diligence
When we talk about due diligence, it’s easy to get sidelined by issues of compliance and regulation.
While these are important issues for any investor to consider, it’s also necessary to balance this with the bigger picture. What is the purpose of the business and can you see a future in it? More importantly, can you see yourself in that future?
This content is for awareness only and is not for financial promotion. If you are unsure please seek independent advice.
