Due Diligence for Angel Investors

Throughout history, businesses have used various tactics to present their assets, processes, and operations in a more favorable light to people on the buyer side of transactions. This practice continues in modern-day business, where companies utilize various strategies, including accounting tricks and fundamental metrics changes, to make their business appear more attractive to customers and investors. Conducting due diligence is essential for angel investors looking to invest in a company. It is also crucial for investors to conduct due diligence to determine if a business aligns with their investment thesis. The process of due diligence involves investigating and analyzing the startup or company to gather relevant information that will help the investor make an informed decision. This investigation thoroughly examines the company's financial, legal, and operational performance, as well as its market position, competition, and potential for growth. The ultimate goal of due diligence is to provide investors with the necessary knowledge to determine whether to invest in the company, how much to invest, and the potential risks and rewards of the investment.?

Importance of Due Diligence in Angel Investing?

Due Diligence is crucial for angel investors because it allows them to assess the viability of a potential investment, identify potential risks, and understand the company's management team and business strategy. Through due diligence, angel investors can better understand a company's financial position, market potential, and competitive landscape, which can help them make informed decisions about investing in the company. Conducting thorough due diligence can also help angel investors negotiate better deal terms and reduce the likelihood of surprises or unexpected issues arising after an investment is made.

Types of Due Diligence

There are different types of due diligence, such as Management team due diligence, financial due diligence, intellectual property due diligence, legal due diligence, and customer due diligence. Each type of due diligence focuses on different aspects of the business, and together, they provide a comprehensive picture of the company being considered for a transaction.

Financial due diligence?

Financial due diligence (DD) is a crucial component of the process that aims to evaluate and verify a company's financial health for acquisition, merger, or investment. Financial due diligence helps the buyer to identify and understand any potential financial risks or issues that may affect the value or profitability of the target company.

The financial due diligence process typically involves a comprehensive analysis of the company's financial statements, including the income statement, balance sheet, and cash flow statement, for the past three to five years. This analysis helps to identify any irregularities or discrepancies in the financials, such as accounting errors, inconsistencies, or fraud.

Three main areas are typically examined when conducting financial due diligence on an early-stage startup with little to no revenue. Firstly, the startup's financial projections would be reviewed to evaluate the assumptions about revenue growth, expenses, and cash flow. Any discrepancies or warning signs in the projections would be identified, and the feasibility of the assumptions would be evaluated. Secondly, the startup's monthly burn rate, the amount of cash it spends each month, would be determined. This would enable an assessment of the startup's ability to continue its operations using its current cash reserves. Additionally, look at the startup's funding history to see how much money it has raised and at what valuation. This can help you understand how much dilution you may face as an investor.

Intellectual Property(IP) due diligence?

Intellectual property (IP) involves verifying the startup's ownership and protection of its IP assets, including patents, trademarks, copyrights, and trade secrets. This due diligence helps investors assess the startup's value, competitive advantage, and potential legal risks. Key considerations include the startup's IP portfolio, existing infringement lawsuits, and the strength of the startup's IP protection. Investors should also ensure that the startup has a strategy for maintaining and enhancing its IP assets in the future. Many founders don’t know that Investors prefer investing in Delaware Corps majorly to have a solid Intellectual Property Base.

Legal due diligence.?

Legal due diligence for angel investors in early-stage startups involves thoroughly reviewing the company's legal documents and agreements to identify potential legal risks or liabilities. This includes examining the corporate structure, contracts, intellectual property, regulatory compliance, and litigation history. The goal is to ensure that the company operates legally and has taken the necessary steps to protect its assets and minimize risk. In addition, a legal due diligence report can inform the investor's decision to invest and provide a basis for negotiating terms.

Customer diligence?

Customer due diligence involves assessing the startup's customer base, market segments, and sales channels to identify potential risks and opportunities related to customers. This analysis includes reviewing the company's sales and marketing strategy, customer feedback, satisfaction levels, and sales channels. The goal is to gain insights into the quality of the startup's products/services, the diversity and size of its customer segments, and its ability to retain and grow its customer base. By doing this analysis, Angel investors can make informed investment decisions and identify potential areas for growth and improvement for the startup.

Management team due diligence?

Management team due diligence is an essential component of the due diligence process that Angel investors should undertake before making an investment decision in a startup. This process evaluates the startup's management team to determine whether they have the necessary skills, experience, and leadership qualities to execute the company's business plan and achieve its goals. Angel investors should review the management team's backgrounds, including their education, work experience, and track record. They should also assess the team's ability to work together effectively and communicate openly and honestly. Lack of synergy between founding team members is a significant killer of promising startups. In addition, investors should evaluate the team's understanding of the market, competition, and industry trends, as well as their vision and strategic planning capabilities. Another critical aspect of management team due diligence is assessing the team's compensation structure and incentives. Investors should review the team's equity ownership, vesting schedules, and performance-based compensation plans to ensure they align with the company's long-term goals and interests.

Avoiding accounting tricks during due diligence?

A report by Havard business review highlighted various deceitful practices companies might engage in to inflate their financial figures artificially. Such practices include exaggerating sales projections through stuffing distribution channels, presenting overly optimistic projections for investments in new technology, disguising true costs by decentralizing functions, and treating recurring costs as extraordinary expenses. Companies may also overstate the potential of their websites as sales channels and underfund capital expenditures to create the appearance of healthier cash flow. Companies may also encourage their sales force to boost sales while hiding associated costs like customer acquisition(CAC). To determine a business's actual value, it is necessary to strip away these accounting tricks and examine the historical and prospective cash flow. Another strategy commonly by use is posing families and friends as customers. Some founders have enough network to create some form of initial traction that looks like the real deal to any unsuspecting investor. Some might even go the long way to create customers out of thin air, as with the recent story of Charlie Javice , the CEO of Frank, who paid a specialist to cook up customer data which was able to convince JP Morgan to acquire the startup before the fraud was eventually discovered. Due diligence teams may need to be sent into the field to investigate actual costs and sales figures properly.

Due diligence allows investors to assess the risks and opportunities of a potential investment or acquisition. By conducting proper due diligence, investors can make informed decisions and avoid potential pitfalls that could lead to significant financial losses or negative outcomes. Ultimately, due diligence aims to ensure the investment aligns with the Angel investor's objectives and offers a reasonable risk-to-reward ratio. Therefore, due diligence is an essential step in the investment process that should not be overlooked or rushed.