Doing Your Due Diligence

There’s no exact amount of due diligence that’s a perfect fit for each investor or each deal. However, as a general practice you should expect to do some level of due diligence on your own— it’s proven to increase your chances on a good return. Find out why due diligence is important and how you can get started.
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Doing Your Due Diligence

Some investors do hours of research before making a deal, and some go into it on gut feelings. As a best practice, most experts suggest that investors conduct due diligence on every deal before making an investment. From getting to know the team, to identifying a market strategy, you can take just a few simple steps to vet a deal before committing.

Why is due diligence important? 

Angel investing is already risky—there’s no need to add to the risk. Doing research beforehand, ensuring you’re not missing bright red flags, and spending time to find out key info aren't just smart, but they can increase your chances of a good return.

Completing due diligence helps you make more informed decisions about each investment and can give you more insight as an investor if you end up mentoring or coaching the startup team along the way. It’s also a way to get a feel for each company’s capital needs over time—which is mutually beneficial knowledge.

In fact, studies show that angel investments involving 20 hours or more of due diligence are 5x more likely to have a positive return than investments with less or no due diligence completed. 

So what is due diligence, exactly? It's just like research that you’ve probably done for other big decisions in life. Gathering information about a company and strategy before making a decision is not that different from researching what car to buy, or which neighborhood you want to move to. And as we know, decisions are better with data.

Do the due

Every angel investor is going to do things differently, and each investment is going to be a new experience. 

In order to save time for yourself and the founder, start with your deal-breaker questions upfront. Proceed with your due diligence if those questions are satisfactorily answered. 

You can determine what initial questions to ask from checklists that angel groups have compiled, best-practice papers with recommendations from top angel investors, and even courses. Here's a checklist to start with:

  • Is the founding team poised for success? Consider each individual's past experiences, including previous startup experience. A paper published by MIT found that founders with a previous exit are more likely to achieve another exit, and tend to achieve higher success in their next ventures. Also, it is important to evaluate the internal team dynamics. Is everyone rowing in the same direction? Is there a clear division of labor? Has the team previously worked together? Consider the soft skills too, such as whether the team is coachable, trustworthy, and good communicators. Lastly, consider what skill gaps the startup will need to fill in the near future. 
  • What is the growth potential? Evaluate the total addressable market (aka “TAM”) and the company's plans to win that business. Are there existing customers for the product or service, or a strong potential for customers? If so, can the customer base pay for the product or service? 
  • What are the investment terms? The terms of the deal  can have a substantial impact on an angel's potential returns. If the founder has already begun to fundraise, there may be little room to negotiate these terms. For example, the valuation can materially change an investor's returns. Take a look at how the math works out in the Early Stage Valuations article.  

Answering these questions is a good start, and you can stop there if you’d like. But it is good practice to look further. If there is a lead investor or if the deal was syndicated (aka shared) with another fund or angel network, you can ask to see what they uncovered in their due diligence process. This allows you to leverage other people's work, helps you focus your time on specific items, and can help check your work. If you plan to make decisions based on other people's due diligence, be sure you trust the work of the person or group.  

It is important to understand that your due diligence will differ depending on the stage of the company. It is unrealistic to expect a startup raising a pre-seed round (which likely indicates a younger company) to have the same amount of operational history and  financial information as a later-stage company. Digging a bit deeper into due diligence, The Angel Capital Association names six key categories to consider when looking at a deal: 

  1. Management team
  2. Product and technology
  3. Market opportunity 
  4. Go to market strategy 
  5. Financial projections 
  6. Competitive analysis

Watch out for your biases 

While conducting due diligence keep in mind the various biases that can influence your decision making. We are all human; as such, our brains develop shortcuts when processing information. Make it part of your due diligence practice to check yourself for biases.

Commonly-discussed biases such as race, gender, and groupthink are likely on your radar, but they are not the only important biases to consider. Lesser-known biases can pop up when making decisions, including:

  • Anchoring: The tendency to rely too heavily on a single piece of information
  • Education bias: Giving extra weight to founders from Ivy League or elite B-schools
  • Confirmation bias: The tendency to seek out information that supports our preconceived view
  • Savior complex: The tendency to root for a company that can save lives (think of Theranos)

How it can help your portfolio

Now that you’ve done your due diligence, what can you expect? 

With angel investing, there’s no guarantee that you’ll get positive returns, but researching beforehand and performing a good amount of due diligence really can help your chances. 

Studies show that investments involving at least 20 hours of due diligence failed 45% of the time, while investments with less than 20 hours of due diligence failed over 65% of the time—that’s a big difference. This study also found that an angel investor's experience in the industry and participation with the company, whether it be mentoring or just checking in, also correlated to greater returns.

Overall, more due diligence equals better chances of a higher return. It just might be worth it.

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Angel Basecamp is your guide to angel investing information and resources. The content is curated from trusted thought leaders in Minnesota who have a variety of experiences and background in angel investing. Angel Basecamp will help you cut through jargon-y terms, help you sharpen your angel investing knowledge, and provide next steps that feel right for you. 

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