Entrepreneurs fear due diligence mostly because they don’t understand it. Here’s an overview of what investors are trying to accomplish.

Entrepreneurs who manage to pull a good pitch together, generate some interest, and get through a pitch successfully, still typically dread the investor due diligence process. This is a mistake. Diligence is not only something you don’t need to fear, it is something that goes much better for if you bring a positive mental attitude. Let’s first explore what is typically involved, and then in the next column in this series I will talk about strategies for getting through it successfully.

 

Concept of Due Diligence
Mainstream use of the expression dates back to the Securities Act of 1933 which provided a liability defense for broker dealers who did a reasonable investigation before recommending a stock. What constitutes thorough due diligence today varies greatly by type of deal–big complex companies with long operating histories take much more work. However, for early stage companies it is really a process of fact-checking, scenario outlining, and model-building.

Early stage investors vary in terms of how much due diligence they bother with–some individual angels do almost none; groups or networks of angels tend to do a fair amount. The reason investors do it is to convert unknowns into calculated risks; the diligence process is about understanding what you are getting yourself into, particularly in relation to the requested valuation.

 

Primary Coverage Areas
Investors first look at team, market and product and secondarily at the likely potential, probability and period of an investment. Investing is about weighing the risks of a deal against the potential benefits. Market risk, team risk, technology risk, IP risk, regulatory risk, financing risk - diligence is about understanding them better. Here are the primary areas of inquiry:

Leadership Assessment
Investors want to understand the skills, motivations, backgrounds and experience of the founding team so they want to spend time with founders, talk to references, and often to do a little digging to turn up some blind references. The goal is not so much to pass judgment on a founder as it is to assess her fit for this particular opportunity.

Market Size and Market Opportunity
No matter how big your theoretical target market, your actual market is limited to the customers for whom your solution is a top buying priority. Assessing market opportunity is about understanding how many of these people there are, or could be. And to be profitable, you need to locate, reach and acquire these customers for less than their lifetime value. Investors are going to want to get comfortable that you can achieve this. Stage of the market also matters a lot–if a business has to bear the cost of educating a nascent market it is a different proposition than a mainstream market for investors.

Customer Need & Go-To-Market Plan
Investors want to understand how much market pull there already is, what you’ve done to verify it, and how the company plans to sell the solution. This requires some detailed scrutiny on your sales methods and marketing plans. Customer buying priorities are also relevant–having a big group of customers who say they would buy your product is great, but, as noted, your actual market is limited to just customers for whom it is a top buying priority, so investors want to know how many there are, or how large the number could become with the right marketing and sales.

Technology, IP, Product Roadmap
Investors need to understand what you have built, what tools you have used, whether the result would be easy to replicate (with or without IP protection) and what kind of un-built roadmap lies ahead. They are trying to gauge the magnitude of what has been done and the technical risks associated with what has yet to be done.

Uniqueness and Competition
The investor question here is around the differentiation of your solution and its likely defensibility over time. Low defensibility translates into low pricing power and eroded margins. Understanding who else is in the market and what they bring to the table is key. The due diligence focus will be on differentiation and those differences which actually really matter to the customer.

 

Financial Projections and Funding Strategy
This analysis is all about your model. The question boils down to two things: (1) short term: what milestones you need to reach for your next round and how realistic your cost projections for getting there are, and (2) long term: how much funding is needed down the road and where it will come from.

Exit Strategy
Finally, investors want to understand the different types of buyers that might be interested in the company, what value they might place on revenue, profits, customers, eyeballs, strategic market position, etc., and what the company needs to achieve for potential buyers to bite. The importance of exit strategy cannot be overstated. Famous investor Ron Conway has said that if he cannot think of five potential buyers within the first minute of talking to a company, he is not interested. That should give you a clear indication of the preparation needed for this aspect of due diligence.

Once investors have gathered and verified their facts across these categories, they will synthesize what they have learned into a mental model or investment hypothesis that makes sense in terms of its potential, its probability and the likely investment period. If they cannot quite get there, they may want to revisit the valuation, but for the most part, if they make it to the end, they are seriously interested investors–otherwise they would have lost interest and wandered off during the process. In the next column in this series I will talk about strategies for keeping them interested and getting them to the end of the diligence process successfully.

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Christopher Mirabile (@cmirabile) is the Chair of Angel Capital Association and an early stage investor in Boston MA, USA. He is the co-Managing Director of Launchpad Venture Group and the co-Founder of angel portfolio management tool www.Seraf-Investor.com.

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