What is due diligence?

Due diligence can sound like an elaborate legal process with definitions like “investigation or audit of a potential investment consummated by a prospective buyer.” Wordy, to say the least.

What it actually means in plain English is exercising a reasonable level of care that any sensible sane person should take in their day-to-day business.

When investing in a company, due diligence usually means examining financial records and other relevant data before sealing the deal. What is reasonable  - or even possible - largely depends on the stage of the company.

The scope depends on the traction

The more history and traction the company has, the more data you have, the more thorough due diligence you can exercise and the better you can predict their outcomes.

With a mature billion-dollar corporation, you have plenty of documents to drill and investigate for months and months on end. With an early-stage startup, you might not have much more than an idea and a team. Not exactly the material for rigorous detailed analysis with intricate spreadsheets.

This can be both good news and bad news. The good news is that the due diligence of a startup can be carried out quickly and efficiently. The bad news is, there’s a lot more uncertainty. But you wouldn’t be an angel investor, if you’d be looking for certainty, would you?

The difference between angel and VC round

Angel round (pre-seed round, seed round)

In the angel round, due diligence mostly focuses on the team and founders. You might have some traction already, but you can’t do very thorough calculations or predictions. You can also check out the market demand, trends, size and competition, but it’s the execution that counts, not necessarily the idea. That’s not to say that you can’t or shouldn’t be thorough.

Focusing on the founders doesn’t mean just using the information that founders provide themselves. Founders are there to sell, you are there to make a sound investment. Dig around in your own network and gather information from all available external sources.

Looking into public records is always a good idea, so if the information is easily accessible, you can take a peek at the founder’s criminal, tax or work records. But bear in mind that an informal track record can be a lot more crucial at this point - e.g. who tanked their previous startup, who fell out with business associates, etc. That’s especially important when investing in foreign startups outside your usual network that you might not know as well.

VC funding round (seed+)

In a venture capital round, you already have the data, revenue and performance to analyze - how was the previous funding spent, what went in, what came out, is there any growth, etc. The process is usually carried out by a legal or financial firm, which makes it much more costly, over €10K in general. The cost comes from involving external experts, but also from the mere load of paperwork they have to work through (documents, legal details, patents, etc.) This results in intelligence-level data that usually isn’t even disclosed to the startup itself.

Should angels rely on gut feeling or data? Why not both!

Early-stage investors mostly fall into two categories - the ones who rely on their gut feeling and previous insight, and the ones who only rely on data.

  • Team “Gut Feeling” - it’s important to note that gut feeling is not the same thing as emotional investing. Emotional investing means falling in love with a team or idea and diving into the investment solely based on enthusiasm  — it’s more like playing a lottery. You develop a gut feeling after seeing enough founders and startups and accumulating enough experience. After a while, you’ll start seeing patterns of success and risk, e.g. in technical competence, stress tolerance, etc.
  • Team “Data” - the other league doesn’t care much about intuition and only looks at hard cold numbers. As previously said, this approach is difficult to follow on the pre-seed/angel level, since there isn’t much data to start with. After all, most unicorns have been rejected by tens of investors back in their day. Some people might go as far as to say that focusing solely on numbers shows that the investor really can’t evaluate startups.

A gut feeling can give you information that doesn’t exactly come off as information. For the best result, you should combine the two approaches, i.e. instincts and experience with the data. Evaluating startups is both an art and a science.

How to share the due diligence workload in an investor network

1. Share the load. Period.

We all know the saying “If you want to go fast, go alone; but if you want to go far, go together.” Pulling together a diverse group of investors with different backgrounds, missions and world views is the best due diligence you can have in angel round investing. Ideally, you should have people who know the particular industry, people who work well with the numbers, etc. to detect and mitigate the biggest risks. This gives you the best possible insight with a reasonable division of workload.

2. Include your network

Using external experts is the main thing ranking up due diligence costs. Use all the (free) help you can get from your network. From friends and acquaintances to people sharing a similar mission - they can all share valuable insight into the strengths and weaknesses of a company. The first round of due diligence should come from the investors, second from the industry network and only as a third option should you turn to paid experts (in practice, they’re rarely used in angel investing).

3. Make the data comparable

To make quick informed decisions, you need to make the data comparable. Using a due diligence template makes collecting and comparing company data efficient and simple. There are countless templates going around but drafting one is not rocket science. After all, early-stage companies are not that different - they all have similar basic information from company name and address to financial history and projections. You can always ask for more details later, but it’s good to collect general data in bulk.

Business angel networks should consider using their own templates for both the benefit of their investors and applicants. For example, in Dealum, you can collect applications with a custom multi-step online form. This makes pre-evaluation faster and automates repeat communication.

4. Assign a leader

The lead investor is much more than an honorary title. They play a crucial role in due diligence by validating opinions, managing the evaluation process and putting together all relevant information. Experienced lead investors already know what aspects they should check in evaluating companies. This can also help other investors reach a consensus on the application.

5. Leverage the risk by voting

We’ve mentioned the power of investor groups before, but jointly discussing and evaluating deals helps achieve better results on average. It’s no secret that the spray and pray approach works pretty well on pre-seed and seed levels (as opposed to a very detailed handpicking with a complicated due diligence process).

Voting is also a great tool to leverage risks and mitigate bias and emotional investing. Voting is not very common for individual rounds unless you count angels voting with their feet. If an angel investor doesn’t believe in a project, they just don’t invest in it.

Voting is more relevant in investment syndicates where it’s important to find the best deal available. For syndicates of 5 investors or more, it’s better to use a digital voting tool since discussing deals and voting over email becomes a hassle. It’s a good practice to actively involve and engage members by collecting feedback and insight about the votes cast (e.g. why they were in favour or opposed to the deal).

If you want to find out more about how Dealum can help you automate your due diligence process, book a demo today!