DUE DILIGENCE in The Angel Investing World
There are five key elements that angels should consider before investing in a particular enterprise. These are the legal, financial, technology, marketing and human resources aspects of the company. Each of these areas presents the investor with several fundamental issues, which should be examined and addressed before embarking on an investment. The experience of many investors is that a failure in just a few items can easily result in failure overall. Thus a major challenge for investors is to distinguish between those items that are deficiencies, and can be remedied, and those items which are fundamental flaws.
There are several factors to consider with technology. For instance, is there a demonstrated demand for the product? Creating a superior rat-trap – or even a wholly new product or technology for which there is little consumer need – will rarely result in a well-trod path to the company’s door. A product’s success is directly related to its utility.
Secondly, will the technology function reliably under the real-world conditions proposed? To what extent has it been effectively tested?
Does the technology offer benefits that are not available from competing products – such as added functions or features or lower costs – or does it simply duplicate offerings currently available?
Is the technology protected? Are patents in place? To the extent that there is no proprietary technology, what evidence is there of an ability to create a competitive business?
Efforts should also be made to check the employment history of management and to determine whether or not the technology or any part of it was engendered in the course of prior employment. Former employers may have substantial resources dedicated to the enforcement of their patent and technology rights.
An investor is also advised to understand the technology from the bottom up. This often involves talking to the full development team. It’s not unusual for senior people to have a limited grasp of the internal workings of the technology.
Finally, it is important to be honest with yourself as an investor. To what extent do you actually understand the technology and how it works? If you do not, it may be advisable to solicit the advice of a third party expert or simply walk away from the opportunity.
As an angel investor, you are betting on the talents of the management team, its ideas and its core values. How well do you know these people? Are their values aligned with
yours and can you work closely with them to move the company forward?
What have they achieved in the past and what are their reputations among their colleagues or in their industry? What is their previous history with investors? Unfortunately, there are entrepreneurs who move from one failed venture to another, and seemingly, have no problem raising money from naïve investors.
In considering the management team, ask yourself whether or not they represent a full package. Does the group understand the marketing, financial and intellectual property implications of their venture, or are they just a “one-trick” pony?
Who really contributed the most to the group’s innovative ideas? Is that person still with the venture and still participating in a meaningful way?
Credentials are an important part of the assessment process, bearing in mind that they do not necessarily tell the whole story. There are many talented and experienced people with limited or no university backgrounds. Consequently, an assessment of each individual’s participation in the development of the technology may yield a more realistic assessment of the team capabilities than would their CVs.
Take time to assess the true value of the investment you are making. During the technology bubble in the late 90s, many angels failed to do this and sometimes lost their entire investment. High valuations usually lead to unrealistic expectations and endanger an angel’s investment in the next financing round. Valuations must be based on sound and realistic projections.
A financial spreadsheet is germane only to the extent that the underlying assumptions are realistic or factual. Consequently, investors should focus on the assumptions. In particular, the absence of certain items in the financial material may indicate a lack of understanding or expertise with regard to the overall business operation. Also, pay close attention to indicators that demonstrate whether or not the entrepreneur has the capability to build a successful business. These include such metrics as revenues per employee and sales cycle, and such considerations as adequacy of staffing and the investment infrastructure.
The existence of proper incorporation and the shareholders agreement will tell you a great deal about the sophistication of the people involved. One element that can consume inordinate time is trying to understand the dynamic between the participants in the venture. Shareholder agreements will not, by themselves, adequately protect the investor in the case of ill will. However, the process of negotiating an agreement or reviewing the terms of the existing agreement may yield insight into the ethics and values of the individuals.
In assessing the feasibility of the enterprise, investors should examine the level of fairness within the existing structure. A failure to recognize the contribution of essential participants may be a signal that the enterprise does not have the necessary cohesiveness to succeed. Investors should also be aware that an excessively complicated share structure may become a substantial distraction from the operations of the business. The enterprise is best served when shareholders have a unity of interest.
This often proves the weakest link in a new venture. How realistic are the proposals in the business plan for moving the product into the marketplace? In fact, do the principals even have a business plan? Are they familiar with the channels in their industry and do they have a plan for accessing them? Who, if anyone, among the principals has a track record in marketing – and is that track record in the same industry as the current venture?
Sometimes, angels are wise to walk away from a potential investment. Here are a few signs that trouble may lie ahead:
- To the extent that there are inconsistencies in values, or trust is not present, then no investment should be made.
- If there is resistance to due diligence and if people are defensive in their response, than there are probably buried issues.
- If the deal has been shopped around, one must ask why others have refused to invest and what negatives are present.
- Excessive passion for the technology may demonstrate an unwillingness to be flexible in meeting the needs of the marketplace.
- Evasive responses and lack of market knowledge about competitive technologies and alternate solutions probably indicate that the entrepreneur does not have the requisite competence to justify an angel’s participation.
- And finally, one should be realistic with respect to the likelihood of working productively with the people leading this venture.
The lessons of due diligence are two-fold. First, there are a series of questions that every investor should ask and that will provide the analysis necessary to make an appropriate business decision. Secondly, the investor can avoid the potential for analysis paralysis by making the effort to understand the core technology and validate the fundamental values of the individuals involved. This will provide the best index as to whether or not an investment should be made.