By Eric Dobson
To the Investors:
Diligence is not a formality. It is not to be skipped. It is not to be glossed over with trust of a charismatic entrepreneur. As we say, “In God we trust; everyone else goes through diligence!” The reason is simple. Studies show that even 20 hours of diligence on a venture increases your odds of success six-fold! (Forbes: How Much Diligence does an Angel Really Need to Do?. Let’s face it. Diligence can be time consuming. But, it can be a lot of fun too. Getting to know an entrepreneur, a team of dedicated individuals, understanding the insider’s perspective on a market opportunity can be addicting.
For those who want to become sophisticated angel investors, there are several key steps that you should follow. As you grow in sophistication, you will branch out beyond these basics and learn what appeals to you most directly. As an alliance of investors over many cities and large geography, there is a need for standardization so we are all looking at the same picture at once when deciding to invest in a given venture. There are 14 steps that precede a final decision to invest in a startup/private equity company:
- Look through the information provided by the entrepreneur for strongly positive and negative attributes and identify top three, key questions that must be answered to proceed.
- Seek peer and Alliance advice – find peers in your network and our Alliance that have expertise and market intelligence.
- Review market information – independently validate market projections of the entrepreneur.
- Study the team – find out if these are people you want to work with for the next five to seven years.
- Talking terms – talk terms early to avoid wasted time and effort of full diligence.
- Review the business plan – discover if the team can actually plan a business.
- Review the financial projections – discover if the team can use their financial tools properly to grow a business.
- Review market traction – find out if they have real market opportunity or not.
- Review the IP – find out if they have valuable, defendable IP that creates barriers-to-entry to competitors and drives acquisition.
- Reference checks – independently verify the entrepreneurs character not just his/her charisma.
- Document review – dig into the details to ensure they are structured properly.
- Review of prior rounds of capital – dig into the prior rounds of funding to ensure there are no deal-breakers from past rounds.
- Review of the capitalization table – dig into the cap table to make sure all obligations of the company are clearly accounted.
- Final gut check – never do a deal you don’t feel good about!
Each of these general categories must be satisfied before you can make a clear decision to invest. They should be executed in order. Each of these categories should be thought of as a stage gate. There is an iterative process inside of each until a point of diminishing returns is reached followed by a Yes/No decision to proceed to the next category or terminate the process and move to the next venture. So, if you are wondering, the answer is yes, you have to say “yes” 14 times before you invest in a deal. You only have to say “no” once.
You should compile your answers into a form that captures the essence of the deal and is ready for sharing with your peers you will want to bring into the syndication with you.
The point of this exercise is several fold:
- Identify problems now that will likely be the undoing of the company later.
- Build a relationship with the company and team.
- Help the company to correct errors that may have crept in over rounds of funding and changes in operations.
- Set a baseline from which you can judge the success of the company’s operations going forward.
- Identify what you can contribute to the company’s growth.
This is all to say this process should be taken very seriously and engaged with enthusiasm. You are NOT simply validating the entrepreneur’s vision. You are protecting yourself and your fellow angels and value-adding the investment you are about to make!
This was originally published under the Appalachian Regional Commission POWER Grant, PW-1835-M.
Copyright Appalachian Investors Alliance, Inc. 2018
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