The Importance of Due Diligence when Investing in Startups
If you are about to buy a used car, you might ask an auto mechanic to inspect it before you hand over your hard-earned cash to make sure you are not buying a lemon. It is important to consider doing something similar if you are thinking about investing in a startup.
What is due diligence?
Putting it simply, due diligence means doing your homework. Before committing to an investment, it is important to understand what you are buying and what you are getting into.
Due diligence on a startup can be divided into the following two components:
- Industry due diligence, which refers to the big picture and involves understanding the industry, who are the incumbent players in the market, who are the competitors, what competitive advantage the startup has, what their chances of success might be, and similar research.
- Legal and corporate due diligence, which involves a detailed investigation on the startup, the founders, contracts, corporate structure, product, compliance, contracts, offering, and more. On the angel investing platform, this component is called Broker Review.
Importance of due diligence
Taking it back to the bare essentials, due diligence is important because it potentially lowers the risk of you losing your money. Due diligence can lower the chances of making a bad investment, from paying more than you should for an investment and increase your chances of seeing a return on your money. However, you can still lose the entire amount invested.
Detailed due diligence provides valuable information that helps investors and founders alike make more informed decisions.
The due diligence process
So, how do you perform due diligence? The due diligence process can be divided into the two components discussed above, being Industry due diligence and Legal/Corporate due diligence, as outlined below.
Industry due diligence means doing wide research. It is vital to see if there is a market for the product or service the startup is offering — for example inventing an amazing new fax machine in 2021 might not be the greatest idea. Make sure there is a market and a demand for the product or service. It is important to recognize the barriers associated with trying to break into a market already saturated with dominant players in an oversupply environment that has already degenerated into a price-driven competition. Talking to customers, subject matter experts, and company management is an important part of the process — the more you research you do, the better informed you will be.
Propel(x) goes through a highly structured process in their Industry due diligence — our in-depth article Due Diligence: The Backbone for Successful Angel Investing highlights seven key risk areas that should be analyzed for effective Industry due diligence:
More information on Industry due diligence for technology startups is provided in our article Conducting Diligence on Deep Technology Startups.
Legal and Corporate due diligence (or Broker Review as it is known on the Propel(x) platform) on a startup involves confirming they are who they say they are, they have what they say they have, and they can deliver on their projections if all goes according to plan. This requires an in-depth investigation into the company and its founders, including background checks, reviewing contracts, and studying the offering. It includes verifying the claims of founders who say they have already raised funds in a current round by checking their bank statements and reviewing financial reports to confirm growth statements are realistic.
Hubble Investments, LLC Broker Dealer registered with the US Financial Industry Regulatory Authority (FINRA) and member of the US Securities Investor Protection Corporation, carries out a detailed Broker Review on any investment opportunity offered on the Propel(x) angel investment platform. Hubble Investments is owned by Propel(x) and are under common ownership and control. These Broker Review reports provide detailed information on the startup such as:
- Company information including physical address and founding date.
- Information about the offering including the amount of the raise, the type of instrument, and key terms.
- Documents reviewed such as the term sheet and subscription agreement.
- Corporate structure and ownership including certificate of incorporation, number and type of authorized and issued shares, stock option agreements, etc.
- People, including background checks and previous work history of the founders, directors, and company officers, and review of employment agreements, employee compensation, and agreements with advisors and consultants.
- Business and operations review including premises owned or leased, any litigation history, insurance cover, and confirmed contracts.
- Intellectual property status such as patents issued, patent applications, IP ownership, or IP licensing.
- Financial information including review of bank statements, financial reports, audit findings, outstanding debt and liabilities, cash position, financial projections, intended use of funds, and appointment of accountants.
- Licenses, permits, certificates, and tax compliance.
However, you should still do your own independent review before investing. Below is a sample of what a Propel(x) Broker Review looks like. Company information has been camouflaged to maintain confidentiality.
For a downloadable copy of the broker review, please contact us at firstname.lastname@example.org
Reasons for due diligence
While startups are not in the business of defrauding people, they are by nature optimistic. So, it is important to be realistic and to determine if their forecasts are potentially achievable. The main reasons for doing due diligence are:
- Reduce the potential for you to lose money on an investment.
- Help you identify investment opportunities that may have a higher chance of success.
- Help you determine an appropriate amount for you to invest if you do decide to commit.
- Increase your level of understanding in an investment.
Costs of due diligence
The costs of due diligence vary depending on the scale and complexity of the company and the investment. There are costs associated with background checks, consultants, advisors, lawyers, and accountants to review the company, plus an investor’s own time.
This is an area where using a Broker Dealer platform can provide advantages. As per FINRA regulations, Hubble Investments carries out a detailed due diligence assessment on all the opportunities that are closed on the Propel(x) investment platform. This means Propel(x) members get the benefit of all that research, time, effort, knowledge, and experience without having to pay for it in advance — they only pay if they decide to go ahead with an investment (when it comes out of the investment fee structure).
A cautionary tale of a due diligence fail
The costs of doing due diligence are discussed above, but what about the costs of not doing due diligence? Consider the infamous case of biotechnology company Theranos.
Founded by then 19-year-old Elizabeth Holmes in 2003, Theranos was established on an idea of running blood tests using new machine technology that required only a finger pinprick of blood to quickly detect a range of medical conditions. An SEC press release from early 2018 shows Theranos raised more than US$700m from private investors. According to a 2015 Wall Street Journal article, Theranos at its peak was valued at US$9b.
But everything came crashing down in 2015 when the technology claims of Theranos were finally questioned in depth, which finally culminated in the company closure in late 2018.
The SEC press release from early 2018 stated that the SEC charged Theranos, its founder and CEO Elizabeth Holmes, and former President Ramesh “Sunny” Balwani with raising more than $700 million from investors through an elaborate, years-long fraud in which they exaggerated or made false statements about the company’s technology, business, and financial performance. The complaints allege that Theranos, Holmes, and Balwani made numerous false and misleading statements in investor presentations, product demonstrations, and media articles by which they deceived investors into believing that its key product — a portable blood analyzer — could conduct comprehensive blood tests from finger drops of blood, revolutionizing the blood testing industry. In truth, according to the SEC’s complaint, Theranos’ proprietary analyzer could complete only a small number of tests, and the company conducted the vast majority of patient tests on modified and industry-standard commercial analyzers manufactured by others .
The Theranos trial began in September 2021, with Ms. Holmes and Mr. Balwani facing fraud charges that could potentially result in a 20-year prison sentence.
High profile people and experienced investors alike were taken in by the Theranos story to the tune of $700m. A thorough, detailed due diligence process might have saved them a great deal of money. However, no amount of due diligence can prevent fraud or total loss of principal.
Originally published at https://www.propelx.com on November 22, 2021.