Angel Investing: Due Diligence (Digging in with Investors)
The range of due diligence that I perform on my angel investments varies greatly from investment to investment. I don’t have a cookie-cutter approach because every startup is different and every deal is different. And if I syndicate a deal, I feel like I have a fiduciary responsibility to do a thorough job on investigating the deal and the startup and I tend to do more for those than when I write a check on my own.
I heard Jason Calacanis talk about due diligence a few years ago and something he said stuck with me. He said that the level of due diligence should be based on the size of the check and the size of round. I also take into account my knowledge in the space and experience with the founders.
I conduct due diligence to understand my risk and balance that against the level of risk I am willing to take.
There have been times I have done no due diligence and have simply written the check. There have been other times where I have done extensive due diligence and have had an attorney review the deal documents.
I’ve been working with a checklist to help guide my process and I tailor my requests to the founders rather than using a standard approach. Since I’ve been speaking on this at a few events lately (including Spero Ventures who was kind enough to record my presentation which you can see here) and have shared my checklist via email, I thought it would make sense to share it here.
I talked about my due diligence process with my producer Jacqueline on episode 56 of Piloting Your Life, Digging in With the Investor if you want to have more context around each of the areas.
Due Diligence Checklist: Main Areas
There are five main areas that I look at:
· The Deal
· Financial Matters
· Corporate and Organizational Matters
· IP and Technology
· Product, Sales, Marketing, Manufacturing
This is pretty straightforward. I want to understand the investment opportunity, who else is involved, and what the startup is going to do with the money.
· Investment request — amount and type (e.g., convertible note or priced round)
· Description of milestones to achieve with requested investment
· Term sheet (if available)
· List existing investors and their contact information
· Dilution modeling (if available)
This too is pretty straightforward. I want to understand the financial condition of the company, who is involved, any financial commitments or restrictions, and financial projections for the future.
· Income Statements and Balance Sheets (audited, if available), since inception or for last 3 years
· Year to date income statement
· Current balance sheet
· Five year financial projections: quarterly for two years; annual for three years
· Unusual or nonrecurring expenses or income from prior years or expected in the future
· State and federal income tax returns for the past two years
· State and federal payroll tax returns for the past year.
·· Full resumes for key personnel including three (3) references for each person
· Management Team and Board Members with contact information
· Company Advisors with contact information
· Current shareholder, option and warrant lists, including issuance dates, original issuance price and vesting. These lists should include any party who owns securities of the Company or has any rights regarding securities of the Company.
· Agreements relating to the purchase, repurchase, sale or issuance of securities
· Agreements relating to voting of securities and restrictive share transfers
· Agreements relating to preemptive or other preferential rights to acquire securities, including rights of first refusal
· Agreements relating to registration rights
· All debt instruments and credit agreements entered into by the Company, including lease financing, which are currently in effect-whether or not any amount is currently outstanding
· List of any guarantees of third party obligations
· Any reports and studies prepared by outside consultants on the Company or its subsidiaries’ or affiliates’ business or financial condition.
· List of accounting and other business software.
· List and briefly description of any contract restricting the ability of the Company to compete in any line of business with any person or entity, or committing the Company or any subsidiary to continue in any line of business.
· List and provide any agreements requiring consents or approvals in connection with the transaction contemplated.
· Any other agreements material to the business of the Company, or that are material or outside the ordinary course of business.
· Life sciences: list necessary regulatory approvals and requirements/timeline to achieve
· Life sciences: reimbursement — CPT codes and reimbursement amounts
Corporate and Organizational Matters
With these documents, I want to understand the organizational structure, communications and decisions, founders, and legal agreements that could impact the startup thereby impacting my investment.
· Legal name
· State of incorporation and date incorporated
· The Company’s current Articles of Incorporation, including any amendments thereto.
· The Company’s current Bylaws.
· List of all founders and current relationship.
· Have there been prior sales of the business that were not completed? With whom and why?
· List of any prior acquisitions, mergers or similar transactions.
· Minutes of all Board of Directors, committee and shareholders meetings and all consents to actions without meeting
· All documents and correspondence relating to any pending litigation, threatened litigation, or disputes which could potentially lead to litigation involving the Company, its executive officers or its directors
· Any consent decrees, injunctions, judgments, other decrees or orders, settlement agreements or similar matters
· Any agreements, understandings or proposed transactions between the Company and any of its employees, officers, directors, affiliates, or any affiliate thereof, including without limitation, employment agreements, indemnification agreements and any loans or guarantees
· List of all consulting contracts
· Employee benefit and profit-sharing plans, including stock option, stock purchase, deferred compensation and bonus plans or arrangements
· A list of officers, directors and employees & their respective positions & compensation at the Company. If any officers or key employees are not currently devoting 100% of their business time to the Company, please note them on this list
· Organization chart
· Names, addresses and other contact information of professional advisors including attorneys, accountants, bankers, etc. (i.e. Working Group List.)
· List of all plant, office and other similar facilities
· Copies of all lease agreements
IP and Technology
What I look for here will depend on the nature of the company. I tend to stay away from startups with patents and look for some other way for the business to establish a moat and protect their opportunity.
· Copies of issued patents
· Titles and filing dates for provisional patents
· Brief descriptions of key claims (for both issued and provisional)
· Technology licensing agreements with brief description of key components
· Data from relevant studies/experiments
· Form of Proprietary Information and Invention Agreements signed by past or present employees and consultants. Any documentation relating to the transfer to the Company or any employee of any technology or invention (Note: this has become something I look for with each investment)
· A list of employees or consultants who have not signed Proprietary Information and Invention Agreements, including a list of any periods of time where key employees or consultants performed services for the Company while not bound by such agreements.
· Any correspondence or documents relating to allegations of the Company’s infringement of the proprietary rights of others, or allegations by the Company of infringement of the proprietary rights of the Company.
· Any licenses or agreements of any kind with respect to the Company’s or others’ patent, copyright, trade secret or other proprietary rights, proprietary information or technology, other than licenses or agreements pertaining to “off-the-shelf” or standard products.
· A list of patents, copyrights and trademarks (existing and pending), and any searches relevant to such items that have been done.
Product, Marketing, Sales, and Manufacturing
Here I want to understand the company’s products, go-to-market strategy, major customers to do reference checks, distribution channels and agreements, competition, production process, and major suppliers.
· Products and services-list and provide samples of marketing collateral
· Sales, costs and profitability of product lines
· Product certifications and third party approvals
· Marketing plan
· Provide supporting evidence for product claims
· Major customers (over 10% of total revenues.)
· Describe channels of distribution (distribution, direct sales, sales reps, etc.)
· Sales team organization description, headcount, compensation scheme
· Current backlog report
· Forecast and pipeline to support revenue projections
· Customer purchase agreements
· Sales/marketing partnership agreements
·List of major competitors
· Market share breakdown by competitor (and by product line if applicable)
· Describe production process (make versus buy, etc.)
· Product costs including costed bill of materials and cost-down projections over the next 24 months
· List of major suppliers and supply chain (are there any major geo-political or single-sourcing risks I should understand?)
· Research & development projects including budget and timelines
What Due Diligence Should a Founder Do on an Investor?
A lot of founders think that any money is good money and don’t necessarily check to see if the investors are going to be a good fit. Not all money is the same and not all investors are who they pretend to be or present in the world.
It is critical for founders to do their own due diligence including asking other founders about their experience with the investor especially if things have not gone well. It is easy to be a good partner when things are going well but not so much when things are going sideways. I also recommend asking other investors, doing Google searches, checking Twitter, and looking at Crunchbase. There’s a new application called Signal that investors may be on and I would take a look at anyone who might be negatively associated with the #MeToo movement (e.g. on the wrong side of it).
During the DD process, if you are getting weird questions that don’t seem to be tailored to or right-sized to the size of the investor’s check or situation, take a step back and rethink whether this would be a good investor. As GothamGal says, dumb money is not good money.
Assume that you are going to be in a long relationship and it is difficult and expensive to get rid of a bad investor.
How Can Due Diligence Help a Founder Help an Investor?
If a founder really gets it and wants me to invest, they will use the due diligence process as an opportunity to build a relationship with me and provide support for the value of the company to me. They will respond to questions in a timely fashion and they will help me build the case for the investment thereby helping me to reduce my perceived risk.
By the time I get to the due diligence phase, I have pretty much made my decision and hope that I don’t find something during the process that makes me decide against investing in the startup. I know that some investors use the DD to find reasons not to invest but given the amount of time it takes for both parties on a thorough DD process, that seems like a negative and inefficient way of approaching it.
In a relationship metaphor (most investment last longer than marriages), I equate the pitch and follow up conversations to dating, the due diligence as the engagement, and signing the docs/providing the cash as the actual wedding.
Keep in mind that I am an early stage investor and my checks are not large (although I do tend to invest in subsequent rounds). This means that I tailor my due diligence to my perceived level of risk.
Every investor will be different and ask for different things.
It’s all about risk tolerance and perception of risk.