Startups And Investor Due Diligence

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Getting funded is one of the major goals in the startup world though sometimes the investment isn't secure. Learn how you can implement due diligence to benefit your business & your investor!

One of the most important lessons a startup executive team seeking to secure investment capital must learn is that due diligence is a “two-way street”. Nothing in the rules of the game prohibits a startup from conducting due diligence on potential investors. The primary objective of investor due diligence is to enable entrepreneurs to separate the “contenders from the pretenders”. That is, to identify those individuals or entities that are no or low probability candidate investors.

Potentially Negative Investor Motives

The concept of investment “contenders versus pretenders” raises the question, why would an investor express interest in your venture if they truly have no interest in investment?

  1. To learn about your market space for free;
  2. To learn about your technology for free;
  3. To learn about your business model for free;
  4. To acquire information to use in conducting due diligence on another similar startup;
  5. To acquire information to use in a competitive analysis;
  6. To receive a free education about an unknown business segment.

In other words, to have access to your intellectual property and research for free. Of course, this is a taboo subject in the funding world. After all, the investor is placed on a pedestal and the new startup must turn cartwheels to convince that its product is feasible, marketable and fundable. With the possibility of potentially negative investor motives in mind, let’s examine how to identify these true investor “contenders”.

Investor Due Diligence

First, we need to make a distinction between individual investors (angels, high net worth individuals) and institutional investors (VC, private equity firms, corporate venture capital). The differences between individual and institutional investors require variations in the approach to due diligence. For example, institutional investors typically manage a fund and have immediate access to investment capital. Individual investors use personal funds and are therefore not necessarily liquid. On numerous occasions I have seen an individual investor issue a letter of intent to fund (“LOI”) only to cancel weeks later because they could not complete a certain transaction to achieve liquidity to invest.

The Process Of Conducting Investor Due Diligence Includes The Following Questions:

1. What are the investor’s possible objectives in the venture? Is it:

  1. ROI – Return on Investment, to maximize return relative to risk.
  2. Strategic – The investor is seeking to possibly joint venture with other investments in the portfolio.
  3. Diversification. The investor has a portfolio of private equity investments and seeks diversification to lower overall portfolio risk.

If none of the above can be fully delineated, consider this a red flag (money laundering, much?).

2. Investment Capabilities – Does the investor have the ability to transact in a timely manner? It is important that the ability to invest is not fully dependent upon completing another transaction or achieving liquidity after issuing an LOI.

3. Investment Model – Money under management refers to a Fund. Investors under management are most likely gatekeepers, and the money may or may not be theirs (think General Partners). A funding advisor is an intermediary who most likely may have little liquidity.

4. Historical Record – What was the investor’s participation in financing within the past two years? How many companies in the portfolio were fully financed by the investor?

5. References – Investment partners in other firms, law firms and clients or companies funded all fall under proper references. If an investor is willing to give at least his/her legal counsel as a reference, there is a stronger chance of legitimacy.

The benefits of conducting investor due diligence has two major benefits for the startup. The most obvious is “a stitch in time saves nine”. Investor due diligence saves time by quickly eliminating the chaff. And yes, there is investor chaff. I have to repeat this, since entrepreneurs have been brainwashed to believe that all investors have only good intentions. Every single player in the game has a high level of self-interest.

The second major benefit of investor due diligence is that the right investor will be completely impressed by the due diligence! It’s a win-win! Remember, many startups that investors encounter have a fresh-faced feel to them, better known in the industry as “shark bait”. It has been unusual for an investor to receive a request from an executive team re: investor due diligence, unless the team has had exceptional legal counsel. This request creates the perception for a sound investor that they are dealing with a savvy team. This impression is of significant value during valuation and investment negotiation.

Investor due diligence represents one tactic in a crafted comprehensive strategy for startups to differentiate themselves, and increases the probability to get in front of a viable investor. If an investor asks why the team is requesting due diligence, simply say that external legal counsel advised this action for mutual benefit – after all, entrepreneurs have to give twice as much due diligence! If an investor still refuses to participate in due diligence even after hearing it was advised by legal counsel, then entrepreneurs, take note.

To your success!


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