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When it comes to investing, one of the most important first steps is due diligence. This essential component gives you a chance to look deep into a company and uncover potential surprises that could cost your firm a lot of money and headaches down the line.
Due diligence is a systematic process that evaluates the risks involved with a particular deal, the details of the deal and the positive or negative impact the deal has on the investment portfolio. You can equate due diligence to doing your homework on a potential investment.
Take a pause
It’s not uncommon for buyers to have a used car inspected before they seal the deal to ensure the car works as described. This extra step keeps them from losing money to a bad investment, just as a home inspection protects lenders underwriting a mortgage. Any investment decision requires some consideration, but the potential losses are much higher when considering investing in a startup.
There are several elements of due diligence in investment management. Two key components are industry due diligence and legal and corporate due diligence. With industry due diligence, research is performed to understand the industry as a whole. It looks at competitors in the industry, the major players in the market, the advantages the startup holds, consumer trends and more. Legal and corporate due diligence looks at the startup’s details, from the founders to the corporate structure and everything in between.
The key to due diligence is doing the homework before the deal gets underway. When an investment opportunity comes up, put the brakes on moving forward until due diligence is done. You can avoid making a bad investment when your decision-making is informed by facts.
Follow the process
Moving systematically through the two primary components of due diligence leaves no stone unturned in learning about a potential investment. The approach is all about gathering information, but each component requires different data.
Industry due diligence
The first step in evaluating a startup is understanding the market where the startup operates. There needs to be a demand for the product or service the startup offers. If there are already several players in the market, consider whether or not this startup can fill in a gap or niche. A market already saturated with oversupply from dominant players is a tough one to break into and be profitable in.
Subject matter experts, consumers and the company management all have a perspective worth listening to. The more information you have available, the more informed you are when making tough decisions. You can further break down your analysis by the following risk categories:
- Competitor risk
- Market risk
- Regulatory risk
- Technology risk
- Execution risk
If the startup you are looking into doesn’t have a well-detailed plan to address and mitigate these risks, you may want to pass on the investment opportunity. These are primary concerns over the company’s long-term viability, which ultimately impacts profitability and your return on investment.
Legal and corporate due diligence
After you confirm consumer demand and market availability for the startup, move on to look at the details of the startup team and its operations. Since your money and sometimes reputation become intertwined with a startup investment, you need to conduct an in-depth investigation into the inner leadership and workings of the company.
Take a deep look into the financials, confirming their reporting about funds or account holdings. Always verify the reality of their growth or projections using their own financial reports and your independent verification. Some of the information to review and verify includes:
- Ownership and corporate structure documents, including stock option agreements, shares and certificates of incorporation
- Documents that include the term sheet, intellectual property ownership, employment agreements, lease or purchase contracts, litigation history and insurance coverage
- Tax compliance, licenses or permits
The more thoroughly you conduct your review, the more accurate your view of the investment opportunity is. You can see beyond the immediate attraction of high returns and evaluate long-term financial stability, functional partnerships and chances of profitability.
Realize what’s at stake
Due diligence is your chance to protect yourself from a bad investment. Startup teams are typically eager and overly optimistic. While they believe in their product or service and will stake their livelihoods on it, you have the luxury of being more realistic about their future. Though there is no intentional fraud behind their investment requests, without due diligence, you may find yourself invested in a company that can never meet its forecasted goals because of a poor business structure, saturated market or inexperienced leadership team.
Due diligence allows you to prioritize investment opportunities with the highest success rates. It also prevents excessive losses as the information guides you to an appropriate investment amount for the situation.
Accept the responsibility
Knowledge is power, and due diligence is the way to gain the upper hand when considering a startup investment. Be willing to do the work and pay the price for due diligence because this expense could save you from making a poor investment decision that costs you more down the line.