Getting a term sheet is one thing but for the investment to finally go through, investors conduct what is commonly known as due diligence.
While large venture capital (VC) firms have teams of people, in-house and external, looking deep into the startups they want to invest in, Angel Investors often have to do plenty of it on their own.
As they must.
Any form of investment must go through a thorough process of due diligence so as to ensure that investors know exactly what they are getting into, and have a brief idea of the future, and this becomes especially relevant when it comes to the 10s of thousands of dollars that Angel investors put in.
What happens when investors don’t conduct proper due diligence?
Well, you could ask that of investors who put in millions of dollars into the now infamously defunct Theranos that defrauded investors with faulty and exaggerated claims of the ability of their devices.
Key areas for Due Diligence
Market Opportunity
It's super important to grasp the market where the startup is playing and size up its growth potential. That means doing some digging on the target market's size, the kind of customers they're going for, the competition they're up against, and the chances for expansion.
Having this info helps you figure out if the startup has a solid business model and the potential to scale up.
Management
The management team plays a huge role in determining whether a startup will thrive or flop.
Take a close look at their track record. Have they built in a similar space before? Have they scaled a product? Do they have the skill sets to pull this off?
All of this will give you a good sense of whether the team has what it takes to pull off the business plan and make it a success.
Financials
If the startup is very early in its journey, it will not have much to show for except projections but even in such cases, do your own research and independently verify the numbers claimed by founders in their discussions and pitch deck.
In case the startup does have revenue, get cozy with the income statement, balance sheet, and cash flow statement. Don't forget to check out the burn rate too, and how long the startup's runway is.
Get an idea of what percentage of revenue comes from which channel, and take a deep dive to figure how profitable the business could be, if at all, at scale.
Technicals
Remember when Elon Musk backed out of a deal to buy Twitter claiming that a large portion of its users were fake?
If the founders claim that their product has a certain number of Daily/Monthly Active Users, it may be a good time to get deeper into those numbers.
Checking technicals, however, goes beyond just checking DAUs and MAUs though. If you don’t understand the technology you are investing in enough, hiring someone who does to do it for you will save you a lot of heartburn later.
Intellectual Property
IP often becomes the one key thing that attracts you to a startup.
This is especially true when it comes to technology, and if the founders claim to have patents (even the pending ones), now is a good time to evaluate their value and potential.
Does the startup really have a defensible competitive advantage?
In several cases, you will find that this won’t be true.
Legal and Regulatory Compliance
You need to dig into their legal and regulatory filings to make sure everything's in order. Check if they've got the right licenses and permits they need to operate legally.
Additionally, in certain heavily regulated areas such as lending, compliances can make or break a business, so when taking that punt, make sure you know what you are getting into.
If the business requires getting into contractual agreements with multiple vendors, hire a professional firm to check that everything is in order.
What’s the best approach?
Startups are a risky investment and as Angel Investor, you must remember that your investments may fail even if you do due diligence the right way.
So while there’s no approach that is correct or wrong, it is recommended to hire professionals in addition to doing your own independent research. Keep a checklist of the most important questions (covered earlier) that need to be ticked before you invest, and hope for the best!