Due diligence is the process by which investors learn more information about potential investments to make the best decisions for the future. Investors interested in an emerging company need to develop a personal due diligence process that looks at the key areas of general inquiry as well as the specifics that matter the most to them. The best due diligence processes take into account everything from business to legal concerns in a simple and systematic way.
To get a better idea of what due diligence typically looks like at different stages of the investment process, investors should note the following general breakdown of what to look for during and after each meeting with a potential investment:
What to Concentrate on in the First Meeting
Before investors meet with the founders of a startup that they are interested in, they typically already have a general sense of what the company hopes to accomplish. For that reason, the initial meeting often focuses on the basic potential of the company. Individuals should pay particular attention to the founders and the team that has already been assembled to see how they work together and, more importantly, what it would be like to partner with them. The founders should have an obvious passion for what they are doing, as well as qualifications to back up their goals.
In terms of business due diligence, potential investors often focus on how well the founders know their own industry. Many investors will test the business plan to ensure that the founders have adequately considered likely scenarios. Sometimes, it can be helpful to walk systematically through the business plan while looking for any holes or overlooked issues. The founding team should also have a clear strategy for taking the product to market, which involves a thorough understanding of the competition. During this stage, investors may not know the specific questions to ask, but it is possible to get a good sense of how much work has been done in these areas.
Perhaps the most important piece of due diligence during the first meeting is to find out what the company’s angle is. In other words, what does it do differently to ensure that it will actually have a market? The founders should be able to able to articulate the angle succinctly and cogently.
Questions for the Days after the First Meeting
The next phase of due diligence involves validating the claims made by the company. Individuals should look into the market size and make sure that what they find aligns with what the company presented at the initial meeting. As much as possible, potential investors should dig into the nuances of the relevant markets to see if any concerns exist and identify how much potential the startup has for really disrupting the market.
One strategy that potential investors may want to use when deciding whether or not to invest is the pitch-it-yourself test, which involves pitching the company to friends, family members, and colleagues to see if they can convince others, and themselves, of the company’s potential. This test can help bring up some issues that an investor might have overlooked.
What to Investigate in Subsequent Meetings
In the second and third meetings with a potential investment, investors need to focus more on specific numbers. At this point, the company should have some calculations involving customer base size and income predictions for the coming years. Investors should focus on hard metrics and challenge calculations, especially if estimations diverge widely from typical industry benchmarks. Many investors also ask about growth plans in terms of products. When the company has money to invest in more product development, will it improve existing products or focus on expanding the produce line? Here, the reasoning behind the answers is typically more important than the answers themselves.
At this point, many investors will call upon their professional network, especially people with knowledge of relevant industries, to get as complete a sense of the dynamics of the sector as possible. Potential investors need to focus on risks—identifying them and trying to understand them as fully as possible. This part of due diligence may involve meetings with the company’s founder, independent research, and more. After thoroughly reviewing the data, individuals must decide whether the risks are worth the potential gain.
Due diligence does not end once the parties sign the term sheet. Instead, investors should have qualified legal representatives to step in and look at the formation of the company and investigate potential skeletons in the closet. Issues like large debts or fired co-founders, for example, can cause major problems down the line.