Friday, January 1, 2016

The 3 Levels of Due Diligence

While there are many checklists and rules of thumb surrounding the process of due diligence, the end point never seems clear.  How much due diligence is enough?  Most investors dedicate a certain number of hours 20, 30 or more and when those hours are used up--they make the investment decision.

In my experience there are 3 levels of due diligence.  The first level answers the question-- do we invest or not?  After reviewing the standard documents and talking to customers and industry professionals, the investor decides if the potential rewards outweigh the risks.

The second level of due diligence answers the question -- what will the startup have to accomplish to be successful?  This is not always an obvious answer such as make sales, or gain 10% marketshare, or ensure the product works.  There's often one or two critical factors that determines success.  In today's world it increasingly comes down to cost --cost of customer acquisition, cost of product development, or some other cost.  Yes, the startup can find customers and sell a product, but at the end of the day the margins come out razor thin if not negative.  Another critical factor I see is building the team -- can we find the right people to fill the gaps (and there are always gaps).  Do you know what the startup must do to achieve success?

The third level of due diligence answers the question -- what can the investor do to help the startup achieve success?  Nothing is more frustrating than to see a startup failing and not be able to do much about it due to lack of knowledge of the industry, the market, or the technology. If you can't help the startup, then it's questionable that it's a good investment for the angel.  I've never invested in a startup that at some point didn't need help.  On the other hand, if I can help the startup through connections, mentorship, or team building, then it may be a good fit.