An excellent look at the Due Diligence process

I recently saw presentations (and ended up briefly presenting one) at John Ricci's Pitch Global event. Several of them were outstanding, but today I wanted to focus on the excellent presentation by Gust's David S. Rose where he highlighted his Angel Investment Monopoly view of due diligence and how to make investments in the angel space.

It was so good...

That I decided to go over it here (not technically stealing it, but rather expounding on it with high praise and citation).

Investment thesis

Rose starts out by explaining what an investment thesis is, and frankly, I never saw it formalized as well. There are actually 2 major parts to it - the angel-specific part, and the universal part.

• Location: What locations do they (you) invest in? As it turns out, something like 80% of investors invest 80% of their money within 80 miles of where they live.
• Stage: What stages do they (you) invest in? I tend to go in at the early early stage, but funds I deal with usually have a range that extends across the board.
• Sector: What industries and sectors do they (you) invest in? My number one rule is 'do no harm', and my number 2 rule is "doing well by doing good". But some investors made a whole lot of money selling vape cigarettes, which I had the chance to get into early and chose not to. I am happy with my choice.
• Business model: What business models do they (you) invest in or avoid? I avoid most frauds and will not do crypto-currency schemes. I avoid drugs (because of the long and expensive FDA approval cycles) and outer space (to much money to go anywhere).
• Size: What size company and check do they (you) invest in (with)? I am a small check writer, rarely over $25K in any one company because I figure the odds are with profile diversification. On the other hands, funds I deal with can go way higher than that.
• Lead/follow: Do they (you) lead rounds or follow other leads? I always do my diligence, and rarely lead a substantial round myself. Like I said, I tend to be early early stage...
• Founder and team: Key factors include (all important but most important of all) Integrity, passion, experience, knowledge, skill, leadership, commitment, vision, realism, and flexibility. If I detect the slightest lack of integrity, I run away, except of course, my detectors don't always work all that well.
• Scalable business: The business can be proven with a small investment and then grown to a large size, where the economics get better as the business gets larger.
• Traction: Of course sales is really better, but traction is (per Rose): "Something outside of the founders' control that demonstrates value creation, and is getting bigger and better every day." What most presenters call traction, I call something else...

If the company doesn't fit, the investor must quit. All of these criteria must meet the standards of the investor, or it is a waste of time to continue the process. Or in the case of some accelerators and incubators, it defines the space the company fits into and the program that applies to them.

Table stakes and key factors

The next step, only to be pursued if the first step is a YES is to understand the situation of the company in the market makes sense and if the money looks sensible.

• Market/pain: If you do not have a well defined need or want you are going to fill, it's not going to work for me. And if I don't think the need is something I want to help fill, same thing.
• Product/solution: No matter how much I think the need is worth filling, if your solution isn't one that makes sense to me and I want to support, It's not going to happen.
• Business model: This is where it can get complicated. We start out with things like business to business software as a service (B2B SaaS), or whatever your thing is, and I have invested in lots of different ones, but it has to go a bit deeper than that.
• Target customers: There better be enough of them at a big enough size to make it worth the time and effort to try.
• Go to market / Competition: How are you going to get sales and who are you competing against?
• Unique advantages: I call this the special sauce, and if you don't have any or it doesn't taste that good to me, we will not go further. unless it's a race...
• Financial forecast: It better make sense and I will be asking about it in detail. Not too hot, and not too cold, but just right, and realistic, backed by facts, and taking into account uncertainties.
• Traction: Note this is repeated from the investment thesis, but when you are trying to make something look like a monopoly board, you need 9 items on a side.
• Raise and valuation: Some folks don't invest less than $50M at $250M valuation and some don't invest more than $10,000 at more than $4M valuation. Of course they have to make sense according to my statistics and the market today, but still, going after a minnow when you are looking for whales might not work out that well.

Rose says that, at this point, if you passed all the tests, you are at a 'Yes... If" situation. In other words, if it all turns out to be true, it's an investment you would make.

Trust but verify

The next step is to verify that what was discovered so far in in fact the reality of the investment. Rose talks about red flags and investor-led due diligence:

• Deal negotiation: This is the part where the company negotiates the terms of the deal with the investors. It's particularly tricky if you want more than one investor, because you might find someone to invest at a high valuation and then find out that others who think it's too high won't come into the deal. On the other side, you might be negotiated down and then end up giving up more for less. And then there are the down rounds, where investors are told bad news that the new investors who are presumably taking less risk are getting a better deal.
• Founder/investor fit: Here's one you cannot adjust to. If we do not get along well, it will not work. And if you fake it to get along with me, you will be looking at rough waters down the line. My strong advice is to be yourself.
• Founder references: Sensible investors will want to do reference checks, not just background checks, and not only with the folks you tell us to talk to. If you tell us you were a convicted felon and we still keep going, your jail house reference checks should be just fine. Or we would not have gotten to this point. Which is why integrity is so important.
• Market size: You may have provided a market size, but at this point it's time to check the real market size. Not the SAM, SOM, TAM, TOM song, but the actual sales you can actually get sold in the time frames identified. Me, I want to know that from the beginning, and you telling me the total market is 8 billion people at $1,000 per year, will not have gotten you past the first gate. This is just me checking on reality and asking you how you justify your claims and how the differences impact the success of the company. If you are off by a factor of 100 and your exit point is at 1% market share of the real market, it likely doesn't make that much of a difference, except in terms of your credibility, which is critical of course.
• Competition: I cannot tell you how many CEOs have told me there is no competition. But to be clear, for your customers, the competition includes 'do nothing', and if there is no competition, it is likely because it's too early in the space.
• Team dynamics: This is about how well your outstanding team works together. Nothing fails worse than a team of fantastic players who hate each other. Your team will spend many hours over many years together on an ongoing basis and their trust of each other and ability to collaborate and disagree reasonably is critical to success. If you cannot agree with me on that, then ...
• Product proof: Nothing in your life likely compares to the many demonstration products and videos I have seen that do not prove out. The distance between a feasible technology and a successful product is indeed vast, or as someone I do not know once said about someone they did not respect: "it's about as close you are to smart."
• Customer references: Investors like to and should talk to actual customers. Better yet a random selection of at least 10 existing customers. or better still, a selection of customers from the 'complaints' list. As a hint, if there are no complaints, you probably are not doing much of a business. If you don't have any customers yet, your former customers (from the last company) will do as a start.
• Other investors: Finally, the followers want to know who else they are following and, by extension, how the leaders chose you and why. The leaders want to know why you have chosen them. It's a great honor to be chosen to take the biggest risk, but on the other hand...

Last steps

This is what Rose calls 'full due diligence', and it consists of 'professional-led diligence' and 'bringing it home'. Essentially, for the wealthier or more systematic among us, this is where you pay professionals to make sure.

• Corporate structure: I start with your legal filings, work my way through your articles of incorporation and board, and down the line. If you are not a C corp in a beneficial tax state (or perhaps a pvt ltd somewhere else), I am likely to say NO till you change over.
• Board composition: Obviously I favor natural wood over composite boards, but when it comes to directors, I want to know what they actually do for you. Big names do not impress me unless they are bringing big benefits to the company.
• Company financials: I will want to look at the actual bank account in some cases (read only please), but certified books may be good enough. And your projections better have a basis in everything else I have seen.
• Cap table and option plans: How much dilution and by whom are we looking at today and into the future? How will power and influence work in the company over time?
• Employees and vetting: I always want to see the contracts with employees and look for potential liabilities, and part of that is seeing what the CEO has done to properly manage the company and process up to here. I have learned many of these lessons, unfortunately, more than once.
• D&O insurance: If I am going to be a director or officer, I will want the indurance, and I will want to see the situaiton for the existing directors and officers and find out why if they are not yet insured.
• IP Verification: I generally go to government records to look things up and read the documents myself to see the real situaiton. If I am working in a group on diligence, I better trust the oither members of the group to do their part because I am not going to duplicate their efforts, even if I will take a look here and there.
• Document negotiation: All those pesky terms and conditions turn out to matter to investors. They can completely change the nature of the investment. So-called SAFE notes not actually an exact copy of the actual SAFE notes are often filled with poison pills. I tend not to eat them.
• Recent changes: By the time I get to the end of this process, things have changed from when I started. I generally am in close touch with investment CEOs and team members before and after investment.

And if all goes well, this 1-3 in 100 will get an investment.

Then what?

The good angel investor adds value over time, AFTER the investment. This takes two to work. The investor has to be willing and able, but the founders and executives must listen and try to understand. Which is why key components of the people include realism, and flexibility. Value is added in two general ways:

• Baseline: These are things that should be expected:
• Refer customers: When I find a potential customer for an investment I refer them because it benefits me. Unless the CEO has not kept up their communications with me and other investors or something has gone wrong. My introduciton is my endorsement and I do noit want someone coming back and telling me they trust me less because of somehing someone else did.
• Post (or repost) items about the company: I am happy to spread the news, especially if it's easy to do. When you succeed, I suceed.
• Suggest ideas: If you don't listen to and sometimes act on my suggestions, I may become sour and less helpful. We should be working together...
• Note competitors: When I see them I let you know, and hopefully you appreciate it. If you already knew about them, why didn't you tell me in your last monthly update?
• Share news stories: Same deal as noting competitors.
• Give moral support: It's lonely at the top, but you don't have to be alone, Your investors can also be your trusted advisors.