This article was written in collaboration with Taylor McAuliffe, researcher and writer for Altitude Accelerator, who focuses on investor relations, startup ecosystems, emerging technologies and financial markets.
Investor due diligence is a rigorous process that requires meticulous preparation. Angel investors have a responsibility to create and execute a due diligence process that aligns both the entrepreneurs and investors.
Karen Grant is a passionate advocate of angel investing in Canada. She received her start at IBM in sales and marketing, working there for 12 years until she was recruited to head Toronto Venture Group. This experience helped catapult Grant to launch her first Angel Group in 2001. Since then, Grant has founded three other angel groups, Northern Ontario Angels, Angel One Network and Equation Angels, which launched in late 2019.
In a previous article, Deconstructing Investment Myths In The Shifting Startup Landscape: Grant emphasized that “investors are scrutinizing opportunities more meticulously, driven by a desire for better returns.” She points out this perfect storm:
“…where you’ve still got founders who are trying to raise money and they’re doing it earlier and earlier. So, they’re being taught that they should be funding their entrepreneurial initiatives with other people’s money. Furthermore, there are investors who, much like venture capitalists, have yet to witness the anticipated returns, and this has prompted them to exercise increased caution.”
We recently met with Grant through Brampton Angels where she dove into the intricacies of the due diligence process, guiding new investors in the technology startup ecosystem.
Grant first defined due diligence and its purpose within angel investing,
“[Due diligence] refers to the care a reasonable person would take before entering into an agreement or a transaction with another party…and there is a significant amount of due diligence, care and attention that needs to be taken in investigating a company and finding out whether or not they’re worth investing.”
Evaluate The Deal
One of the purposes of an angel group is to source deal flow. As a result, investors will be faced with countless opportunities. To be a successful investor, Grant emphasizes he or she must be able to quickly recognize when a deal is not aligned and not be afraid of saying no from the start,
“When you’re conducting due diligence, it’s transformational, not adversarial. One of the objectives of conducting due diligence is to try to get to a quick no. There’s nothing worse than dragging out a due diligence with a company that you don’t have enough money to make it worthwhile or you’re not really that excited about the deal. It serves no one. Get to a quick no, cut them loose so they can move on to other investors that may be interested in the deal.”
Once investors have decided to move ahead with a company, Grant stresses the importance of a proper due diligence strategy. Extensive and accurate due diligence is the backbone of a properly executed deal. However, not all angels spend the necessary time and effort to ensure all terms are clear before entering the deal. Leading with assumptions can increase future risk. Grant underscores the investors’ job is to truth check,
“The most common due diligence pitfalls are hidden assumptions. The founders have hidden assumptions. The investors have hidden assumptions. You need to make sure that those things are clarified. Some investors just don’t do the work or do bad fact checking. They don’t check deep enough. They don’t look at the financials. They don’t look at the HR plans. They don’t look at employment agreements.”
Sometimes it’s the simplest aspects that investors skip over in their due diligence. Grant highlights how investors can be so focused on the financials that there are other indicators of a sour deal they overlook,
“…something as simple as finding out what their credit rating is. Do they have a criminal record? It’s amazing how many angels don’t bother doing that kind of research.”
The product and solution, Grant asserts, are what investors need to pay attention to when evaluating a deal. The ability to quickly identify whether the product “is a painkiller or a vitamin,” is critical, Grant states. Investors must be diligent in evaluating if the product is effectively targeting a problem that is relevant to the market. Other questions to investigate include the description of products, the unique attributes and opportunities, the stage of the product, the product roadmap and the current projected process for full commercialization.
Investors need to also pay attention to the character of the founders. Grant advises investors they are going to be in a long relationship with these founders and they need to be convinced these founders can get the job done and manage their time.
“Focus in on the management team,” Grant advises, “Make sure they’ve got good social skills, high EQ and all the things that you need for a good leader or leadership team. Make sure they work well together and they’re not throwing each other under the bus.”
On the other hand, Grant makes it clear that if any red flags come up, investors should not readily dismiss them, and be willing to discuss any hesitancies with the rest of the interested investors. “If you see founders not being responsive to questions or recommendations that you are bringing forward from the investment side, walk away. It’s been my experience that reasonable founders will listen,” Grant says. Displays of character are illuminating in determining the viability of a deal, she continues,
“Keep an eye out for a lack of transparency. If you catch the founders in a lie, do not do business with them. Integrity in this business is crucial–both integrity from the founders and integrity of the investors.”
Arguably the most important aspect of due diligence is ensuring the founders and investors align on details such as business plans and funding forecasts. It must be clear where the company is going, how they are going to reach their milestones and if there is a clear and attainable route in place. Grant proposes,
“Look for business milestones for the next six months and the next two years – what are they, when are they and how are you going to get there? Those are the questions that investors need to ask and where founders need to strongly consider if they haven’t already.”
“You’re trying to find out whether or not their forecast makes sense and whether it’s supported by a business plan. You should be able to understand what it’s going to cost and how far it’s going to get you. You’re checking the founder’s logic. You’re checking their ability to do reasonable forecasting and checking that they’ve hit all the boxes. If, all of a sudden, they’re going to grow their staff by 50 people with this round, that seems highly unlikely. If they are going to do that, question how are they going to do it? Where are they going to source them? What are they paying them? Are all those salaries in the forecast? It’s surprising the holes you find when you start doing that kind of research!”
While executing on due diligence, Grant believes that informed decisions are the key to successful deals. She indicates that leveraging the knowledge of your angel group and recruiting people who have relevant domain knowledge are simple ways to improve the quality of your due diligence,
“…Bringing in third party specialists if needed– IP lawyers, or technical experts. Perhaps you need an accountant or a finance person to go through the finances because you don’t have that on your team. Expertise is critical to validate decisions.”
Grant reiterates on the importance of informed decision making,
“You need somebody involved in the due diligence process who has domain knowledge. They know about the business, and they’ve got knowledge that they can bring to the table to quickly look at something and assess whether or not it’s worthy. Having someone in the business who knows that you should expect to see this marker for success in this industry and it’s not present–that’s an important message! Due diligence should be done by experienced people.”
Communication is Vital
To keep the momentum of a deal going Grant counsels angels on the importance of “good communication skills and practices” both with the company founders and interested investors. She shares the importance of a defined process and the key role of the lead investor:
“Process is vital to success. The process will help keep things moving forward. Everybody knows the deadlines and what the expectations are.
A lead investor is necessary for a successful due diligence process. The role of the lead investor is to organize and stick to the timeline to ensure the job gets done properly. They play a pivotal role in orchestrating a thorough and efficient due diligence process. This includes initiating negations with the founders, ensuring all deliverables are met, reviewing terms and finally ensuring the investment decision is well informed.”
Grant encourages investors to look at due diligence as a project,
“It is crucial to have a lead investor. This is a project, and you need a project lead who will get everyone organized, assign tasks, make sure that the deliverables are coming and initiate the negotiations of the terms and the valuation with the founder.”
The lead investor acts as a central point of knowledge where both investors and founders can ask questions, be informed about current state of the deal and have foresight for next steps,
“The lead investor sets shared goals with the entrepreneurs and establishes the timeline. Manage expectations and let the founder know it’s going to go through two months of this. Explain how the process is going to work. Setting expectations and communicating clearly is crucial and it brings stress levels down.”
From Grant’s personal experience as a seasoned investor, she recommends having weekly deal status updates so other investors are receiving timely information,
“Pick a day and send out information and updates on what’s going on. In week one, you do recruitment, every one’s in place, and their marching orders are set. By week two, you should be able to send out some indication of the initial findings, initial terms and the status of the negotiations. Continuously update everyone involved. Make sure that everyone’s plugged in and they’re getting the same information.”
A clear and structured process is essential for the success of any investment deal. It ensures steady progress, with all parties aware of deadlines and expectations. Due diligence serves to synchronize the goals of entrepreneurs and angel investors, laying the groundwork for a successful partnership. Angels must remember that information and communication are key to a successful due diligence strategy. Finally, Grant emphasizes that due diligence marks only the beginning of an investor’s journey,
“As an Angel investor, readiness to invest is just the start. It’s the ongoing commitment to nurture the company towards growth and success that truly leads to shared triumph. Active engagement and valuable contributions to the company are key to a favorable outcome.”
ABOUT: Taylor McAuliffe is a researcher and writer with Altitude Accelerator, a non-profit innovation hub and business incubator which provides programs to help founders grow and scale. She has a deep admiration for reading and writing, with a strong background in writing for various domains, including investor relations, startup ecosystems, emerging technologies, and financial markets. Taylor holds a BA from McGill University.
