Due diligence (AKA “doing your homework” on a startup to see if investing is the right call) should clearly take time… but how much? Marianne Hudson, executive director of the Angel Capital Association (the trade association for angel investors in the US) wrote an article on this topic. Her full article (with her permission) appears further below.

One of the biggest debates in the angel industry is how much due diligence investors should do before they invest. From “rank and file” angels to rock star investors like Ron Conway or Mark Cuban, opinions differ vastly from literally doing none to conducting formal processes that take months.  So how do you decide what the right amount is for you?  And what are the factors you really need to check out?

Count me in the camp that believes that doing due diligence is a very important.  For me, it is about being comfortable as an investor that the team, market and product have a chance for success, that there are no red flags pointing toward failure, and better understanding the company’s capital needs over time.

As I’ve posted before, angel investing is risky.  Due diligence doesn’t completely “de-risk” a deal, but it helps eliminate deals in which there are clear problems that lead to failure – things like products with no real customers, CEOs with integrity issues, and no true right to sell the innovation.

A 2007 study found that angel investments in which at least 20 hours of due diligence was done were five times more likely to have a positive return than investments made with less due diligence time.  Put another way, while 45 percent of investments in deals with 20 hours of diligence resulted in a loss, 65 percent of the investments with less diligence took a loss. That is pretty compelling.

The point here isn’t that an individual must do at least 20 hours of due diligence for every opportunity you seriously consider.  Instead it is to understand that due diligence can help you make better decisions and increase chances for a good return. And you don’t have to do all of the work yourself – many times you can access diligence information conducted by other investors you trust.

Getting Started – Key Factors

There are some very good practice resources for angels to learn about comprehensive due diligence, including questions to ask, checklists that angel groups use, best practice papers summarizing recommendations from top angel investors, and courses on investment best practices.

Although I always recommend using background resources like these, if you lean toward a faster approach, here are my top three due diligence questions to address:

Is the entrepreneur and team up to the task – and do they have the integrity you need?

A starting point is to ask the entrepreneur a lot of questions and of course check their references.  As you talk with those references, get them to suggest additional people for you to talk with.  Sometimes these are the most important interviews you will do.  In these discussions, Internet research and possibly a background check, you can also find out if the person has had issues in managing money or has been arrested – the kind of red flags that make investors walk away.

Rick Vaughn, leader of the Mid-America Angels in Kansas City, provides some good color about what you’re looking for in assessing the entrepreneur.  “It goes back to that old saying that people get funded, not business plans.  To some degree we are looking at the entrepreneur and thinking, does this person have the vision, patience, courage, creativity and integrity necessary to lead a successful venture?

“Investors are going to be thinking about how they will feel about working with the entrepreneur and the rest of the management team.  Do they feel good about forming a relationship? Investors want our level of trust to increase with each interaction we have with the CEO and the team.  If it doesn’t, that can be a deal-breaker.”

Are there customers or strong potential customers for the product or service?

A company can only grow and make money if they have customers who will pay them money.  If you prefer an early-stage company that has a product ready for sale, then it is important to ensure the company has established customer relationships.  If you like startups that are still developing their innovation, then you need strong evidence that potential customers really see that the startup can solve a pain point that they will pay for.  Generally having two established customers who will confirm that they are buying or will buy the product is a decent hurdle.   Understanding the customer situation also helps confirm or reveal important things about the market for the product and length of the sales cycle by interviewing customers.

Also, as the due diligence best practice paper notes, “Customers need not just the will but also the ability to pay (for these products).  If the venture targets customers without sufficient budget for the product, it won’t matter how badly they want it.”

How much capital does the company really need to get to an exit?

While it is important to dig into the potential exits for a company, it is also critical to get a beat on how much capital the company needs now and in future rounds of growth.  This provides a sense of the hurdles the company will face and how much your ownership stake may be diluted over time.  Many companies tend to underestimate how much money they will really need.  Ask lots of questions of the entrepreneur and financial team to get an idea of how realistic their financial plans are and mine data on companies in similar industries to see their financing and exit trajectories.

So what is the right amount of due diligence for you? Every angel will personalize the process for their own needs.  However, if you are new to angel investing, you can gain a lot by reviewing the wealth of resources available and talking with experienced angels about what is important to them and the processes they use.  Although you’re likely to adjust your approach as you make more investments, you will definitely increase your odds by incorporating due diligence into your investment decision making.