It has been almost 2 years since we founded AngelCentral. We now have a quality pool of angels who are investing with (hopefully) a considered portfolio strategy, selecting from a large pool of varied startups and who have a framework for evaluating founders, market and deal terms. The next question we get from more experienced angels is on how to conduct due diligence on the startups they wish to invest in.
(For this article, i will assume the angel is not a lead investor and are still following a VC or syndicate lead)
Philosophy & Mindset
I will start by saying due diligence happens after you decide to invest in the round. In an ideal world, you complete DD then decide to invest. However, the real world does not usually allow you the luxury of telling a founder to share detailed datarooms before you at least soft commit. So the normal way nowadays is to evaluate the startup via a few meetings and within 1 month, decide to invest provided everything else in DD process works out.
So I would encourage fellow angels to have a mindset of verifying key information when it comes to DD phase. This is very different from the pre-commitment mindset of finding reasons to say no when evaluating the startup for investment.
How Deep Should Early Stage DD go?
By definition, there isn’t that much to DD for early stage startups. Less legal documents, simpler product and fewer years of financials to look at. Also, for angels, we must be prepared to sometimes be given a smaller dataroom. Eg, the lead investor will rightly want to see all salaries and even some client names, but angels probably don’t have a business doing that. It really depends on how comfortable the founders are with you.
Areas to DD
So what do we find in a typical startup DD dataroom? In this folder (usually a cloud folder), you should have access to :
1) Corporate Structure & Shareholding Matters
Eg. ACRA filings in SG case. Shareholder tables pre and post investment, Past & Current Subscription Agreements, Latest & Proposed Shareholder agreements, Founder agreements etc.
Verify – shareholdings, post/pre investment numbers, investing in holding company, ESOP contracts, rights of shareholders, founders agreement terms etc
Eg. excel management reports, audited previous year reports. Cash flow, balance sheet and P&L, AP/AR statements, Bank statements
Verify – key expenses like management salaries, marketing costs etc, cash in hand, AR/AP etc
3) Asset Ownership
Eg. domain name registration, software contracts, property titles etc
Verify – ownership of domain names, apps, source code, databases collected.
4) Contracts & Legal
Eg. employment contracts, client contracts, JV partnerships, MOUs etc
Verify – terms are in compliance with laws and same as shared pre DD
5) Product Development/ Traction
Eg. analytics snapshots, login access to product demo, big picture milestones/Dev plans, customer interviews, production BOM etc
Verify – usage and milestones as shared during evaluation, key contracts, client renewals
6) Any Other Information
Eg. Investment Deck, Financial Projections etc
That’s Way Too Much Work!!!
Truth be told, most angels don’t do all the above. That is why we are not lead investors! For deals which Ning & I are not leading, we usually just pick a few key ones to verify and take about 1-2 days to complete DD. Usually i like to check on management salaries, make sure traffic is real, check out product and customer feedback a bit more. I rely on the lead to make sure hygiene stuff like cash, shareholding, legal issues are all sound.
When Do I Cancel the Deal?
Shao Ning & I view DD as something we do to tick the boxes. We will only cancel the deal if something is very off or which gives us a feeling founders were not ethical/honest. Eg, if founders said they pay themselves $4K per month post round but in projections they say it will be $8K. And when asked, they say its because they are raising more money. That will be a sign for us to walk away!
But if it is last month sales reported at $10K, but in reality it was $9K. And management has a good reason why they reported wrongly, we will usually give them the benefit of the doubt.
In summary, due diligence is something angels should do just to make sure the key reasons we are investing are verified. The amount of information we go through and which the startup shares has to be commensurate to the stage of investment. We can and should rely on quality lead investors to do the full due diligence work but do remember if they make a mistake, all they will say is sorry. So end of the day, we have to feel comfortable. Good luck and have fun!
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