There’s no question that angel investing is a risky business. Not only is there an ongoing debate about the roles that angels should play in their investments, but opinions differ widely on how much due diligence should be performed as well. Is it worthwhile to begin a process that could take months? More importantly, what happens if you decide not to become an angel after several months of performing the due diligence process?
Here’s some good news: due diligence for the angel doesn’t have to be a long-term issue. Research has shown that angels who dedicate 20 hours to the due diligence process are 5x more likely to see a positive return on that investment.
How To Get Started With Due Diligence
Many angels have a number of practical resources they used to begin the due diligence process. This includes best practice lists, sample questions to ask, and even checklists that have been created by some of today’s top angel investors. For those who are really serious about this process, there are even courses and seminars available that outline some of the best practices which are used today.
These resources take up some time to get the beginning angel up to speed, but this process is one that is well worth taking on. If you don’t have a lot of time to get the ball rolling on an investment, however, here are three important questions that should be asked of every potential investment opportunity.
1. Are the people involved going to be able to complete the task?
Beyond anything else that an entrepreneur must have for an angel to consider investing into them, passion must be present for the job that is being done. Growing the business must be the #1 priority of the entrepreneur and their team in order to be worthy of an investment. Entrepreneurs may give a lot of different excuses as to why they don’t dedicate a majority of their time to their project.
- They have a family that expects to see them for a certain amount of time every day.
- There are additional professional responsibilities they must fulfill.
- The idea is more of a pet project to them and so they put in the time when they can.
What you’re looking for here are red flags like those mentioned above that will give you a clue that it is time to walk away. Is it harsh to walk away from a single mother with 3 kids who is working 12 hours a day already and trying with all her heart to made an idea work? Sure it is, but this isn’t a personal decision.
It’s an investment decision. Background checks, arrest records, a poor credit score: these are all places to look during the due diligence process to find a reason to walk away.
2. Do people even care about this idea being considered?
Businesses aren’t able to grow if there isn’t a customer base supporting it in some way. Some early-stage start-ups might not have that customer base established as of yet, but they’ll have identified their key target demographics and have a plan to reach out to them. The angel needs to find strong evidence in the market that there is viability for the idea being considered during the due diligence process to protect their investment.
A start-up will claim anything to get a positive flow of money from time to time. The angel can affirm or refute those claims with their own research.
3. What will it take to get an exit?
Eventually an angel needs to get out of an investment through an exit. This means there must be some insight before the investment is made as to what capital levels will be necessary to make this happen. Once a target figure is achieved, then it becomes easier to identify roadblocks that may arise to prevent an exit from occurring. It will also give the angel an idea of how much their actual equity could be diluted over a specific period of time.
Due diligence without consideration of an exit trajectory is bad news just waiting to happen. Some of the best angels today are spending 75% of their time plotting their strategies here. If you’re using 20 hours as the benchmark for due diligence, then spending 15 of those 20 hours on your exit strategy is what is happening today.
Due diligence is important because of the potential exit strategy. Most angels invest into entrepreneurs they already know so that the exit strategy is much easier to plot. It takes time to perform this due diligence, but it is your money as an angel that is at stake. If you don’t have much time, then consider these three points as you research the next investment to get a better idea of what may happen.