Startup due diligence is all about asking the right questions. If the information from the founders does not answer your questions, it is useless. And if your questions are being ignored or answered with more useless information, that's a powerful signal.
Questions depend on the stage the company is in, the industry, company specifics and the investor's expertise. A Series B company has a different profile from a seed or pre-seed company and the questions should be different too. For example, a seed company won't have much traction, revenues or sales activities, so it's pointless to ask management about those.
A post on the Angel Investment Network blog discusses due diligence for angel investors. The author points out that early stage startup investors should not expect due diligence to be as deep as for later stage companies.
Due diligence at the level of early-stage investments is predominantly about checking the claims of the company in their documents.
This does not mean you should carry out minimal [due diligence]. Evidence suggests that investors who spend longer on [due diligence] get higher returns (UKBAA research has shown that at least 20 hours due diligence has a positive impact on the likelihood of a multiple investment return (Siding with Angels; Robert Wiltbank, Nesta-UKBAA)).
Correlation or causation, it doesn’t really matter. You should carry out thorough due diligence.
But the point is that it is not a complicated process. People making their first skirmishes into angel investments are sometimes put off by the idea of DD. They think that they don’t have sufficient experience to do it properly and as a result, they’ll be throwing away money.
They think like this because they have the expectation that their [due diligence] ought to be as rigorous and detailed as that carried out by a private equity firm, for example.
But this is an unfortunate belief. It’s naïve to think that the same level of DD should be carried out – there is not enough information on early-stage companies. Because they are early-stage!
(Note: the referenced UKBAA report can be found here).
We agree with the above. It's all about asking the right questions. A well-designed set of questions will provide useful information, will be easy on the founders and may reveal red flags when the answers are not what one expects.
The above blog post goes further and provides six sets of questions angel investors should answer:
- Team & Management
- The Business
- The Market
- The Technology/Product (if applicable)
- Finance & Tax
Some of these have to be addressed by direct discussions with the founders, others - by running background checks. But one area requires either industry knowledge or access to experts - #4 The Technology/Product. Here is a short version of the technology/product question set:
1. Is the technology standalone or does it rely on integration with other businesses/technologies?
2. Does the technology have many potential applications (platform technology)?
3. Is it or can it be protected by IP rights?
4. Is the technology novel and disruptive or an improvement on existing tech?
5. Is there anything else like it?
6. Is it launched and in the marketplace?
7. Is it ready for market?
8. Who are the current big players in this space and what are they currently working on?
9. How quickly are the technology trends changing?
Most of these questions require some knowledge of the broader technology space and the market. If you don't have it, you need an expert to help you. As we noted many times, experts are expensive and not always up to speed with the latest developments. Many questions can be answered by performing extensive research online, reading articles, asking on forums and making notes. But this takes time. Using search engines always brings up noise from irrelevant sources, duplicates and online shops of dubious origin. Who hasn't given up on a search query after just a couple of pages of search results?
We conceived Avogadro One as a simple tool to help you find partial or complete answers to questions 1, 2, 3, 4, 5, 8 and 9. Using our solution, an investor will find these answers, make notes, prepare further questions and build a thesis. Due diligence should be about Aha! moments, not wrestling with Google or spamming your network.
What technology/product questions do you ask when doing due diligence?