Are You Investing in Startups Without Doing Due Diligence?
For businesses that make investments on behalf of others, such as a venture capital investment firm, conducting due diligence isn’t just about good investing discipline, in many cases it’s also a legal requirement, as the business is acting as an agent (in the principle-agent dynamic) and thus has a responsibility to conduct and prove their diligence in having acted on others’ behalf.
Individual investors making decisions on their own behalf don’t have a requirement per-se to conduct due diligence, but it demonstrates good investing discipline that’s likely to lead to superior outcomes for the investor.
Why do investors complete due diligence before investing?
Due diligence is a key element of making investment decisions – its purpose is to establish the extent to which an investment opportunity, which looks attractive at face value, holds up under more detailed scrutiny. A simple definition of due diligence would be “an investigation, audit or review performed to confirm facts or details of a matter under consideration. In the financial world, due diligence requires an examination of financial records before entering into a proposed transaction with another party” (Investopedia)
Many investors may also have certain philosophical factors they apply to the investments they choose to make. These could include ethical, social or environmental considerations, or be sector specific, for example focused on finding investments in disruptive software services. Due diligence helps the investor confirm whether the opportunity under consideration aligns to their investing philosophy.
Who carries out the due diligence process?
Both pillars of due diligence, outlined above can be carried out by several different stakeholders. Companies seeking investment will put out information about their business to try and attract investors. The people making that information available to investors and distributing it, the ‘placement agent’, should vet that information to make sure it’s complete enough.
For more details on who carries out due diligence and what the risks involved are, read our article on the subject here.
What are the key aspects to consider when doing due diligence?
Effective due diligence involves examining all aspects of a business to understand its path to success, alongside developing a strategy for how an investment in that business would sit within an investor’s broader portfolio strategy.
Depending on the maturity of the business that is seeking funding, an investor will have to adapt the information they seek, and how they go about uncovering it. Companies at the very start of their existence (pre-seed) may have little information available, few historical data points to rely on; investors here need to focus more on the business plans, the founders and management team, the financial model, and fundamentally, the validity of the idea behind the business. By contrast, more mature businesses will have a greater wealth of information available, but of course this needs to be scrutinised, analysed and compared in order to make informed decisions.
Broadly speaking, the elements of due diligence include, but are not limited to, detailed examinations of the following:
1. Company capitalisation – the historic path of the company’s valuation.
2. Capitalisation table – how many shareholders there are, how broad the mix of shareholders are, whether there are dominant shareholders, the number and types of shares issued through the various funding rounds, existence of special terms held by shareholders or share types, such as liquidation preferences or protection clauses, and finally any employee stock option pool.
3. Business plan – the size of the company’s target markets, the capital needed to unlock them, the extent to which those markets have high entry barriers (such as regulatory licenses), the Unique Selling Points (USPs) of the company and its customer value proposition. For startups, one must consider how compelling the “Proof of Concept” (POC) is, and of course, one of the simplest questions any investor should pose of startups is “does this company have a direct solution to a customer problem that exists or is this a solution seeking a problem that needs solving?”. Most importantly, all investors should scrutinise the growth plan of the business and evaluate whether such plans are realistic – ideally using a probabilistic outcome model.
4. Management team and share ownership – the experience and qualifications of senior management and founders, the track record they’ve had with previous businesses, the make-up of a company’s board and their ability to attract key players as non-executives and/or advisors. Whether founders and senior managers hold a high proportion of share – and whether they have been selling any of those holdings recently, are key factors in company due diligence.
5. Financial model – the company will have a variety of artefacts available, across their periodic reports and accounts including cashflow statements, balance sheet, profit and loss statements and so on. In many cases, all these artefacts exist in different forms and often in various sources. It is critical to assess a company’s profitability (or intended path to becoming profitable), revenues, margin trends, operating expenses – both make-up and trend – and ultimately, return on equity. Investors should never forget that at its most basic level, the value of a company is determined by its ability to generate future profits and return those to shareholders.
6. Competitive, sector and industry positioning – how does the company stack up within the competitive ecosystem in which its operating, how does it compare to other players? Is this a new, emergent industry where dominant players have yet to establish themselves, or is the company looking to disrupt a traditional industry with large, established organisations that dominate the landscape? Investors may choose to analyse an industry using Porter’s Five Forces Model as a structured framework for understanding the competitive dynamics affecting a company.
What is Porter’s Five Forces Model?
A model that identifies and analyses five competitive forces that shape every industry and help determine an industry’s weaknesses and strengths.
7. Valuation multiples – depending on the company’s maturity (pre-revenue startups may not have this available for example), these may be represented by established ratios such as:
- Price/earnings (P/E ratio): an indicator of how much investors are paying for the expectation of future earnings being realised.
- Price/book value (P/B ratio): the enterprise multiple which reflects how the price compares to the book value of the company if it were wound up now after all debts and assets are taken into account.
- Price/sales (P/S ratio): an indicator of how much investors are paying for the revenues being generated by the business – a helpful measure for companies in the early phase of their development
- Price/Earnings Growth (P/EG ratio): an indicator for how much investors are paying for the expectation of future increases in earnings, a key factor in disruptive, early-stage growth companies
- Pre-money/post-money valuations: how has the value of a start-up company changed as it has progressed through its various funding rounds, from pre-seed, seed, series A, through to pre-IPO.
8. Destination of funds from capital raising – for example, is the company raising funds to invest in the growth of the business (such as R&D or marketing), funding international expansion or in expanding the employment footprint of the business? An example of a due diligence red flag here might be that a company is raising funding to simply pay bonuses to senior management.
9. Equity dilution possibilities – how and when does the company expect to raise future financing, and how does this impact the value of an investor’s position.
10. Loan covenants and other material impacts to company operations and financing – for example, the company may have taken on loans that allow the lender to take control of the company in case of a default on loan repayments.
11. Recovery strategy – in the event of a company failing or being in danger of failing, the investor can recover any of their investment via either the secondary markets or liquidation.
12. Exit strategy – irrespective of a company being successful and growing its valuation, investors can be challenged to realise their upside. It is key that an investor understands how they can harvest upside as the company continues its growth through various funding rounds (potentially in secondary markets), and how the company intends to ultimately realise enterprise value back to investors – whether through dividend payments, acquisition by another company or group of investors, or by floating the company onto public markets with an initial public offering (IPO).
13. Endogenous risk factors – risks within the business that, if manifest, might lead the business to fail. For smaller businesses this can often involve cashflow being misaligned with capital availability but could also involve things such as a key person choosing to leave the business or failing to agree terms with key suppliers.
14. Exogenous risk factors – forces outside the control of company management that can negatively affect a business’ path to success, which could include changes in market conditions (such as consumer demand, interest rates, or inflation), government policy, regulations, emergence of disruptive technology, competitor brand power, or emergence of new competitors.
15. Short-term / long-term risks – does the investor perceive any risks that can be successfully overcome in the short-term (such as the grant of a regulatory license) versus longer-term factors such as stability of the company’s senior management.
For companies in certain stages (such as startups) or sectors (such as software-as-a-service, eCommerce), investors should also be cognisant of further metrics that help to show whether a company is an attractive investment opportunity or not.
These may include, but are not limited to:
- Burn rate: the rate at which a company spends its cash.
- Cash runway: the implied amount of time a company can continue operating at a loss before depleting its cash on hand.
- Burn multiple: the amount a company is spending to generate each incremental dollar of annual recurring revenue (ARR).
- Revenue per employee: the sales efficiency of a company by comparing its revenue to its number of employees.
- Market penetration: the percentage of total customers in a company’s target market acquired by the company as of a specific date.
- Attrition rate: the employee turnover within a company, or the number of individuals that leave their positions over a specified period.
- Customer lifetime value (CLV): the average profit a customer brings in for a company throughout their entire lifespan of doing business together.
- Customer Acquisition Cost (CAC): the costs incurred in the process of convincing a customer to buy the product.
- CAC:CLV ratio: the ratio between the cost incurred to acquire a customer and that customer’s total lifetime value.
- Gross merchandise value: the sum of all merchandise sold across a given period – most often tracked by retail and eCommerce companies, and customer-to-customer (C2C) marketplaces.
- Average order value (AOV): estimates the typical amount spent by a customer in each order, commonly placed on a website or mobile app.
- Conversion rate: the number of conversions – orders placed, subscribers, trials, or sign-ups – as a percentage of the total number of visitors to a webpage.
- Take rate: the fees collected by a third-party service platform, such as an eCommerce marketplace or payment services provider.
- Repeat purchase rate: the proportion of a company’s customers that make more than one purchase.
- Daily active users (DAU): user engagement by counting the unique users or visitors that interacted with an app or site on a particular date.
- Monthly active users (MAU): user engagement metric that tracks the number of unique visitors that engage with a site, platform, or app within a specified month.
- DAU:MAU ratio: user engagement metric that measures the approximate number of days in a month that users perform a specific action.
- Net promoter score (NPS): a customer’s willingness to promote a specific product or service to their friends and colleagues.
Due Diligence checklist
Effective due diligence can take a long time, there’s a lot of information to gather, process, analyse and compare against other opportunities and an investor’s existing portfolio. One of the challenges for individual investors is to conduct this due diligence in the time they have available. This is especially the case for venture capital investments, as investors are typically offered a finite window in which an opportunity is first made available for consideration, and when they must have either made a firm commitment or declined.
Tools such as Floww do a huge amount of the heavy lifting involved in this process, allowing investors – individual or professional alike – to make better, more informed decisions, in a shorter amount of time.