Doing Realistic Due Diligence

Due diligence amounts to a sort of company back-ground check and is an important part of the investment process. But how exhaustive the due diligence is depends significantly on the size of the investment. Due diligence is very expensive and extremely time consuming, so it makes little sense to spend a high percentage of a relatively small investment on an exhaustive investigation. Furthermore, because angel investments occur so early in a business' life cycle, you may not have a significant history to review.

The goal of due diligence is to answer the following questions:
Does this investment meet your investment goals?
Can you add value to the company?
Can you work with the team?
And ultimately, is this a deal you should do?

Much of the due diligence you do now will be less about uncovering legal paper trails and more about vetting the idea, the team, the market and the model. At this stage of the game, much of your due diligence can be done by thoroughly reading the business plan, utilizing your network and spending time with the founding team. Has the company set and achieved major milestones? Do they have customers you can talk to? Does the founding team have its own skin in the game in the form of founders' own money or uncompensated time? You might also consider collaborating with other angels who are interested in investing to share the administrative burden and expense of due diligence, and possibly leverage each other's industry knowledge where, independently, such knowledge may be lacking. However, if that's not a realistic or practical alternative, here are a few considerations for the kinds of inquiries you want to make before committing your dollars:  

Management:
Does the team have a proven record of relevant business experience? Do they know their shortcomings and are they prepared to bring in outside leadership? Are they passionate and committed? Do they have their own skin in the game in the form of their own cash or sweat equity? In addition to getting to know the team on a personal level, you may want to review a list of all the Company's directors, officers and key employees. Each should be subject to non-competition, confidentiality a and nondisclosure agreements. If key members of the team are not currently subject to vesting schedules, you may want to secure their continued dedication and commitment to the company by using reverse vesting. The company also should have in place a stock incentive plan by which to compensate current and future employees, consultants and advisors.  

Market:
What's the market opportunity? How big is the market and what's the anticipated growth rate? Do market trends support the business model? What are the barriers to entry? Can the company describe the target customer's problem or pain? Does their solution eliminate that problem or pain? How long is the selling cycle and how is the relationship sustained? Has the company correctly identified the purchasing decision-maker? Has the company identified its competitors?

Business Model:
What is the company's value proposition and competitive differentiation? Does it require significant change in the customer's buying behavior or use patterns? Is there an infrastructure that supports the business model or does the company have to create the value chain? Is the company relying on intellectual property as a central component of their business model?

As intellectual property is often the very thing behind the idea in which you're investing, it's important that the company owns what it believes it owns. A "patent pending" is an invention for which a patent application has been filed, but is nothing near a guarantee or probability that a patent will be issued. Furthermore, the "patent pending" may represent a provisional application that has been filed rather than the full-blown application. Provisional applications can allow entrepreneurs to test the marketability of an idea before committing to the expense of the patent process, and they definitely serve an important purpose. Unfortunately, many entrepreneurs, in an effort to reduce their start-up costs, file their own applications, and as such face an even greater risk that an issued patent will be narrow in scope and relatively easy to design around.

In addition to being aware of the patent status, you should look for the following intellectual property issues:
•   The founders have assigned intellectual property to the company and have signed a proprietary rights agreement whereby future innovations belong to the company. Patents and/or patent applications have been assigned to the company.
•   If the company is able to leverage someone else's intellectual property by way of a licensing agreement, you should review closely the terms of the license. Is it exclusive? World-wide? Does the license require significant royalties that may reduce the company's probability of success?
•   The consultant issue: Carefully review any outside consultant agreement, in particular where software development or other intellectual property creation is involved. You should be certain that the company has made provisions in its consultant agreements for the company's ownership of consultant-created intellectual property.

Trademarks, though often ignored as differentiating intellectual property, are nonetheless important to a company. A company's brand identity and good will can be seriously damaged if their brand isn't protected by trademark. Too often companies decide on product and/or company names before analyzing their availability only to later be faced with the inability to register a trademark with the US Patent & Trademark Office or worse, a cease-and-desist letter from someone with superior rights. Thousands of dollars spent in brand marketing and good will can suddenly become worthless. Such a loss can be easily avoided with some good proactive dollars spent up front in determining a name's availability and then protecting the company's right to use it. Ask your company whether or not they've been counseled on trademark protection, and discourage the team from committing to a brand or a branding strategy before they've used experienced trademark counsel to determine whether or not the name is available.


Numbers: Have the company's financial projections been vetted? Are the market numbers realistic? Are the anticipated market and the company's capitalization strategy in synch such that you can expect a angel-scale return on your investment? It's important to know what the company's current cap table looks like, so you can be sure you're getting the portion of the company you think you're getting. If the company has created a stock incentive plan, you want to make sure those shares are counted as though they have been issued, even if there are still plenty of shares authorized under the plan that have not yet been issued. You'll also want to make sure you have an accurate picture of all the options and warrants that have been issued. If those options and/or warrants are exercised, they can dramatically change the cap table and your ownership percentage.

Although at this stage of the game the company may not have much to provide in the way of financial data, if the company has been operational for a reasonable period of time, you should get an accurate picture of how the company spends its money. At a minimum, you should request income statements, balance sheets and cash flow statements in addition to the cap tables.

Legal Review
You want to make sure the company has the proper infrastructure in place to take your investment. You should be able to review the certificate of incorporation or articles of incorporation (which document is appropriate depends on the state of incorporation) and the company's bylaws. In addition, you should be able to follow the company's history by reviewing the minutes of shareholders' and directors' meetings.

At a minimum, you're looking for the following in the company's articles or amendments to them:
•   Sufficient numbers of authorized stock to allow for the company's capitalization strategy, most immediately pressing is that there be sufficient numbers to accommodate the angel round
•   Authorization of preferred stock
•   A "blank check" preferred designation, which allows the board of directors to authorize investment rounds without shareholder approval