Due Diligence: The Critical First Step for Angel Investors


Every investor should be aware of the necessary role that due diligence plays in the investment screening process. Most institutional investors have embraced the due diligence process and in most cases have made advanced due diligence practices a matter of policy. Unfortunately, most angel investors shortchange the process either because of a perceived lack of resources or because they don’t fully appreciate its importance. This series of articles will address all forms of due diligence and focus on those needs specific to angel investors.

Each topic in the six-part series will focus on a different aspect of the due diligence process. In addition to the information contained in each article, there will be additional information provided on the Intelex Web site (www.intelexltd.com).

· Structuring the Due Diligence Review

· Documents Collection

· Market Due Diligence

· Competitive Due Diligence

· Investigative Due Diligence

· Cultural Due Diligence

What is “Due Diligence”?

The term due diligence was originally applied by the Securities and Exchange Commission to an underwriter who is supposed to exercise “due diligence” in assuring the public that a deal is legitimate. In the private equity community it has come to mean any research that is conducted to assure that a deal is legitimate. Historically, due diligence had been limited to a detailed examination of a company’s financials. However increases in deal flow, emerging technologies and globalization issues, as well as increases in both fraud and litigation, has led most institutional investors to investigate beyond the numbers.

In practical terms, better due diligence means better investments. By examining such issues as real life market and industry trends, the competitive outlook for a company, profiles of the management team and so on, the angel investor assures a solid foundation for future investment and growth. It doesn’t matter if a seed level investment achieves initial success, if information is later disclosed which prohibits future investment. These are issues that cannot be glossed over, as evidenced by last year’s “hit” of Hitsgalore.com.

Hitsgalore.com, an Internet company whose market value soared from $53 million to $1 billion in three months, didn’t disclose its founder was accused of cheating customers at a previous job. As a result of a lawsuit, this information became public and Hitsgalore.com shares plummeted 53% cutting the company’s market worth by $534 million. It was the largest percentage loss of any U.S. stock. Perhaps the most unnerving aspect of this story is that all of the problems could have been completely avoided with proper due diligence.

Reducing exposure to liability should be of foremost concern to all investors, however, it is an area that is often overlooked by angel investors. In today’s increasingly adversarial and litigious business environment, the due diligence review is one of the most important and risk-fraught elements of any investment. Without complete and accurate information, those negotiating the transaction will be unable to address potentially significant areas of concern. At best this can lead to a failure to pay or receive a fair price for the target company or its securities and, at worst, can result in significant liability to the client.

How are Angels’ Needs Different?

Most investments made by angels, especially those new to private equity investing, are seed level or very early stage investments. While this stage of investment is not unique to angels, many of the issues surrounding the investment are. Most angels cannot assume the same level of risk that larger, institutional investors can and, as a result, must be even more critical when selecting candidates. Perhaps the greatest difference is the deal flow that angels are often exposed to.

Deals that are presented to institutional investors tend to come from a “known source.” Perhaps the deal originated from another banker in the firm or from another existing professional relationship, or maybe it worked its way up the investment ladder based on its merit alone, either way by the time an institutional investor sees a deal it is already pre-qualified. While there is still much due diligence to be done, the deal comes with a certain amount of credibility. Angel investors are not always this fortunate.

For many angels, the deals they see are the ones that can’t make it to the institutional investor. Commercial banks and VC’s won’t do the deal based on either deal size or business concerns. Not only does this leave the angel at a disadvantage when dealing with a legitimate investment, it also exposes the Angel to a level of fraud typically not found at the institutional level. The other deal-flow concern unique to angels is that, often times, deals come from friends or family members. While this does provide for deal-flow from a known source, the pre-existing relationship often makes it uncomfortable for angels to conduct the necessary due diligence required of any transaction. However, properly structuring the due diligence review will allow the angel to avoid many, if not all, of the potential pitfalls involved in investigating friends and family. Next month we will discuss Structuring the Due Diligence Review. Issues covered will be for both individual angels and angel clubs. If you have any questions on this topic, please feel free to e-mail me at mcherry@intelexltd.com and I will try and incorporate the answers into my article.

Cherry is the President of Intelex, Ltd., a due diligence and business intelligence firm headquartered in Greenwich, CT. Cherry has been performing advanced due diligence for clients since 1992. Cherry is a member of the Society of Competitive Intelligence Professionals and the Association of Certified Fraud Examiners. He may also be reached at (203) 622-0031.