Due Diligence and Hidden Costs – What’s the true cost of investing in a startup?
If you haven’t already read it, our article on the key components of conducting good due diligence covers all the basic and necessary components of the due diligence process. It’s important however, for investors to consider all the factors that are applicable to the investment opportunity in question, and build a checklist reflective of the company, where it is in the maturity cycle of a company and the industry/sector in which it operates.
What does good due diligence involve?
Due diligence can be split broadly into two pillars:
- Quantitative due diligence
A detailed look and cross examination of the numbers that sit behind a business.
This can include, but is not limited to financial statements, business plans, financial models, tax treatments, intellectual property (ie. Patents) statuses, R&D pipelines, technology roadmaps etc.
It’s also important to verify any documents that have been shared with you in data rooms to ensure they are accurate.
2. Qualitative due diligence
A more instinct-based approach involves considering the quality of a company’s management and leadership, as well as looking at the company’s growth prospects in the market. Assessing company management usually includes factors such as evaluating a founder or leader’s experience, the appeal of the disruptive idea their business is built on, and the culture of the company.
Individual vs. Professional Investors due diligence processes
Depending on the type of investor you are, there are several different stakeholders who may carry out the due diligence process.
In some cases, companies will provide information about their performance and growth ambitions with the objective of attracting investors to them. The entities acting as a ‘placement agent’ (i.e.. the entity making the opportunity available) should have vetted the information to make sure it is sufficiently complete.
Professional investment firms however usually delve much deeper, often employing entire teams of analysts to collect as much data on the possible investment as possible. With huge resources and networks at their disposal, they can find and process vast amounts of data and information to draw recommendations as to whether or not a potential investment is sound.
On top of this, their teams will compare all opportunities to similar ones available elsewhere, as well as to previous investments made.
This is where individual investors may be at a disadvantage compared to professional investors. Individual investors will often have to do much of the discovery work themselves or look to invest alongside others whom they trust have sound judgement, as well as the tools, time and understanding to help them make investment decisions.
In any case, due diligence is an onerous and often expensive, time-consuming exercise which is vital to making sound investment decisions. Because of the nature of the task, most individual investors will struggle to complete it with the same depth as a professional investment firm.
What are the risks involved in failing to complete sufficient due diligence?
Even when an investor hasn’t missed a critical consideration, failing to complete high quality due diligence can lead to unintended consequences in their aggregate portfolio. There is a risk that their overall portfolio becomes disproportionately skewed towards certain factors, sectors or markets. These can lead not only to suboptimal investment outcomes but can also damage the reputation of the investor – regardless of whether they’re a member of an angel network, a professional investors in a venture capital firm or a family office, or simply an individual investor telling their partner over the evening dinner table.
The risk of failing to perform effective due diligence is extreme, and especially so when investing in young companies that are not yet well-established. The single biggest risk of getting due diligence wrong is missing or failing to consider something that is a material determinant of the business’ ability to grow and become a successful enterprise – which could lead to money being lost, misspent and investor reputations being significantly damaged.
A cautionary tale of insufficient due diligence
Beyond the risks of getting due diligence wrong, as discussed above, there are also costs to not doing your own due diligence and trusting too deeply in what you’ve been presented with. Consider the infamous case of the biotech company Theranos.
Theranos was founded on a suitably industry disrupting idea of running blood tests using then-new machine technology that needed only a pinprick of blood from a finger to detect a wide range of medical conditions. On this revolutionary idea and technology, the 19-year old Elizabeth Holmes raised over US$700 million from private investors. In 2015, just 12 years after its founding, the Wall Street Journal placed Theranos’ valuation at US$9 billion.
In 2018, the SEC charged Elizabeth Holmes and Theranos’ former President Ramesh Balwani with running years-long and drawn out frauds which exaggerated or made false statements about their company’s technological capabilities, business and financial performance to raise an impressive US$700 million. Falsified product demonstrations, misleading investor presentations, and media articles by duped investors led the world to believe in their portable blood analyser. The truth was far from that – their proprietary analyser was able to run only a small number of tests, and the rest were run on industry-standard technology made by other companies.
Of course, the vast majority of founders do not have such malicious intentions or disregard for the law, but it is worth noting that high profile individuals and experienced investors alike were taken in by the Theranos deception and lost vast amounts of money. Had they all conducted detailed due diligence processes, they may have saved a lot of money and no small amount of face. That being said, no amount of due diligence can completely prevent fraud or total disregard of principles.
Investors should recognise that a very high proportion of young companies and start-ups fail, where their investors’ initial stakes simply become valueless. Successful long-term investing is as much influenced by avoiding hidden indicators of failure as it is picking those marked for the highest potential.
High quality, professional level due diligence, powered by tools such as Floww, give investors a better chance of selecting companies that they have more confidence in their underlying business performance and plans for growth.
