One of the most important parts of being a smart investor is mastering the art of due diligence. It’s more than checking off the boxes, and by the time you even get to doing due diligence on a company, you’re already biased in favor of the company, so you have to simultaneously fight that bias while also looking for reasons to invest. Let me save you some time and money by sharing how NOT to do due diligence.
1. Do NOT dump everything you can into an AI chatbot and ask if it is a good investment. Even with advanced commands telling the chatbot not to be biased toward your position, it won't do you much good. AI is a great tool for due diligence, but you need to use it carefully, and you can't trust it to do all the work. Start by asking yourself, “What are the top three or four risks with this company?” and use AI, ALONG WITH OTHER RESEARCH TOOLS, to dig deep into those three key risks. Ask iterative questions, not just one big question, so that you can dig deep. In addition to the key risk areas, be sure to have a back-and-forth on the ten key diligence areas: product, team, competition, market, go-to-market strategy, legal landscape, valuation, financial model analysis, deal terms, and exit strategy.
2. Do NOT just use the diligence package from a professional diligence consultant. Those tend to be glorified marketing pieces with little more than you can find in the pitch deck. Even quality diligence packages from others should serve only as a starting point for your own diligence process.
3. Do NOT just use a checklist. Articles of incorporation - check. Bylaws - check. Patent filings - check. Checklists can help you make sure you look at everything, but you’ve got to look deeper than the list. I’ve seen companies with “patents” that were never granted, even though they gave me the patent numbers. Others had let their incorporation status lapse years ago. Still others violated other major corporations’ patents. The checklist just gives you hints about where you can find anomalies if you dig deeper. If you see a rabbit hole - don’t be afraid to jump in.
4. Do NOT think of due diligence as primarily focusing on product, market, and finance. I’ve found that due diligence is at least 50% psychology and assessing the team's attitudes. Here are a few common things I look for: 1) Exit orientation. Are they really focused on the exit and understand how corporate value is created, or are they just looking for you to invest in their job? Are they “stewards” or “owners”, focusing primarily on themselves or the company? 2) Grit. Things WILL get tough. Will they stick with it? Few teams make it all the way to exit together, so you need to know if, when things get tough, will they just give up and you’ll lose your money? Or will they get creative, rework their strategy, cut costs, and make it work? 3) Peripheral vision. Do they see what’s happening in their industry, in the economy, in politics or social trends? Great CEOs don’t develop tunnel vision, focusing blindly on just their own product.
5. Do NOT cut diligence short. I’ve met investors who say, “if my check is under $1 million, I don’t need to do diligence. Others are just lazy and say, “There’s nothing to do diligence on for pre-revenue companies.” There is no crystal ball, and you can’t predict everything, but these investors will come up surprised when foreseeable circumstances cause them to lose their investment.
At the end of the day, your best bet is to join a group like Rockies Venture Club, which has been doing professional diligence for years and draws on the expertise of a large pool of investors with deep experience, and a dedicated team that makes sure all the i’s are dotted and the t’s are crossed. Diligence can take a lot of time, and it’s more effective and more fun when the work is spread out among a team.
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