The amount of due diligence that angel investors conduct on the start-up businesses they’re considering funding can mean the difference between gambling and investing, according to a panel of experts.
“There are a lot of skeletons that due diligence can bring out of the closet,” said Elizabeth Kraus, co-founder of the Impact Angel Group, a Boulder, Colo.-based network of investors dedicated to making a positive social or environmental difference, while earning a profit.
Among the discoveries she’s made while investigating angel investing candidates are a founder with a history of tax evasion and a start-up that falsified product performance data.
“Start-ups have to be viable to make an impact and due diligence helps me invest in things that are viable,” she said.
Kraus was one of the speakers at a a seminar held Tuesday in Denver as part of the 6th Annual Angel Capital Summit, sponsored by Rockies Venture Club, a nonprofit organization that connects angel investors with promising entrepreneurial companies.
Kraus says she’s come full circle in her views on how much due diligence angels should perform.
“When I first started angel investing, someone told me that it’s more economical to take the time and money you’d spend on due diligence and invest small amounts into the companies that ‘feel right’ to buy an early seat at the table, then see how it goes,” she said. “But after learning some hard lessons, I no longer subscribe to that theory.”
Citing the findings of a November 2007 report from the Kauffman Foundation, the world's largest foundation devoted to entrepreneurship, Kraus said there’s a strong correlation between the amount of time angels spend on due diligence and the returns they realize.
Kraus says the transformation from her initial to current approach is the difference between “gambling and investing in something remarkable.” As an impact investor, she wants to put money into ventures that will promote positive social or environmental change.
Sheila Lamont, an attorney who works with Kraus and serves as director of deal flow and due diligence at Boulder-based Angel Support Network, suggests that investors plan to spend about 50 hours on due diligence for each company of interest, spread over a few months.
Lamont also said it’s crucial for potential investors to get to know the company and the entrepreneur, as well as his or her other investors. In one case, Lamont found the company’s documentation looked great. “But the entrepreneur’s lead investor and majority owner was in the middle of a divorce and his assets were frozen,” she said. That could have severely limited the entrepreneur’s ability to raise follow-on capital from the lead investor, as planned.
Joni Kripal, an angel investor with a focus on emerging businesses in the health care industry, said she asks entrepreneurs if they’ve talked to thought leaders in their space and if they’ve looked at the competitive landscape. “Their responses often give me clues as to where I want to dig in later,” she said.
Kripal said it’s essential to read the fine print. One of the most significant items she overlooked on due diligence was a footnote at the bottom of a capitalization table showing the shareholders and their pro-rata ownership of the securities issued by a company she was evaluating. While most cap tables display ownership stakes on a fully diluted basis, allowing potential investors to determine a business’s overall capital structure at a glance, the footnote indicated that the table was not fully diluted. She had to do some math.
Once in a while, due diligence actually uncovers positive information about a company.
Lauren Costantini, vice president for therapeutic and device development at the Colorado Institute for Drug, Device and Diagnostic Development, invests in emerging life science and medical technology companies. She once evaluated a start-up whose medical device would have taken at least five years to get through the rigorous U.S. Food and Drug Administration approval process.
While performing due diligence, Costantini discovered that the product had an immediate non-medical, consumer application that could allow it to bypass the FDA route. “It could produce revenue in six months versus five years,” she said.
