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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
Business due diligence is where things start to get a bit more serious. You’ve evaluated opportunities and chosen a handful of companies that might merit an investment. Due diligence digs deeper and sometimes wider to validate whether the story told by the entrepreneur stands up under scrutiny.
Due diligence (or business due diligence) refers to the process by which investors investigate a company and its market before deciding whether to invest. Due diligence typically happens after an investor hears the pitch and before investment terms are discussed in any detail.
important Due diligence is arguably the most important part of the angel investing process. The amount of due diligence that is done on a company is the factor most correlated with investor return; the more due diligence you do, the more likely you are going to invest in companies that make you money. Rob Wiltbank looked at the amount of due diligence completed by angel investors, and found that the number of hours of due diligence performed on a company was one of the key success factors in angel investing outcomes.* In fact, investors got a 2X better return on an investment when they did more than 20 hours of due diligence versus when they did less than 20 hours. We cannot overstress the importance of due diligence.
confusion You may know of active angel investors making investment decisions with little due diligence. These are likely angels investing alone, and making those investments based on prior relationships or the recommendation of a fellow experienced angel. In part, this is because they have more money and less time. They can afford to lose the money on some percentage of investments more than they can afford to spend the time doing rigorous due diligence on all their investments.
Angel groups and institutional investors tend to have more formal processes and do more due diligence. This reflects some of the benefits of investing as part of a group. Because groups often invest more in the aggregate than individuals, they can justify the time investment of more diligence. Groups may also be investing money on the part of members who are not actively involved in the process and who expect some level of due diligence to be performed.
Our goal in this section is to help you focus your business due diligence efforts, and to give you some insight into what to look for and how to think about what you find out. We will focus on business risk due diligence in this section. Legal due diligence is also important, and is addressed in its own section.
In addition to what’s included here, there are many other areas that may merit due diligence, depending on the nature of the business. In general, understand the key sources of value in the company and what its key challenges on the road to success might be, and dig into them. The answers will not all be perfect, but at least you will better understand your risks and what you are getting when you invest.
founder Most startups will know that their pitch deck should include slides representing the following: team, customers, competition, product, market size, and finances. If they are missing any of these, that may be a red flag that the founders are underprepared. Regardless, angels should expect to dig deeper into each of these through the due diligence process.
danger When a founder dismisses your concern about a particular issue or is not forthcoming with data that you have requested (be it customer names, founder references, customer counts, or something else) it may be tempting to let it go as there is lots of other work to do. Experienced angels take this as a sign to be persistent. If data is not forthcoming that may be where the skeletons lie.
It is easy to see how it can take more than 20 hours to perform even just the business due diligence on a company! Ideally you are sharing that load across a team. Some angel groups and many websites offer due diligence checklists. We’re happy to be able to share the due diligence checklist from Alliance of Angels with our readers, which can supplement what you learn here.
As we discussed in Evaluating Opportunities, the startup team may be the most important determinant of a company’s success. While you should have gotten a good sense of the team’s potential when you were first evaluating the opportunity, digging deeper into the makeup of the company during due diligence will help you gain certainty on your initial impressions.
There are also legal considerations when it comes to diligence on the company team; we discuss employee assignment agreements and vesting of founders’ stock in Legal Due Diligence for Angel Investments.
Below are a few personality traits to consider. Throughout the diligence process you will likely have multiple conversations with the founding team. Try to assess some of these important traits:
Hustle. Hustle is shorthand for a team’s tenacity, resourcefulness, and passion. The team needs to be able to make decisions and meet goals quickly, overcoming obstacles again and again. In short, they need to be able to execute. Talking to the key members of the team about challenges they have run into, how they solved hard problems, how long it took them to build the prototype or get their first sale, how they convinced their first key hires to take the risk, can all give you a sense of how they are able to get things done.
For example, Pete worked with one CEO who was pulling all-nighters reviewing and negotiating key partner contracts in the early days of his startup, while having his infant daughter strapped to his chest with a Babybjörn carrier. At the other extreme, Pete was mentoring a first-time CEO who kept discussing their vision and the technology research they were doing, but who never built even the most basic prototype. The first CEO built a company and raised over $80M, the latter was never able to turn their vision into reality.
Commitment. Building a successful company requires the ability to work steadfastly for years through sometimes extremely difficult circumstances. The core founders should be committed to the enterprise. They might talk passionately about how they want to change their industry. Try to get a sense of their motivation. You are looking for someone who will stick to it when the going gets tough. Be wary of an entrepreneur who mentions a plan B if this venture doesn’t work out: “If I can’t get this to $1M in revenue in a year, I’ll just go back to work for Microsoft.”
Compatibility. What about the strength of the team bonds? Is the team likely to fracture and break up? Can you sense tension when different members answer questions or discuss challenges or decisions? It’s a good sign if several members of the team have worked together before, as they will know each other’s personalities and capabilities well. If it is unclear from their backgrounds that they have worked together, feel free to ask questions about how they know each other, whether they have collaborated in any capacity, how they became convinced that the other could take on key management roles beyond their existing experience. The breakup of the founding team is one of the leading reasons early startups fail, so don’t overlook this issue.
Coachability. Finally, it is important that a CEO is coachable, especially a first-time CEO. A wise CEO will seek guidance from investors, advisors, and experts in their network. They will face many new challenges and you want them to be willing to benefit from the experience of others. Pete can attest that there is nothing more frustrating than a young first-time CEO who will not heed the collective advice of the board of directors and advisors!
In Evaluating Opportunities, we touched on functional coverage of the team, meaning the degree to which the key functions required for success (product development, sales, marketing, customer success, design, finance, et cetera) are represented in the team. The critical functions will vary to a degree according to the type of company, and certain functions will often be outsourced, like legal and often the CFO role.* Beyond those roles, look carefully at who is employed, and who is contracted or outsourced.
The entrepreneurs feel pressure to show a complete team in their presentation, but as you dig in you will often find that there is a mix of full-time and part-time employees or contractors, and even friends chipping in for just an equity stake in the dream. This mix is not uncommon, but you will want to know who you are investing in, who will be full-time when the money is in, and what has been promised to whom.
important It is highly recommended that you interview each of the key team members called out on the team slide (the ones you are investing in), and ask them directly about their level of commitment. You may find that some are never planning on committing full-time. In that case, you have a functional gap to fill on the team, and a potential red flag as to why this person is not excited about the venture.
caution There can be liabilities associated with deferred wages or vague undocumented promises of equity to people who have made contributions over time. Understand the personnel history of the company as early founders or contributors may have already exited, but still own a stake. Furthermore, anyone who is contributing to the company in some capacity should have signed an invention assignment agreement acknowledging that their work is owned by the company. We will discuss liabilities and employee issues in more detail in Legal Due Diligence for Angel Investments.
You should also determine whether the technical development team is in-house or outsourced.* Outsourcing software development teams is increasingly popular among startups because it can be significantly cheaper if the coders are offshore; and because building a good in-house development team is hard, expensive, and time-consuming. For an entrepreneur, it can be challenging to convince a great software developer to commit to an idea and work full-time for little or no salary while they build the first version of a product. It is often easier to find a team of developers in Eastern Europe or South Asia to build the first version of the product for a few tens of thousands of dollars.
caution As the investor, you want to know what you are getting into, and make sure that whoever is managing offshore teams, if that is the case, has done that before. If there is no one technical enough on the team to vet the offshore team, provide architectural guidance, and vet the code coming in, that might be a cause for concern. As the business grows, it will likely have to backfill the technical roles locally, which will take energy and resources.
Beyond interviewing the team members yourself, it is highly recommended to get some reference checks on the team. In addition to checking the references supplied by the company, you’ll want to track down your own. Use LinkedIn to see if you have any way to get an introduction to other people who know them or have worked with them. It is not uncommon for entrepreneurs to amplify the scope of their responsibilities in their last role as an employee. That’s understandable to a degree, since they are trying to convince you that they can be an effective CEO of a soon-to-be-huge company. So it is important to dig in on this.
There are other ways to get some additional information on the founders and key team members:
LinkedIn. LinkedIn provides job history information and also can show references provided by former bosses, partners, or direct reports. Increasingly, LinkedIn is a publishing platform as well, and many entrepreneurs may have written articles about their industry.
Twitter. If team members are active on Twitter, you may be able to get a sense as to whether they are actively consuming articles and commenting with insight on the domain of the startup, and whether they are attending or speaking at conferences. Not everyone is active on Twitter, however, and eschewing Twitter (in our honest opinion) should not be a strike against the entrepreneur.
Google. Google searches will bring up all kinds of information about an entrepreneur. Conference appearances, blogs, articles, or scientific papers they have written, and more.
While it may seem creepy to some people to be scouring the web for information on your startup founders, remember that the internet is largely how the startup is going to generate awareness and promote itself. If they are effectively doing that already across social media, that’s a positive signal of their marketing savvy.
Finally, you can pay services to verify employment or education, but these may be an unnecessary expense if you can find what you need through basic web searches.
In Evaluating Opportunities we discussed why you want to make sure the startup in question is targeting a large market. In performing due diligence, you may want to do a quick check on that market size calculation.
Let’s start by defining what we mean by market size. A common mistake entrepreneurs make is to use the value of the target industry they are selling into, rather than the value of the product or service they are selling. Using a fictitious example:
exampleA startup wants to sell an IoT tire pressure sensor that costs $10 and is compatible with 19” wheels. The total addressable market is not the value of cars sold, or even the value of wheels sold: it is the value of sensors sold.
Jared Sleeper at Matrix Partners has written a useful article about different ways to calculate the TAM (total addressable market), including “top-down” and “bottom-up”:
Top-down market sizing. The entrepreneur, and later the investor in due diligence, will Google around trying to find some research company or government estimate on market size for the product in question. This may or may not exist, and if the product in question does not exist, they, and later, you, will have to look for proxy markets. If there is no report on the tire pressure sensor market size, then you would need to find an analogous market size.
Bottom-up market sizing. This is more about estimating the number of likely customers, which forces the entrepreneur to go through a more useful exercise around product/market fit.
exampleContinuing with our example above, we would want to look at how many new cars are sold with 19-inch wheels, or perhaps how many existing cars on the road have 19-inch wheels. Right away you can see that this brings up clarifying questions about the market. Is this product meant to be a retrofit product for existing car owners? Is it a way for new car buyers to save on expensive options like factory tire pressure sensors? Is it going to be sold through tire dealerships, or car dealerships? Is the value proposition that it is cheaper than alternatives? In that case, you need to cut down your estimate of the market to those buyers who are price sensitive—Ford buyers versus BMW buyers, for example.
Every market sizing exercise will be different. Have the entrepreneur walk you through how they did it. Ideally their approach reflects some solid thinking about what existing products they are substituting (for Uber it was taxis), and the breadth of product/market fit for a new product category.
Ideally the target market should be growing; it is always easier to build a company in a growing market. Just being in a rapidly growing market will generate some sales even if the initial product is not dramatically superior to the competition. The company will also have more pricing power in a fast-growing market. In a slowly growing market, the startup will have to steal its customers from the competition.
Because traction is such a critical indicator of potential success, it is important to do diligence on the stated customer count and customer engagement and motivation.
examplePete once got excited about a company that claimed to have 85K customers. This was a consumer and small business product. After a few probing questions, it became clear that these “customers” were acquired when the company’s product was an add-on to a large ecosystem. These customers were on a free tier of the product, and the company determined that it could not monetize them, so it pivoted to a different value proposition. Entrepreneurs know how important customer traction is to investors, so the pressure to present numbers in a positive light can be extreme.
caution Early-stage companies may end up signing very unfavorable contracts to secure key deals or early customers that they need to move the business forward. If the company or its valuation is heavily dependent on a particular distribution contract or customer letter of intent (LOI), ask to see it.
B2B companies (or business-to-business companies) sell their product or service to other companies, not individual consumers. B2Bs sell things like an inventory tracking app to restaurants, or a loyalty system for retail stores. A subset of B2B is enterprise sales, where companies sell to larger organizations like Microsoft, Intel, HP, or Procter & Gamble. B2B companies will usually have a list of existing customers, a number of trialing or beta customers, and a pipeline of deals.
founder The hardest part of B2B startups is selling to businesses, especially enterprises. There was an old saying that “nobody gets fired for buying IBM”; meaning, go with a big name and reliable provider. A manager or executive takes a big risk when they buy a software system from a startup, since the company may not be around in a year, or could suffer operational problems when they try to scale, or fail to deliver software or training support. As a result, it is often the case that entrepreneurs’ first sales are to companies where they have a personal connection, such as a former employer. This is not a red flag. However, entrepreneurs need to be realistic about how they can expand their sales beyond their personal network.
exampleWhile Pete was performing due diligence on a startup that had created a software system for managing police staffing and the use of police department vehicles for events (such as football games), he asked the founder how he had gotten the first sales. The founder was a former police commander himself and used to manage this process on pieces of paper and chalk boards; so he had both great domain expertise and credibility with police departments. His first sale was to his former employer, the town’s police department, and his second sale was to the township next door, where he had a strong relationship with the head of the department. He had a few more sales in the state after that based on relationships and referrals. His challenge, he admitted, was finding sales people who would have credibility with police departments with whom he had no personal connection.
So, what’s the takeaway? The founder’s first sales were based on personal relationships, which is common. But if in his pitch he had said that the company had closed the first four sales within 30 days and had modeled accelerating sales rates in the first year, you now have reason to discount the next few months’ sales velocity. The entrepreneur is now having to sell outside of his personal network, so things will likely slow down until there is a good list of referenceable happy customers that the sales team can point to (ideally with case studies published on the company’s website.) Scrappy entrepreneurs very often tap their personal networks for early traction. Make sure you know where in the company’s story that ends and the sales to cold customers take over.
important There are many specialized markets in the B2B space, which is one reason that domain expertise is so important. Schools, governments, medical practitioners, and many other markets all have their own sales calendars and hurdles that entrepreneurs must navigate. Perhaps none is more daunting than enterprise sales, where the sales person has to navigate to find who in a large organization is the actual customer, who has purchasing authority, who has veto authority, and how the procurement department factors in.
The enterprise sales process can be very long and taxing. Because the sales process is long, and companies that sell to enterprises need to know how they are doing relative to sales expectations and cash forecasts, they track a sales pipeline, also called a sales funnel. The specific steps in that sales pipeline may vary by company, but it’s usually something like the following:
Leads. Leads are prospective customers that came to the company’s website and requested a demo.
Qualified leads. Prospects that someone has talked to in order to confirm that they have a budget, are looking to purchase a solution soon, and the contact has the authority to purchase.
Proposals or requests for proposals (RFPs). Some sales person has sent the prospect a proposal.
In-negotiation deals. There is active negotiation on a contract.
Trials or proofs of concept (POCs). This may be appropriate for some software products, but typically means that the product is being used on a test basis often for free within a prospective company.
Closed deals (or lost deals). Signed customer contracts, or definitive no’s from prospects.
founder An entrepreneur should be able to tell you about their sales pipeline, even if it is in the very early stages, and ideally their win/loss ratio. If they have a few sales, they should also be able to tell you about their annual contract value (ACV), that is, how much is the average customer paying per year for the product/service.
founder The entrepreneur’s financial model should reflect the length of time they need to close deals (three months? six months?) and the cost of sales people. Remember, those “in-network” sales we discussed in the example above will often reflect a shorter sales cycle than what the company will see as it tries to expand sales.
Ideally, you should speak to a handful of paying customers, if the company is far enough along to have any. If you spend a couple of hours talking to three or four customers you will be much more enlightened about the prospects of the company’s product, price point, and marketing. You may also learn who the key competitors really are in the eyes of customers. Ask them:
How did they hear about the company or product?
What are they using the product for?
What problem is it solving and how much is that worth to them?
What product were they using before, or what other solutions did they consider?
How do they like the product so far? Does it meet expectations?
How do they like working with the company? Is the company responsive, competent, et cetera?
Are they actually paying for the product?
Companies may resist giving you actual customers to call as they may worry that it will make their customers nervous. Keep in mind that all startups are trying to punch above their weight, meaning they want to appear to their customers in many cases as mature businesses that are not in need of money.
This can be a valid concern, but there is usually a way to work through this. For example, you could let the entrepreneur know that you’ll position the financing round as “expansion capital,” and will follow a script like this when you talk to customers:
“We love the team and the product. It seems to solve some real problems and have some real advantages. We are interested in investing in the company, and part of our investment process is to talk to a few customers.”
That sort of a script should ease most of the concerns of an entrepreneur.
danger If a company refuses to let you talk to customers or drags their feet in giving you contact information, that could be a red flag. It may be that the entrepreneurs have claimed that a company is a “customer” when they are in fact just evaluating the product and have not committed to purchasing it or even trialing it.
Early-stage companies may not have paying customers or even trialing customers or beta customers. In that case they are very early in the traction stage and likely much more risky. If they are following best startup practices, they have done a lot of potential-customer interviews and demos of a minimum viable product to gain confidence that they are working on a product that customers will buy. Ask to talk to some of the potential customers they interviewed.
For very early-stage investments, it is all the more important to work your own network and angel group to find people who are familiar with the company’s product category so that you can validate the customer pain point, and the fit of the product as a solution. Ask them what they think of the product, the value proposition, and the solutions that already exist in the market. Is the startup really solving an urgent pain point? Is there really a gap in the solutions available?
If a company is not selling to large enterprises but is selling to small or medium-sized businesses, then many of the B2C metrics below should also be examined. Finally, make sure that the revenue generated from a customer aligns with the marketing and sales effort to acquire that customer. For example, if the product is going to generate less than $1K per year in revenue, it should likely not be sold via a sales team; it should be largely self-serve for the customer, with little support required. If a product sale requires the customer’s CTO or CEO approval and it involves a six-month sales cycle, it needs to generate thousands or tens of thousands of dollars a month in revenue from that sale to justify the costs of sales people, contract negotiations, and any on-boarding and support costs.
B2C companies (or business-to-consumer companies) are offering a product or service to the general public.
B2C companies at the early stages will typically not provide a list of customers to talk to (imagine downloading a yoga app and then getting a call from an angel investor 😬) but if the company has an app or product in the marketplace you can hear the voice of the customer by reading customer reviews (see Usability). Beyond that, there is still work you can do to better understand the company’s relationship with any customers it may have.
Many companies are building products that will be profitable only if customers use them over a period of time and come back fairly frequently. This includes gaming companies, online services businesses like on-demand food delivery, online marketplaces, fitness apps, and so on. In this case, digging into what Dave McClure brilliantly popularized as the “pirate metrics” (AARRR!) is really important:
Acquisition. How many new customers is the company acquiring and at what cost?
Activation. Are those new customers engaging in the product? Having customers downloading an app and then never using it will not result in a profitable business.
Retention. How engaged are those users? Learn what percent are coming back daily, weekly, monthly, never.
Referral. Do the customers refer other customers? This is often key to scaling profitably.
Revenue. What percentage of customers are generating revenue, often in the form of upgrading from a free product to a paid version? What percentage of customers are delivering more margin than it costs to acquire them?
The entrepreneur should be able to show you charts with actual numbers pulled from a database of how many customers are signing up per week or month, the number of daily or monthly active users, and the level of attrition (leaving, quitting, cancelling).
If the company’s revenue model is purely transactional, like selling widgets, then many of the same metrics apply, with the exception of activation. The retention metric is about repeat purchases, which is often critical to profitability.
Customer acquisition cost (CAC) is a critical metric of the B2C startup. The company should be able to tell you about their most effective marketing channels, and what it costs on average to acquire a customer.
Customer lifetime value (or CLTV or CLV) is another critical metric. Entrepreneurs should understand (or at least have a model with assumptions around) the customer lifetime value and how long it takes for them to recover the cost of acquisition. For the company to be profitable, their CLTV has to dramatically exceed their customer acquisition cost (CAC). That may not be the case initially while they are experimenting and tuning their marketing mix and retention and pricing strategies—but they should have a hypothesis of how they are going to get there.
dangerIf a company cannot provide the data discussed in this section, that might be a red flag. If some of the numbers don’t look good, that is not a deal killer as long as they are tracking the right KPIs (key performance indicators) and working and testing diligently to improve the ones that are not working.
In every pitch deck there should be a slide about competition.
danger If a company says there is no competition it may be a red flag that they don’t understand their customers or their market. If you were the inventor of the first car, for example, you might have been tempted to say that there was no competition; but in fact the competition was horses and carriages and trolleys and trains and bicycles and human feet.
founder Most entrepreneurs know that they have to be better than the competition or at least differentiated to get funded, but their products are early and as a result are often lacking in features. This creates a temptation for founders to be dismissive of certain competitors or to leave them out of the competitive slide in their pitch altogether. They shouldn’t—again, these are key indicators of how well a founder understands her market, customers, and product. Evaluating competition is very company-specific, but the following are some general guidelines for angels to follow when doing diligence on competition:
Start with the list of competitors provided by the company and look at those products closely.
Look at each company’s website. Who are they selling to? How are they positioned? What do they cost?
If it’s possible for you to try out their product, do so.
Read reviews of those products.
You may even want to call up a salesperson from one of the competitors to hear their pitch and their counterargument to the “weaknesses” identified by your entrepreneur.
Do your own search for competitors.
Google the type of product or pain point (try searching, “best solutions to X” or “comparison of X-type products).
When you discover new companies not mentioned by the entrepreneur, bring those products to their attention and judge the reaction. If the entrepreneur was really unaware of clearly competitive products (unless they are very niche) that might be a red flag that they have not done enough homework on their own market.
At a minimum, you should get a thorough demo of the company’s product (if it has one). If it is a product that you can use yourself, then use it as much as you can even if you are not the target customer. Is it elegant and effective or confusing and buggy?
It is not uncommon for an entrepreneur to show a very polished demo of their product using a very specific scenario, and it may turn out that the product only works elegantly under quite specific constraints.
exampleLet’s say the startup you’re considering has an app that finds adventure activities for travelers, and the demo shows someone going to Belize looking for a scuba diving trip. The demo shows five options with pricing information, and everything else you’d need to know. Great. Now you should try the app yourself and search for glacier walks in Iceland, rock climbing in Patagonia, whatever you can think of. Are the results just as good?
If the product is live in the marketplace, look for reviews. The Apple app store has reviews, as does the Android Play store. There are review sites for enterprise software as well, though it often takes longer for a startup’s product to show up in those listings. When in doubt, just Google for reviews and often sites you have never heard of will have written about the app or service in question. Reading reviews is a great way to get a sense of whether actual users are happy with the product, where it falls short of expectations, and whether there are real limitations to how well it works.
Hopefully you or someone on your diligence team has the skills to do some technical due diligence. Understand what technology choices they have made and why. How will they scale? If it is a hardware or manufacturing company you are considering investing in, then take a look at their manufacturing and/or prototyping facilities. Venture capitalists often hire technical experts to do thorough technical diligence and talk in depth to the company’s engineering leader(s). If you do not have the requisite technical knowledge on your diligence team, consider asking a friend or colleague with the skills to help you.
It is beyond the scope of this book to do a deep dive on technology due diligence. It is common that the initial implementation of a product is a little rough around the edges because startup teams are trying to build a lot of functionality quickly. That said, in the case of a company with a software product there should be the capability, or at least a clear plan, for user scalability, meaning the ability to support 10X or 100X more users. There is nothing more heartbreaking than seeing a huge surge in demand for the company’s product only to have the application or service collapse under the load. Even if you are not technical you can ask questions like “What will it take to support 10X your current user base?” The wonderful advantage the current startups have over those of years ago is that with modern web services like AWS, the answer in a properly architected system is often just more money.
Depending on the company’s product, there may be many regulatory requirements it needs to meet. That can vary from UL underwriting to HIPAA compliance. If you are staying within a domain you know well, you will likely know the regulatory compliance issues and can gauge the management team based on their approach to them. If you are not familiar with the regulatory compliance issues, make sure someone on your diligence team or perhaps your lawyer can help you.
There are some new compliance issues that have been introduced over the last few years around consumer privacy and the obligations they place on any companies that store consumer data. These include the EU’s General Data Protection Regulation and the California Consumer Privacy Act.
Every pitch deck has a financial projections slide showing that in 3–5 years the company will have millions or tens of millions of dollars in revenue and be profitable. Those projections come from a financial model built on a set of assumptions about growth rates, customer transaction size, customer acquisition costs, attrition rates, and others more specific to the type of business.*
The model and the assumptions will be very specific to the type of business. Especially in B2C businesses, the profitability will be very sensitive to some of those assumptions. Any of the pirate metrics mentioned above will likely have big impacts on profitability. The entrepreneur should be able to defend any critical assumptions in the model by pointing to comparable businesses. For B2B businesses, some of the critical assumptions will be conversion rates in the sales pipeline we mentioned above, attrition rates (how many customers don’t renew their contracts), length of the sales cycle (impacts growth rate and cost of customer acquisition), contract size, and how much revenue a single salesperson can generate.
Ask for a copy of the model and work with it until you understand what the key drivers of growth and profitability are. Test the impact of the key assumptions:
What if the conversion rate of customers upgrading from free to paid is 2% instead of the assumed 5%? Does the business become wildly unprofitable?
What if the transaction size is $50 instead of $100?
What happens to profitability if the attrition rate is 15% a year instead of the 5% represented in the model?
What if it takes on average six months to close a big customer instead of three?
founder Another thing to check in a financial model is how the entrepreneurs are thinking about staff growth. Pete has seen B2B models where the number of customers grows 100X over three years, but the operations and support staff only double. If that seems optimistic to you too, you can plug in a few more headcount to some of those functions, grow the engineering staff to account for product complexity and support, and see how far out that pushes profitability.
Many venture capitalists will build their own financial models from scratch to make sure they understand the drivers. If you can’t get the model from the founders or it is too convoluted for you to be able to test the assumptions, then you may want to build a simple one yourself. Remember entrepreneurs may not be experts at financial modeling, which is fine, but you don’t want that to lead you to a poor investment decision.
important At the end of the day, it is important to keep in mind that three or four-year financial models almost never pan out per the plan. The most common scenario is that sales and/or profitability progress more slowly than the plan projects. What you are checking for when doing diligence on these models is two primary things:
Does the entrepreneur have a realistic idea about what will drive the unit economics (how much money does each customer make or lose for the company under a given set of assumptions) and what revenue level and cost structure are required to be profitable overall?
If things do not turn out like the rosy assumptions in the model, does it just take slightly longer to become profitable, in which case it means the company has to raise more money than expected over time and you will have a lower return on your investment; or will it be a complete financial disaster requiring some change of course and much more risk?
You should also look at a company’s financial statements. For one thing, you want to make sure that they don’t have a lot of debt that has to be paid or a large accounts payable list. If they owe tens of thousands of dollars to prior contractors for engineering or design or legal work, then your investment may go toward paying old debts rather than moving the company forward.
You may also discover that there were prior employees or founders whom you will need to dig into on the legal side. You will want to make sure that the company has been paying any taxes, especially payroll taxes. Looking at the financial statements will also help you get a handle on the company’s burn rate.
Burn rate is the amount of money a startup is spending every month. For a startup that is pre-revenue, this is considered the “monthly burn.” For a startup with revenue, the burn rate is the monthly spend less any reasonably expected revenues.
caution If a company that has been around for a year or more and is not using the services of an accounting firm or has not engaged a part-time CFO or equivalent service, that can cause some heartburn on the part of angels. It may be difficult in such cases to get financial statements to understand where they stand in terms of any existing financial liabilities or to get a handle on their ongoing expenses. We will talk more about why this is important below in the following two sections.
It is important to understand whether a company is about to run out of money or not—and, when you are putting new money in, how long that money will keep the company going.
In startup lingo, runway refers to how much time in months the company has before it runs out of cash, calculated by dividing the amount of money they have in the bank by the burn rate (the amount of money they spend each month). For example, if the company is spending $25K a month and has $100K in the bank, it has four months of runway left.
Raising money is very time-consuming, and a company should always raise enough to keep it going for at least a year, preferably 18–24 months. Due diligence on the financial statements should get you the figures you need. Keep in mind that the burn rate often increases after a company raises money. They may hire additional personnel, or the founders may start to take a small salary, or they may increase their marketing spend.
It is worth understanding how the company is planning to use the money it is raising in the current financing round. In the ideal scenario, that money is being used to pay for the existing team’s salary, for hiring new engineers or sales people, to execute a marketing strategy, to file patents, to pay for ongoing office rent and for other key expenses. If that is the case, then you can run the burn rate calculation we talked about above with the existing expense level ramping up to the higher expense level if they are growing staff. This will give you the expected runway that the new financing is buying.
dangerIn the worst case scenario, the company has been deferring salaries, and accruing significant credit card and other debt, including running up accounts payable with its suppliers. If half the funds raised are going to pay existing debts, for example, then you will be buying half the runway you thought you were, and the company will soon be out raising money again.
examplePete was asked if he wanted to invest in a company where he knew one of the founders and had been following the company’s progress for a while. It was a $750K fundraising round. When he dug into the documentation for the round, he was surprised to see that $450K was going to pay deferred salaries. Another $100K was to pay three months of component suppliers invoices. Pete politely passed on the round, and the company was out raising money again from its existing investors three months later.
Some amount of debt may be normal, and there are no hard and fast rules. Ideally, you don’t want it to exceed a month’s worth of expenses. If the company still has cash in the bank when you invest, then at least your investment will be used for moving the company forward.
founderMake sure you ask the founders whether they are taking a salary and whether that will change for them or any other employees when they raise this round. It is common that founders take no salaries very early on while they are bootstrapping, and then typically take a below-market salary after they raise an angel round. Founders typically have huge amounts of equity, and that will be their big reward if they are successful. That is how billionaires like Mark Zuckerberg and Jeff Bezos are made. Until they raise a significant amount of money, say $5–$10M, they should not be taking market rate salaries. Beware of any founder who expects you to pay for their $250K a year salary while they are taking angel investments. You want their equity to be their skin in the game. That said, not all founders have the same circumstances. A founder may be paying a mortgage and supporting a family, and it may be challenging for them to survive on a $75K salary. They may need $125K. That may be legitimate and should be a point of discussion and negotiation, and can be documented as part of the deal as appropriate.*
examplePete was approached with a very early-stage deal—essentially two guys with an idea for something cool, and a bit of paperwork. They had no validation of the idea and no traction. In reviewing the business plan, Pete noticed that they were each planning on taking salaries of $150K from day one. The proposed investment was a $500K round. Essentially they wanted to be paid $300K to figure out if this idea had any legs. They were not putting in any of their own money, so in this case, the investors were taking all the risk, and the entrepreneurs have little or no skin in the game. Where would their sense of urgency come from?
If a founder(s) has spent $50K or $100K to get the company off the ground, should they expect to be paid back with investors’ money? We would say “no.” That is the cost of their initial 100% equity ownership. When they are raising money and valuing the company at $1M, they have already made a hypothetical 10–20X return on their investment.
dangerWhether listening to a pitch or conducting due diligence, beware of vanity metrics.
examplePete was doing due diligence on a consumer mobile app startup a few years ago that said in their angel pitch that they had achieved 30K downloads from the Apple App Store in their first week. That sounds impressive, but how many of those downloads turned into real engagement that could eventually be monetized? A few probing questions revealed that the founder knew one of the editors of the App Store and was able to get the app featured. It turns out that 30K downloads is pretty typical for a featured app, and that once that visibility was gone, the download rate fell precipitously. The entrepreneur was not lying, they were just touting a vanity metric. While downloads are necessary, they are not sufficient or directly indicative of potential profitability.
Vanity metrics are numbers that may sound exciting but don’t translate in any direct way to the health of the business.* In a B2B scenario, a vanity metric would be how many people came by the sales booth at the conference. The meaningful metric is how many qualified sales leads came from the conference.
examplePete invested very early (pre-launch) in a company that had locked down a vendor contract allowing them to be the sole consumer sales channel for a very desirable subscription mobile communications product. On one of the first investor reports, the company touted how many different states they were getting web traffic from. Not how many unique users were visiting the site, or the cost of that traffic, or the conversion rate to purchase. There are likely hundreds of web crawlers on the internet working continuously to visit and index every website. How many states the traffic came from means absolutely nothing. Even website traffic means nothing until you can convert it at a reliable rate to a registration or a transaction. One can always spend money to buy traffic to a website via paid advertising. What matters is the cost of acquiring paying customers and for how long they continue to pay.
Legal due diligence refers to the process of reviewing a company’s legal documents to ensure that the company has not made and is not making any legal errors that will put the investment at risk.
Legal due diligence is separate and distinct from business due diligence; its purpose is to make sure that there is no reason from a legal perspective that an investment should not proceed. You typically turn to legal due diligence after you have completed your initial business due diligence and have come to terms on the transaction.
Should you hire a lawyer to help you with legal due diligence? This depends a lot on the circumstances of the company you intend to invest in, and your own comfort level. We discuss when it might be appropriate to hire a lawyer a bit later—whether or not you do, it’s wise for the person making the investment to have some familiarity with the topics and issues that might need to be looked into during this stage.