- By SeedInvest
- June 14, 2022
- 10 minute read
As an investor, it’s important to know where your money is going and how it will be used. Investing in startups is inherently risky, which is why you’ll want to do your due diligence before making any kind of investment. Understanding who the founders are, the company’s target market, and business model can give you a better idea of what the company may do with the funds and the potential for return on your investment.
What Is Due Diligence?
According to Investopedia, “Due diligence is an investigation, audit, or review performed to confirm facts or details of a matter under consideration. In the financial world, due diligence requires an examination of financial records before entering into a proposed transaction with another party. Due diligence is a systematic way to analyze and mitigate risk from a business or investment decision.”
The process of due diligence is significant for any investor. Engaging in due diligence allows you to understand where your invested capital will go, and what the company you’re considering might be able to accomplish. The purpose of due diligence is to mitigate your investment risk by making a comprehensive appraisal of the investment opportunity and its potential for profit.
Due diligence involves making sure that the startup you’ve chosen is real and legitimate, and has reasonable prospects for success. Engaging in your own due diligence will allow you to uncover important factors like:
- What market the company will enter
- How does the company fit and compete in that market
- The backgrounds of the firm’s founders
- The short-term and long-term goals of the business
- Whether the startup in question will abide by the terms of the investment round
- The potential that may or may not exist for your investment to be profitable
According to Forbes, 90% of startups fail – meaning that investors lose 100% of their money. So, if you’re going to invest in a startup, you should know everything you can about it. This will help you make a valid decision before parting with your hard-earned capital.
You’re likely an investor because you want to make a profit, and carefully assessing the opportunity and risk is essential to doing so. And let’s be honest here. If the startup you invest in is one of the successful 10% you’ll potentially see strong returns on your investment.
Why Is Due Diligence Necessary for Investing in a Startup?
Consider the following: you come across a startup that seems like a sure thing. It’s entering a competitive market and offers a usable product. Instead of doing additional research, you skimp on the due diligence and base your decision on these factors alone. You invest your money, expecting things to move in your favor.
Two months later, you discover that the founders—who are fresh out of school and lack any real-world business experience—have made several mistakes and owe more money than they earn. Before you can react, the firm files bankruptcy and closes.Your money disappears along with the company.
Scenarios like this are one of the reasons due diligence is important. With SeedInvest this type of scenario is extremely unlikely since our experienced team would have uncovered troubling issues and the startup would not be listed on our platform. While making it through our due diligence process does not guarantee success, we don’t allow just anyone onto our platform.
Following a systematic due diligence process may protect you from making rash investment decisions. Taking the additional time the process requires can partially insulate you from disappointment in future returns. Although due diligence does not protect you from all potential losses because investment in startups is inherently risky, not performing due diligence is practically guaranteed to lead to poor investment outcomes.
What Are Some of the Steps of the Due Diligence Process?
Some of the steps in the due diligence process include assessing:
- Risk management
It’s important to examine the market of the startup you’ve chosen. Not every business venture can be based on an original idea, but it’s important to be aware of your competition. If the startup is entering a competitive or saturated market, this may lessen its chances for success.
If the company you invest in isn’t successful, you may not see a return on your investment. The firm might struggle to produce profit, so you’re likely to get little to no money back from your actions. A startup entering a less crowded market may have an easier time presenting and selling its product, which may increase the chances of generating revenue and profit. That’s not to say a crowded market is a bad thing. Crowded markets often indicate strong industry growth. However, a company entering a crowded market may benefit from being either extremely competitive or unique if it’s expected to succeed.
Knowing the people behind the startup is something you take seriously. A company is only as strong as its team, and a group that lacks experience or has failed in multiple ventures in the past could spell trouble for your investment.
You can start by researching the founders of the company. Examine their backgrounds and understand where they come from. Have they launched other businesses in the past? If so, what were those businesses, and what were their accomplishments? Did they achieve their goals and ultimately generate a return for investors?
Although not necessarily an indication of positive future results, startup founders with a solid track record of profitable companies may be more likely to continue a successful streak compared to one who is just beginning their entrepreneurial journey. That doesn’t mean that you should never invest in a new founder, but it does mean that you should weigh the experience of the founder in your investment decisions.
How much money has the company raised? Does it have reserves and how long is its runway? A company can only survive if it has money in the bank.
You’ll want to make sure the company you’ve chosen has the funds to tackle any emergencies or unanticipated expenses. It’s also important to think long-term. Thus, investing in a startup that has enough money to cover its operations over the next two to three years may be a stronger investment choice than one that only has enough left to sustain operations for a few months, so be sure to check a startup’s financial resources before investing.
Investors should also check a company’s key business metrics. These include revenue to date, revenue growth, gross margins, customer acquisition costs, and customer LTV. All these items are potential determining factors in how well a startup can do and how long it may last. A startup with more bases covered has a better chance of thriving in a competitive market.
Is the startup’s organizational structure a fit with its stated goals and objectives? Are the right people in the right organizational roles to move the startup forward? Is the legal structure correct? These questions will help you evaluate whether the business is set up for success down the road, or if changes may need to be made to have a better chance of success.
Understanding the product the company is offering is an invaluable asset as you consider an investment. Is the product a new idea, or will it share its market with strong competitors? Is the product appealing to the right audience? Are there early adopters of the product? The answers to these questions are essential to your investment decision-making process.
Assessing and managing risk applies to both founders and investors. As an investor, you must understand your own risk tolerance and measure the risk versus the potential reward for each investment. You will also need to assess the risk appetite of the founders of the startup. Can you see areas where the founders have instituted risk management strategies internally for the company? If so, that may be a reassuring sign of the maturity and experience of the founders.
Terms of the Investment Round
Ensuring the terms of the investing round are fair to you is another step to take. You’ll want to be clear that the terms are correct for the company’s current valuation and that you’re not taking on too much risk. You’ll want to fully understand how your funds will be used over the course of the next 1-3 years. Do you notice anything that may get in the way of your returns? If so, do your best to work things out with the founders so they have what they need while your investment remains safe and in their good hands.
Due Diligence Problems
There are several common issues an investor may experience during the due diligence process. These include:
Entrepreneurs can be idealistic. This is a positive trait in many ways, but it should not hinder one’s perception of reality. Depending on the industry, working to open a second office in three years may be more realistic than trying to earn a billion dollars in two. Developing a business takes time, and you may discover in the due diligence process that the founders of your chosen startup have not set timely or realistic milestones and goals.
Upon researching the startup’s staple product, you may find its audience is limited. Maybe the product is designed only for specific individuals. Maybe there are legal issues that prevent it from being offered in every jurisdiction. Maybe there are technical aspects that make it hard to understand. Factors may arise that limit the addressable market for the product. In these cases, your investment capital may not go as far as you’d like.
Weak Term Sheets
You may find yourself discouraged by the term sheet offered by a startup. It may include elements that put you at a disadvantage and grant excess power to the founders, meaning you’ll be overruled every time you have an opinion on an issue if you are an investor. The good news is that a term sheet is non-binding and opens the door to negotiation. While negotiating takes time, it’s important to establish a term sheet that fairly benefits all parties involved.
Due Diligence and SeedInvest
At SeedInvest, we feature a wide array of startups for investors to choose from, all of which have gone through a vetting process and are required to provide due diligence materials for your review. Our team ensures that each company listed on the platform has filed as a corporation or LLC alongside a variety of other due diligence research.
Once the structure and ownership terms of a startup are established, we review its legal documents and check for risks. From there, the data we gather is reviewed by an investment committee, which offers the final say in whether the company can be listed on the SeedInvest platform.
Our due diligence process doesn’t replace investor due diligence, but it certainly supplements it and helps lead potential investors to interesting startups currently fundraising. Browse our list of potential startup investment opportunities here.
- This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. Past performance is no guarantee of future results, and there can be no assurance that an investment strategy will be successful or that the historical performance of an investment, portfolio or asset class will have a direct correlation with its future performance.
- SeedInvest's due diligence process is no guarantee of success or future results. All investors should carefully review each investment opportunity and cancel their subscription within the allotted time-frame if they do not feel comfortable making any specific investment based on their own due diligence. Learn more about due diligence on the SeedInvest Blog and our vetting process in our FAQs.
- Past performance is no guarantee of future results. In addition, SeedInvest's due diligence process is no guarantee of success or future results. All investors should carefully review each investment opportunity and cancel their subscription within the allotted time-frame if they do not feel comfortable making any specific investment based on their own DD. Learn more about due diligence on the SeedInvest Blog and our vetting process in our FAQs.
- All securities-related activity is conducted by SI Securities, LLC dba SeedInvest, an affiliate of Circle Internet Financial, and a registered broker-dealer, and member FINRA/SIPC.