Investigating an Investment Takes Due Diligence

Article excerpt

Entrepreneurs are eternal optimists.

It is not unusual for an entrepreneur to make a presentation to an investor, get a positive signal of the investor's interest, and conclude the money is in the bank. In the entrepreneur's mind, everything else is simply detail. In the investor's mind, everything else depends on the details. Arriving at these details is a process known as conducting due diligence.

Investors are picky by nature. They might receive several hundred business plans per year of which one in 10 might exhibit criteria that warrant follow-on discussion with the entrepreneur. An investment may be made in one out of 100 plans submitted.

The fact that a venture capitalist or angel investor does not fund 99 percent of the opportunities they see does not necessarily mean those ventures are not commercially viable; rather they simply may not represent an opportunity that will dominate its competition with unfair competitive advantages. Investors look for venture investments that are as close to a monopoly as possible.

Even as picky as they are in selecting investments, investors are even pickier in researching investments.

Although the business might meet the investor's initial criteria, offer prospects for a high return on investment, and have a stellar management team. Investors are generally dispassionate about the opportunity until a term sheet is agreed to and the background research is completed.

The term sheet defines the agreed-upon valuation of the business, financial and legal terms of the deal, rights of both parties and their legal obligations. Once the term sheet is agreed to, the research or due diligence process begins.

For the most part, investors initially assess the representations made in the entrepreneur's business plan based upon their own experience and knowledge. However, they know that regardless of the number of plans seen, the number of articles read, or the number of investments made, they will not arrive at a final investment decision until the due diligence is complete.

Due diligence is a costly, tedious, time-consuming and necessary activity to validate the technical, market, and business assumptions represented in the business plan and to discover answers to questions raised by information omitted or typically not addressed in the business plan.

The research approach is to discover the "deal breakers" or major problems as soon as possible. Taking this negative approach is not a reflection of investor attitude but is a function of time, money and efficiency. Since more deals fail to survive the due diligence process than ones that do, it is only natural to get to "no" as soon as possible. …

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