Why Startup Investors Do Due Diligence

Startup investors need to ask the right questions to mitigate risk. Here are 5 key considerations to add to your VC due diligence checklist.

Most investors learn that they need to do due diligence the hard way. They don’t ask tough questions about the founders or the company. Later they discover something bad that could have been found out by asking questions before investing. They lose their money and vow not to make the same mistake twice.

Like many angels, conducting due diligence is one of my least favorite things about investing in start-ups. But I do it because it has helped me avoid several bad investments. Today I want to highlight five problems that due diligence helped me to avoid. I do this not to put myself up as a diligence expert (I am not), but to show how investors can avoid several problems by conducting due diligence.

VC Due Diligence Checklist – Key Considerations

Who Owns the IP? In one of the first investments I ever evaluated, I was part of an angel group diligence team that was looking a start-up whose founder had developed a piece of technology while he had worked at his previous employer. When the founder pitched to the group, he explained that his employer had no claim on the IP; he worked on it on his own time at home. As part of our due diligence effort I called his previous employer to ask if they had a claim on the startup’s IP. That call revealed that the previous employer and the founder were headed to court because of a dispute over ownership of the IP.

Are the Sales Real? Last year I was considering investing a SaaS software company. The founder showed me his financials, which projected a healthy growth in sales over what they had been during the prior quarter. The growth in sales was driven by four new customers that the company had signed to annual contracts. I asked to see copies of the four signed contracts. The entrepreneur hemmed and hawed for several days, but never sent the contracts. So I declined to invest. Later I found out that the contracts had not been signed.

Is the Founder Working Full Time? Recently I took a look at a startup with very good sales traction and an attractive valuation. The founder had a good track record and was working for a portfolio company of some investors I know. Because it takes so much work to create a startup, I rarely invest in companies unless the founders are working on them full time. I asked the founder what he was planning to do about his current job. He said that he had an arrangement with that company to work part-time and do his start-up full-time. My next call was to my friend the investor. I asked him to check with his portfolio company on this arrangement. My friend made the call and there was no part time employment plan. Another deal was sent to the round file.

Is the Bank Statement Real? As part of my due diligence, I always ask for the bank statement of the company. I then call the bank to verify what the statement shows. I’ve never had a problem; the numbers have matched for every company I have ever considered. However, one angel group I am familiar with wasn’t so lucky. They invested in a company where the founder had photo shopped a statement to show that the company had cash that it didn’t actually have. The investor group later discovered that the founder had been siphoning money out of the business for months.

Is the Company Following the Law? Over the years I have learned to verify a bunch of basic things that companies need to do or else they will run afoul of the law. In particular, I have learned to check whether the founders are paying state and federal payroll taxes; whether foreign-born founders have the right visas to work in the United States; and whether the start-up’s technology infringes on someone else’s patents. Over the years, I have had to walk away from several companies where they had run afoul of the law on one of these dimensions.

Due diligence gets few investors excited, least of all me. But it is valuable. The time I have spent on due diligence over the years has saved me a lot of money.

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Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.