Introduction
Every
investor should be aware
of the necessary role
that due diligence plays
in the investment
screening process. Most
institutional investors
have embraced the due
diligence process and in
most cases have made
advanced due diligence
practices a matter of
policy. Unfortunately,
most angel investors
shortchange the process
either because of a
perceived lack of
resources or because
they don’t fully
appreciate its
importance. This
series of articles will
address all forms of due
diligence and focus on
those needs specific to
angel investors.
Each
topic in the six-part
series will focus on a
different aspect of the
due diligence process. In
addition to the
information contained in
each article, there will
be additional
information provided on
the Intelex Web site (www.intelexltd.com).
·
Structuring the Due Diligence Review
· Documents
Collection
· Market
Due Diligence
· Competitive
Due Diligence
· Investigative
Due Diligence
· Cultural
Due Diligence
What is “Due Diligence”?
The
term due diligence was
originally applied by
the Securities and
Exchange Commission to
an underwriter who is
supposed to exercise
“due diligence” in
assuring the public that
a deal is legitimate. In
the private equity
community it has come to
mean any research that
is conducted to assure
that a deal is
legitimate. Historically,
due diligence had been
limited to a detailed
examination of a
company’s financials. However
increases in deal flow,
emerging technologies
and globalization
issues, as well as
increases in both fraud
and litigation, has led
most institutional
investors to investigate
beyond the numbers.
In
practical terms, better
due diligence means
better investments.
By examining such issues
as real life market and
industry trends, the
competitive outlook for
a company, profiles of
the management team and
so on, the angel
investor assures a solid
foundation for future
investment and growth. It
doesn’t matter if a
seed level investment
achieves initial
success, if information
is later disclosed which
prohibits future
investment. These
are issues that cannot
be glossed over, as
evidenced by last
year’s “hit” of
Hitsgalore.com.
Hitsgalore.com,
an Internet company
whose market value
soared from $53 million
to $1 billion in
three months, didn’t
disclose its founder was
accused of cheating
customers at a previous
job. As a result of
a lawsuit, this
information became
public and
Hitsgalore.com shares
plummeted 53% cutting
the company’s market
worth by $534 million. It
was the largest
percentage loss of any
U.S. stock. Perhaps
the most unnerving
aspect of this story is
that all of the problems
could have been
completely avoided with
proper due diligence.
Reducing
exposure to liability
should be of foremost
concern to all
investors, however, it
is an area that is often
overlooked by angel
investors. In
today’s increasingly
adversarial and
litigious business
environment, the due
diligence review is one
of the most important
and risk-fraught
elements of any
investment. Without
complete and accurate
information, those
negotiating the
transaction will be
unable to address
potentially significant
areas of concern. At
best this can lead to a
failure to pay or
receive a fair price for
the target company or
its securities and, at
worst, can result in
significant liability to
the client.
How are Angels’ Needs
Different?
Most
investments made by
angels, especially those
new to private equity
investing, are seed
level or very early
stage investments. While
this stage of investment
is not unique to angels,
many of the issues
surrounding the
investment are. Most
angels cannot assume the
same level of risk that
larger, institutional
investors can and, as a
result, must be even
more critical when
selecting candidates. Perhaps
the greatest difference
is the deal flow that
angels are often exposed
to.
Deals
that are presented to
institutional investors
tend to come from a
“known source.”
Perhaps the deal
originated from another
banker in the firm or
from another existing
professional
relationship, or maybe
it worked its way up the
investment ladder based
on its merit alone,
either way by the time
an institutional
investor sees a deal it
is already
pre-qualified. While
there is still much due
diligence to be done,
the deal comes with a
certain amount of
credibility. Angel
investors are not always
this fortunate.
For
many angels, the deals
they see are the ones
that can’t make it to
the institutional
investor. Commercial
banks and VC’s won’t
do the deal based on
either deal size or
business concerns. Not
only does this leave the
angel at a disadvantage
when dealing with a
legitimate investment,
it also exposes the
Angel to a level of
fraud typically not
found at the
institutional level. The
other deal-flow concern
unique to angels is
that, often times, deals
come from friends or
family members. While
this does provide for
deal-flow from a known
source, the pre-existing
relationship often makes
it uncomfortable for
angels to conduct the
necessary due diligence
required of any
transaction. However,
properly structuring the
due diligence review
will allow the angel to
avoid many, if not all,
of the potential
pitfalls involved in
investigating friends
and family. Next
month we will discuss
Structuring the Due
Diligence Review. Issues
covered will be for both
individual angels and
angel clubs. If you
have any questions on
this topic, please feel
free to e-mail me at mcherry@intelexltd.com
and I will try and
incorporate the answers
into my article.
Cherry is the President of Intelex, Ltd., a due
diligence and business
intelligence firm
headquartered in
Greenwich, CT. Cherry
has been performing
advanced due diligence
for clients since 1992.
Cherry is a member of
the Society of
Competitive Intelligence
Professionals and the
Association of Certified
Fraud Examiners. He may
also be reached at (203)
622-0031.
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