Investors: A Philosophy For Early-Stage Startup Due Diligence

Believe it or not, the biggest risk takers in an investment round are the entrepreneurs themselves.

By Adam Quinton (Founder & CEO, Lucas Point Ventures)

This post originally appeared on LinkedIn.

When early-stage investors conduct their due diligence, we all have our own set of criteria and benchmarks. Some of those objective. Many are not! This can be rather frustrating for founders because a lot of the dialog with investors, as a result, is an inefficient one-on-one dialog.

But before getting to the details why you should conduct due diligence, what’s the appropriate stance for investors to adopt as they undertake due diligence? What’s a good, as you might call it, a philosophy of due diligence? For me, it means treating the real risk takers with respect. (Hint: investor risks are, in the round, pretty modest.)

Personally I frame this by thinking about the different situations of the players on each side of the table. Those players being:

  • The buyer of the equity – that would be the angel or VC investor (e.g. me)
  • The seller of the equity – technically that would be the company, although it amounts pretty much to the entrepreneur/founder

As I see it, these two participants are engaged in activities with very different risk profiles.

1.  What Does Investing Mean for the Buyer?

We know that any individual angel investment is "risky" due to the power law of highly asymmetric returns involved in early-stage investing. i.e. each individual investment has, other things being equal a high probability of total loss (maybe 40 percent), a high probability of only modest positive returns on cash invested (maybe another 40 percent) and that the outcomes that generate that attractive average annual returns come from the outsized gains on less than 20 percent of all investments. Indeed there is a power law within the power law. For example, most of ALL VC returns in 2012 came from one single investment: Facebook!

Across large sample sizes, angel investing is an activity that generates returns in the +/-20%/year range. Indeed a Kauffman Foundation study pointed to 27 percent/year returns for angels investing in groups. That equates to returns that are pretty reasonably commensurate with the risk assumed, on average. The Capital Asset Pricing Model gets it right!

Of course, Finance 101 tells us that idiosyncratic/unsystematic risk can be mitigated by diversification. Admittedly the degree of diversification required that would reduce risk exposure largely to systematic (market) risk is impractical for all but a very few angels, as David S Rose, CEO of Gust and Chairman Emeritus of The New York Angels noted in one post that makes up his prolific Quora record.

Several studies and mathematical simulations have shown that it takes investing the same amount of money consistently into at least 20-25 companies before your returns begin to approach the typical return of over 20 percent for professional, active angel investors.

This means that early-stage investing is pretty damn risky in terms of your likely return profile. And, mathematically, we can see that with anything less than well into a double digit number of investments, the most likely outcome for an angel investor is the loss of most all of your (could be my) capital! Ouch.

But this creates a paradox. Armed with that knowledge, any rational angel (VCs are somewhat different here because they are investing other people's money for the most part) should only invest money she/he can afford to lose – and lose totally. i.e. it can "all go to zero" but the angel's lifestyle is unchanged.

Bottom Line: For the rational angel, while there is evident investment risk in this "asset class," you should take zero lifestyle risk ... assuming you only put money to work you can afford to say goodbye to without pain. (i.e. no need to cancel your next vacation, cut down on your restaurant visits or whatever!)

2. What Does Taking an Outside Investment Mean for the Seller?

The sellers, the entrepreneurs, are of course on the other side of these extremely asymmetric returns. For them the most likely outcome is: They lose "everything."

So maybe all the savings they put in to bootstrap the company, maybe the money from the sale of their house, the years of sweat equity and not to mention regular earnings from more mundane salaried employment forgone. So a big direct financial cost, indeed a big financial and lifestyle opportunity cost.

Indeed, as Noam Wasserman points out in his excellent book The Founder’s Dilemmas, rational founders do not start companies! Because the evidence suggests they will be better off getting a salaried job somewhere.

Bottom Line: A pretty meaningful (and adverse) asymmetry for founders/entrepreneurs in terms of their most likely financial and lifestyle outcome.

The Takeaway

So given 1 + 2, what is the implication for all us investors as it relates to due diligence?

I think of it like this: As the investor, you need to recognize who is taking the real risk here. Treat them with commensurate RESPECT. And that is NOT you the investor. It is the amazing founder(s) you are backing.

That does not mean you leave the entrepreneurs alone and don't impose on their time to conduct due diligence. The Kauffman study I cited above makes it clear that, for the investor, due diligence improves outcomes. Investors experienced better returns in the deals where they exercised more due diligence. Sixty-five percent of the exits with below-average time spent on due diligence reported a return that was less than their original investment. Losses occurred in only 45 percent of the deals where investors did above-average due diligence.

Rather, as a practical matter, RESPECT to me in this context means undertaking your investment due diligence with the following three thoughts top of mind:

  • Be super sensitive to the entrepreneur’s time. Don’t suck them into your own time-wasting analysis paralysis just because it might be an interesting intellectual exercise for you. This also might kill their ability to execute their business. Founders have no staff, no admins to hunt stuff down for them; they have incomplete data — heck they probably aren’t drawing a salary.
  • Get to YES or NO as quickly as you can. Set a deadline to get them an answer and stick to it. I am a firm believer in the Pareto Rule here. Namely that 20 percent of the time you spend gets you 80 percent of the answer. You can spend the other 80% percent of the time to get the final 20 percent of the answer. But it probably won't change.
  • Communicate directly and honestly why your answer is NO, if that’s where you end up.

A key issue you face as an early-stage investor doing due diligence is a question of balance. There is no right answer to that, but in my view a little (no, in this case a large amount of) respect goes a long way.

About the guest blogger: Adam is Founder/CEO of Lucas Point Ventures and an active investor in and advisor to early stage companies. In 2014 he was named one of the 25 Angel Investors you need to know in New York by AlleyWatch. He serves on a number of Boards and Advisory Boards and member of and/or advisor to several angel groups including Astia Angel where he is a founding Angel and chairs the Astia East Coast Advisory Board. In addition he is a Mentor for the new Boulder based accelerator program MergeLane.