Due Diligence

You may have heard many times about due diligence in the investment world. A good due diligence process ultimately becomes the deciding factor in whether or not to invest in a company. It also lays the foundation for smooth integration.

But what is personal due diligence? How is it different from Keiretsu Forum’s five-stage due diligence process? How is it done? And why is it absolutely necessary?

Keiretsu Forum member and investor Mark Kerschner sheds light on the topic. He has been investing since 2017 and has made 11 investments since then. Here is his 5-Step Due Diligence Process.

5-Step Personal Due Diligence Process

1) Understand your strengths and weaknesses

Mark says the first thing to consider when you start investing is understanding your strengths and weaknesses. He explained that his experience in different financial roles in various countries helped him see things from a different perspective.

If you're an investor in a company's due diligence team, and you have a solid understanding of its industry, use that knowledge to drive the discussion forward. Alternatively, if you're on a due diligence team and feel like your knowledge is not relevant to the sector, ask yourself who you can add to the team to better comprehend your questions and challenges.

Evaluating your position in the due diligence team is the first step. During due diligence, you should ask yourself: What am I bringing to the conversation? How can I use my strengths? How can I overcome my weaknesses?

2) Do you know why you want to be an early-stage investor?

Mark says there are many different reasons to invest, and every investment will put you down a different path. It's important to ask yourself, he continued, why are you investing in a certain type of business? Is it because you want to support environmental and social causes? Is it because you are rich and want to give something back? Is it because you are a capitalist and want to support young entrepreneurs?

Investing in early-stage companies can be extremely advantageous to investors. Investing in a start-up from the beginning benefits investors as in most cases it leads to significant returns. Investors can work alongside the higher-ups of the company, give their input, and make instrumental decisions for the success of the start-up. Investing in a start-up can also be very risky, but if successful, the rewards will exceed the initial capital provided. Knowing this and then starting your due diligence with a company that fits your investment appetite is a crucial step.

3) Determine how much you are willing to lose?

The hardest idea is that you have to accept that you can lose the amount you invested.

As an investor, you must accept the risk factors of investing in early-stage companies and know that the chances of a significant return on your investments are slim. Mark recalls getting the same advice from another member of the Keiretsu Forum: " Never forget that early-stage investments are very high risk."

Only invest in what you are willing to lose! Mainly because the risk is so high that it takes a lot of work to look at a company profile before investing, especially if you want to reduce and/or eliminate risk as much as possible.

4) Determine your time horizon

Are you planning for a liquidity event in 3, 5, or 10 years from now?

Time horizon is important because it is an important factor in determining whether an investment is suitable for an investor. It is also a crucial factor in determining the level of return on investment. The longer the investment period, the higher the potential return. As an investor, you need to consider your age, income, lifestyle, and risk tolerance before investing. Mark noted that he often finds that liquidity time frame expectations do not always match reality. Liquidity events are often delayed, and as an investor, you should always consider a delay in this process when investing.

5) Create a checklist to set yourself up for success

Join Multiple Angel Groups: Mark shared that if he could go back in time and start over, while also being part of other groups, he would make Keiretsu Forum his primary angel investor group. For example, he is currently part of Atlantic Bio Angels, as his investment interests continue to be drawn to therapeutics and medical devices. Joining multiple angel groups can be a great learning opportunity, especially when you notice the qualitative differences between groups, and learn from other investors’ insights, backgrounds, and perspectives.

Embrace the power of Mindshare: As an investor, it is important to be part of a diverse group and harness the power of mindshare. This is where you learn the most, especially about yourself.

Get to know fellow angel investors: Nothing beats some old-fashioned networking! Whether you're a seasoned angel investor or new to the game, there's always something to learn as you meet and build relationships with your fellow angels.

Invest with patience: Invest patiently! As an investor, you may be happy to invest in the first company you come across, but the truth is that rounds always come and they don't always end tomorrow. You need to spend several rounds of due diligence to really vet companies and understand them.

Participate in Due Diligence: Mark remembers that the best investments he made were when he was involved in the due diligence process. It gives you the opportunity to have professionals who understand the company or other parts of the industry, have a different perspective, and really study the company in depth. The due diligence process can also give you a complete picture of the company you are considering investing in.

Ask questions to the CEO: You can spend time with the CEO and get to know what they think. Do they stick to their cause, or are they willing to accept outside opinions? Will they listen to the board or advisory committee? If you are not on the due diligence team, he recommends that you still make sure to have multiple conversations with the CEO.

Speak to the Advisory Committee:

Meeting team members along with the CEO is also important. If a company has an advisory board, call them and ask to meet with them. Ask how involved they are and how often they are involved in what's happening at the company. Due diligence, while very time-consuming, creates the greatest chance for success.

Conduct a site visit: Visiting the site and really getting to know the company can be time-consuming, but it is a very important step before making any investment. 

Winners & Losers in Investing (With Examples!)

Mark shares some examples of companies he has invested in, and looking back at his past investments also gives him a chance to see where he's made the right decisions and where he's gone wrong.

Example 1: Company XYZ

Mark’s relationship with the company:

• A Keiretsu Member called about an opportunity
• Technology company, his bailiwick.  “Company has great technology”
• Spoke to CEO who seemed knowledgeable about the space
• Impressive deck
• No Due Diligence or Mindshare
• No site visits
• Invested the lowest amount

Mark said it was one of his biggest mistakes. Another Keiretsu member who brought him to the company reminded him that it takes 22 investments to get a 2X or 2.9X return. Mark regrets that he did not conduct a thorough personal due diligence with this company and he did not enjoy the benefits of participating in mindshare and a due diligence process with the team. As a precaution, it's one of his lowest investments, and it's one of two that are currently hanging by a thread. He said he would not have invested in the company if he had taken the time to research it further.

Example 2: FEMSelect

Mark’s relationship with the company:

• Watched a 60-minute clip on the plastic mesh disaster in surgery
• Witnessed FEMSelect in an Angel Investor Fair. Fellow BSA members explained how open the relevant markets are
• Multiple meetings/talks with CEO, with a final meeting in New York
• Reviewed all available materials about the company
• Reviewed Keiretsu Forum's Due Diligence report and saw an updated presentation
• Stayed in touch with management

FEMSelect is a company that Mark has invested in through Keiretsu Forum. He recalled watching a 60-minute presentation on the disaster of plastic mesh in surgery. He spoke to the CEO multiple times, reviewed materials, called company employees and associates, and even reviewed the Keiretsu Forum due diligence report. FEMSelect is currently in the commercialization stage, is starting its VC round, and is well on its way to profitability. Mark is very happy with his investment and praises the research that helped him get ready to invest.

Example 3: Seneca Therapeutics

Mark’s relationship with the company:

• Two-hour discussion with the founder’s advisor
• Lunch and four-hour discussion with founders and advisors
• Personal research - what is an oncolytic virus, patent protection, etc.
• Initial Investment
• Keiretsu Due Diligence Team Member (investment disclosed)
• Ongoing dialogue with founders on how to strengthen the company
• Secondary investment
• Invited to be a Board Member
• “Volunteered” to become the company CFO

Mark took a 2-hour train ride with a member of Keiretsu Forum and one of the advisors to the founder of Seneca Therapeutics, where he had the opportunity to briefly learn about the company. He found the experience interesting and ended up organizing a personal follow-up meeting with the founder and advisors, which lasted 4 hours, through which Mark was able to learn about areas he was unfamiliar with. Mark started researching oncolytic viruses and patent protection and eventually made a small initial investment in the company. The company then presented at Keiretsu Forum, and after Mark disclosed his investment in the company, he worked on the due diligence team and got to know Seneca's team very well. After making his second investment, he was invited to join the board and eventually volunteered to be the company's chief financial officer.

Mark's advice to investors is to do personal and team due diligence before you start thinking about investing in any company.

 ABOUT THE SPEAKER:

Mark Kerschner is an Angel Investor, Advisory Board Member, and Board Member. He began his career with PWC in NYC and has been a CFO of both public and private companies, working in the chemical, engineering, and pharma industries. Currently, he serves as a Board member and CFO of Seneca Therapeutics, Inc. He is an active member of the Broad Street Angels, Mid Atlantic Bio Angels (MABA), and Keiretsu Forum. Click here to watch his keynote address.  

Due diligence is an investor's first opportunity to explore potential investments. This is the process of reviewing, investigating, and validating investment opportunities to confirm all relevant factual and financial information.

Did you know that the due diligence process is the most important step in safeguarding investor interests? Failure to conduct proper due diligence can lead to poor investment decisions. It is in the best interest of angel groups like Keiretsu Forum to conduct due diligence as we facilitate funding.

Entrepreneur and Due Diligence Director Juan Arango created the first due diligence (DD) process for Keiretsu Forum by taking a 500+ page manual created by Michael Grounding and turning it into a functional process. The goal of Keiretsu Forum's current due diligence process is to provide members with the structure they need to make informed investment decisions. Our due diligence process has evolved steadily since its inception to provide investors with a 360-degree view of the company they wish to invest in, and our revised process ensures a complete report within 4-6 weeks.

Keiretsu Forum 5-Step Due Diligence Process

Here is a step-by-step guide of our process.
 

Step 1: Data Room and Team Recruitment

To begin the due diligence process, it is important to fill out the data room with information about the company and attach the specific documents requested by the Keiretsu Forum team. Without complete data, the due diligence process cannot begin. Secondly, when recruiting a due diligence team, it is the entrepreneur’s responsibility to take charge of the process. You need to keep this in mind and invite angel investors who are excited about your company and who will likely write checks.  Keiretsu Forum members are experienced in conducting due diligence and know-how to handle the process. But it is up to the entrepreneur to invite the right investor to join their team. To choose the right investor, you need to talk to them and understand their investment ability and willingness. If you feel an investor is the right fit, but they are currently not investing any capital into companies, instead of trying to convince them it is advisable to look for someone else. The optimal number of investors on the due diligence team is no more than 5-6 people. You also want investors to have expertise in different areas such as finance, technology, etc. so that they can use their expertise in the DD process.

Step 2: Launch, review, schedule & ask critical questions

This stage of the due diligence process includes the launch, review, scheduling of deep-dive calls, and creation of questionnaires. The Keiretsu Forum team will facilitate this process and help resolve any issues along the way.

Step 3: Deep dive calls, transcription & visioning

At this stage of the process, the due diligence team & entrepreneur will be in regular communication through the deep-dive sessions. These calls can often last up to an hour or more and focus on what the due diligence team wants to know about the company. Members of the Keiretsu Forum team are on hand to transcribe every deep dive call. After each deep dive, the Keiretsu Forum team captures, cleans, edits transcriptions, and adds them to the "DD Notes" document, which is in a question-and-answer format. This document, also known as the first version of the DD report, is shared with the due diligence team to review and ensure all data is correct. Ideally, it would take anywhere between four to seven deep dives to get all the necessary data from the company.

Step 4: Review, approve & publish the report

As we enter stage 4 of the Due Diligence process, the Keiretsu team produces a document called a "Zero/Rough Draft", which is a combination of all the data received so far from the deep dives. The document is divided into sections and formatted for ease of reading. The task of the due diligence team and entrepreneur is to review the data represented in it and ensure that it is accurate. If any data is missing, you can add it as well. We urge everyone to use the "Track Changes" option in the document so everyone knows what changes were made to the document and by whom. Once all changes have been made and the document beautified, the document will enter a final stage called a "Final Draft" format.

Step 5: Share results

In the 5th and final stage of the process, the Keiretsu Forum team adds logos, executive summaries, Term Sheets, investor references, investment reasons, potential challenges, background checks, etc., to the final draft. We also clean up the language to make it seem like it was written by a third party and add a template to match the look of our professional DD reports.

Two additional considerations:

Weekly Status Call: We ask investors to set up a weekly status call. They can last 15 minutes but not more than 20 minutes, and the purpose of these calls is just to find out what due diligence work has been done in the past week and what is in the pipeline.

Updating Investors: Entrepreneurs send weekly updates to investors outside the due diligence team who are interested in their company. This is just to keep investors informed about progress and ensure their continued interest in the company.

Common Due Diligence Assumptions

If you have never joined a due diligence team, you may have some questions! Here are answers to some common assumptions about the process:

Does every discussion between investors and entrepreneurs count as due diligence?

Yes, this is correct! Every conversation between an investor and an entrepreneur counts as due diligence. After all, every conversation about the business might eventually lead to a potential investment.

Do checklists and templates limit the scope of work?

Yes! Checklists and templates limit the scope of the regular workflow. Professional angel investors have long known how to conduct due diligence on companies. We believe that by suggesting conversation topics, we are not utilizing their expertise. Our goal is to let investors take the lead and get answers to the questions that they are interested in.

Can an investment decision take up to 4 weeks?

Yes! With Keiretsu Forum's new due diligence process, it can take anywhere between 4-6 weeks to make an investment decision.

Are the deep dive sessions recorded and transcribed?

Yes! We urge investors and entrepreneurs to record all deep-dive sessions. We do this simply to capture important conversations, thought processes, and questions of all investors. This gives us the basis for a very solid due diligence report. For example, professional angel investors will ask 90% of the questions that any investor will want to know.

Will the due diligence team be required to write reports?

No! Our new due diligence model ensures that all conversations are recorded and transcribed. All angel investors and investors involved in the due diligence process are not required to write reports. The Keiretsu team will capture the recording, transcribe, edit and share the document with the entrepreneur and the due diligence team to clean up the language and ensure all data points are correct and all questions are answered. As a result, the due diligence team does not have to write any reports, just revise the document to ensure completeness and accuracy.

Can a due diligence report be shared?

Yes! There will be one single sharable link for the due diligence report.

Is due diligence for potential investors a sales process?

Yes! Due diligence by potential investors is considered part of the sales process. If you can talk to investors and convince them to put money into your business, it's a deal! Therefore, it is important to consider this as part of the sales process, and the central theme of all discussions should be to answer key questions from investors.

Due Diligence Best Practices

Below are some of the best practices suggested by Entrepreneur and Due Diligence Director Juan Arango for speeding up the due diligence process.

Immediately recruit investors for your team: Start by assembling your due diligence team. A team can consist of 5-6 angel investors.

Record every single deep dive call: Record every deep dive call and send the recording to the Keiretsu Forum team for transcription.

Prepare your data room in advance: Create and populate your data room so investors can easily access all the information related to your company.

Stay up to date on revisions in the Due Diligence Report: Constantly track changes in the due diligence report and answer questions from investors instantly.

Focus on key questions that need answers: Focus on the key questions investors ask so that their queries are resolved and they feel more confident writing checks.

To learn more about Keiretsu Forum’s Due Diligence process, visit here.

You probably already know that starting a business can be a challenging journey. Few companies have the right product-market fit, the right team, and the right business model to guarantee their future success. Have you ever wondered where most businesses go wrong? How and why, do they fail? The factors that hinder success are often not just one, but many. As an investor and entrepreneur, it is important to understand why before you invest and/or start a business.

Rob Neville has been active in the Keiretsu Forum NorCal region for ten years, initially as an entrepreneur and investor. In the Portland chapter of our April 2022 Roadshow, he outlines the top three reasons start-ups fail. They are as follows:

TOP REASONS WHY START-UPS FAIL

According to Rob Neville, the top three reasons start-ups fail are capitalization, poor product-market fit, and teams. The reasons below cover over 90% of start-up failures.

1) CAPITALIZATION

The first hurdle start-ups need to acknowledge after their launch is that they don’t have enough capital, this can be due to the failure to raise money, or that they did not raise enough money.

The CEO must be a good storyteller

The process of raising capital is closely tied to whether the CEO is a compelling storyteller. At the end of the day, if you cannot tell a story about your company, you cannot motivate your audience to write a check. Any CEO who cannot do that will have a hard time raising money. Rob recalls hearing presentations from companies in the past, where the idea was great, but the presentation did not convince him to write a check. During the due diligence process, he often helps revise presentations and coaches CEOs on how to tell the company story more persuasively.

 Address the most important risks early

 From a capitalization perspective, start-ups are always risk-oriented, so as an investor, everything is about addressing those risks. During the due diligence process, it is important to identify significant risks early on, before any funds are invested in the company.

 Align GANTT Charts, Revenue Usage, and Financials

 A GANTT chart is a bar chart that represents a project timeline. Rob recalls that he rarely encountered a company's GANTT chart where the revenue and financials were all lined up. As an investor, it is important that you work with the company to adjust all elements on the chart and accurately reflect it in all other documents.

Talk to primary vendors

It is vital not to blindly believe what the company says, and to have a dialogue with other stakeholders such as primary vendors. Example: If there is a manufacturer that makes widgets for a company, you should talk to them and confirm that the timeline shared by the company matches their timeline for delivering a complete and functional product. If not, adjust the GANTT chart and financial data accordingly.

Appropriate security and terms

 Proper security is an important factor in this process, as you take many risks when investing in a business. So, whether you see a $1 billion valuation or even a $100 million valuation, if the company is coming to angels for investment, the numbers are probably not 100% credible. It's wise to spend a lot of time making sure safety measures are in place. Investors generally prefer convertible bonds to SAFEs because they are safer.

2) PRODUCT-MARKET FIT

The second hurdle to overcome is product-market fit. As an investor, don’t simply trust the data the company provides, do your due diligence to see if the product has a place in the market or not.

Validate every assumption

 The CEO said the product is in high demand. Don't believe it.

The CEO said the product has a 70% profit margin. Don't believe it.

 Don't believe in assumptions and don't listen to opinions. If there's one thing to watch out for, it's peer-reviewed data. For example, if a company is making assumptions about data, then every number they talk about, every number in their executive summary, and every number in their slideshow needs to be correlated, challenged, and validated.

Rebuild TAM/SAM/SOM

 It is important to develop your Total Addressable Market (TAM), Serviceable Addressable Market (SAM), and Serviceable Obtainable Market (SOM) and challenge the business with your data. In most cases, they will probably just adjust their model based on your input.

Market Validation (early traction, survey)

 How to measure market efficiency? The first step is to look at customer acquisition cost (CAC) and lifetime value (LTV). This can be done by mapping sales in the marketplace, but if a company isn't already selling anything, it's important to know the size of its customer base. This can be done initially with a qualitative survey; you use your network for this. Next, conduct quantitative research with the help of the company to understand who the customer is and what their buying process is like.

Mega Trends

 Never invest in a sinking ship. Any investment you make should be in an expanding industry. Therefore, adapting the product to the market is critical, which is why investors should spend a lot of time talking to as many customers as possible during the due diligence process.

3) TEAM

If a company has a good team, all other factors generally fall into place. As an investor, how do you approach the challenge of understanding the people behind the company?

Get to know the board and team

 For angel investors, the only real opportunity to meet the team of the company you invest in is during the due diligence process. So, what can you do to overcome this challenge and know if the team behind the company has what it takes to make the company successful? Spend time with them formally or informally. A due diligence meeting is one thing, but you can also meet informally, such as for dinner or set up discussions during a sporting event. Conduct secondary reference and background checks, talk to as many people as possible, and make sure any data shared by the CEO and executive team is validated by these checks.

Wild Assertions/Lack of Humility

 Always pay attention to any assertions made by the CEO.  If he or she makes an exaggerated statement, treat it as a red flag.  As an investor, you don’t want wild assumptions, you want a humble CEO who understands the ups and downs and sticks to the facts.

Relevant Experience

 It is important that the core team working for the company are investing their own money into the business and are there in a full-time capacity. It is imperative to judge teams by their backgrounds and whether they have the grit and tenacity to move the company forward.

The following chart by CB Insights outlines additional reasons why start-ups fail.

Rob’s Due Diligence Philosophy

• Due diligence is more than checklists and fact-checking
• The Due Diligence process should shape the company into a viable and investible entity
• How can this be done? Focus on what makes start-ups crash
• It should validate your pre-defined investment criteria
• Due Diligence continues well after the DD report is done

Rob explained that as an investor, you should always go beyond the due diligence checklist. When a company comes to you and you have a legitimate interest in the company and see areas for improvement, it's important to take action, especially when doing due diligence. If the CEO can't tell the company's story well, you should spend weeks or even months helping them solve the problem and turn it into something convincing. The process of due diligence shapes a company into a viable and investable entity, not just through its pitch presentation, but also through its financials and go-to-market strategy. This can only be achieved by taking an active role in the company. If you have completed the due diligence process, you may not be ready to invest 100% in the company. You can invest the minimum amount and watch the company’s performance over time, and once you are confident that it can achieve its goals, you can go ahead and invest more money. Thus, the due diligence process continues way beyond the completion of the report.

ABOUT THE SPEAKER

Rob Neville is a successful entrepreneur now turned angel investor. As CEO of Savara, Rob attracted one of the largest historical amounts of angel investment ($50m from 400 angels including $15M from Keiretsu) - Savara was listed on NASDAQ in 2017. Prior to co-founding Savara, Rob founded and served as CEO at Evity, which he subsequently sold to BMC Software returning 30X to angel investors in just over 1 year. Based on his work at Savara and Evity, Rob was honored as a three-time finalist for the Ernst & Young Entrepreneur of the Year Award, winning the life science award in 2018. Rob now serves as a repeat judge in the Earnest & Young Entrepreneur of the Year Award. Rob is currently Managing Director at Springbok Ventures, investing in and assisting early-stage start-ups. Click  here to watch his keynote address.