EVALUATING INVESTMENT

OPPORTUNITIES
Fundamentals of Due Diligence

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About the Authors

Ham is Co-Founder of Seraf and the

Chairman of Launchpad Venture Group, a
Boston-based angel group. Through his
involvement with Launchpad, Ham has
built a personal portfolio of 50+ early
stage investments. In addition, he is a
board member or board observer with 5
early stage companies.

Christopher is Chair Emeritus of the Angel

Capital Association and Managing Director
of Launchpad Venture Group. He helps
manage Launchpad’s portfolio of 70+
companies, he has personally invested in
over 65 start-up companies, and is a
limited partner in four specialized angel
funds. Christopher is a board member,
advisor and mentor to numerous Seraf Co-Founders
start-ups, and a frequent panelist and Ham Lord & Christopher Mirabile
speaker on entrepreneurship and
angel-related topics.

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 Presentation Overview

ROLE OF DILIGENCE ACKNOWLEDGE WNTBB

1 Avoiding Obvious Mistakes
4 What Needs to Be Believed

IDENTIFY KEY RISKS LEARNING THE HARD WAY

2 Without risk there is no reward 5 A few lessons learned

DEVELOP INVESTMENT THESIS APPENDIX

3 Establish Potential, Probability and Period 6 Templates, Checklists and Questionnaires

Every company’s diligence challenges are going to be unique.

If you understand the overall purpose of diligence, you have a “key risks” framework you can apply,...

If you understand that diligence is fundamentally about documenting assumptions,...

you will be ready to tackle any diligence project that comes along!

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 Why Due Diligence is Important

Diligence is not about removing all risk and eliminating all mistakes

Investing at an early stage - lots of unknowns, there will be failures

Diligence is about spotting and avoiding the *obvious* mistakes

It’s easy to imagine why things might work. It takes effort to grasp
subtle and complex ways things can go wrong.

The Importance of Due Diligence in Angel Investing

For some reason, in life it seems like it is always faster to imagine the obvious ways something might
work than it is to grasp the sometimes subtle and complex ways things could go wrong. Perhaps people
are optimists, or perhaps it is the tendency to want to believe an earnestly and passionately-told story
from someone who is betting their livelihood on it.

But whatever the reason, more time spent on due diligence always yields a more balanced and nuanced
view. Additional time allows you to get the perspective of different experts, spend time with the team,
educate yourself on the market, understand the psyche of the target customer. If you do not take the
time to put in a little work, you are just making a blind bet during that overly optimistic honeymoon phase,
and you are giving up the chance to consider very easily-discovered issues and to ponder whether it is
realistic to expect a team to work around them.

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 During Due Diligence, You Will...

Spend time with the management team

Educate yourself on the market
Understand the psyche of the target customer
Ask common sense questions

There is no right amount of diligence. Any diligence you do is better

than none at all.

The Importance of Due Diligence in Angel Investing

Team is by far the biggest focal point of my inquiry. Other factors are important, but none has the
make-or-break importance of questions around team quality. The issue comes down to a simple
realization that an “A team” with a “B plan” will outperform a B team with an A plan every time. Rising
market “tides” do help all boats, but not enough to save boats with holes in them or boats with no
captain. How do A teams do it? An A team is reading the market all the time. They can tell that it’s not
coming together. They pivot before they’ve gotten themselves into such a capitalization hole that there’s
no way the company can ever perform for investors. A good CEO will pivot, but a great CEO will pivot in
a capital-efficient way. She will recognize that the data and the progress are just not there and start to
move early and decisively before the company has raised and spent so much money that the cap table is
just irretrievably screwed up. That takes vision, courage, humility, communication skills, analytical skills,
listening skills, business management savvy, leadership skills, tenacity in the face of disappointment, and
grit and determination. Plus maybe a sense of humor and some healthy perspective. These are the the
things you are looking for. Team chemistry and dynamics are also key - a group of high functioning
individuals is different from a high-functioning team.

Secondarily, I focus on market size and segmentation with a particular attention to the number of
potential customers for whom the company’s solution is a top pain point and a top buying priority. Too
many diligence efforts stop at “yup, I am satisfied that there are lots of people out there who would buy
this.” The question is, where does it lie in their priority list? Are there enough of them who view it as a
“need to have” rather than a “nice to have” that reasonable market share represents a big market?

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 3 Guiding Principles of Due Diligence

Identify Key Risks

Develop the Investment Thesis
Acknowledge “What Needs to Be Believed” to Invest

Diligence is not about eliminating all risks and avoiding all

mistakes. It’s about spotting and avoiding the obvious ones.

An Investor’s Guide to Due Diligence in Early Stage Companies

Identify Key Risks: After the pitch, distill the story down and create a list of 3 or 4 critical areas that
need further examination. These areas are superficially covered in the investor pitch deck (e.g. customer
problem, market opportunity, management team, competition, financials, etc.). Each topic area is going
to have a few important questions that we need to further research.

Develop the Investment Thesis: Forming an investment thesis means building likely scenario in your
head. A useful filter for assessing potential investment opportunities is the Three P’s: Potential,
Probability and Period. (1) Total Potential of this Company’s Success: Is this a billion dollar IPO
opportunity or is it more likely to be acquired for under $50M? Or something in between? (2) Overall
Probability of Success: Are there a limited number of risks that can be mitigated or are we buying a
lottery ticket for Powerball? (3) Likely Period Until Pay-out: Will it take 10 years to complete the product
and get FDA approval, or could this company be acquired in the first couple years by a big competitor?

Acknowledge “What Needs to Be Believed” to Invest: Once we have a handle on the key risks, and
built an investment thesis, we need to synthesize them into a company hypothesis. The best way to keep
yourself honest when doing this is to actually list “what needs to be believed” for the investment to make
sense. Thus, when we get to the final stage of our due diligence effort, and we write up our very brief
report, we make sure we know and prominently document right at the beginning “What Needs to Be
Believed” or WNTBB. If an investor just cannot get comfortable that something on the WNTTB will come
true, then maybe this deal is not for them. The core of the WNTBB exercise is really a test to make sure
we are not fooling ourselves. It forces us to ask: Have we identified the key risks? Do we understand the
premise of the deal (i.e. the investment thesis)? Is there a balanced logic to the deal?

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 Main Areas of Focus in Due Diligence

Team: Are they an “A” team or a “B” team?

Product: Are they selling a “Need to Have” or a “Nice to Have”?
Market: Is the market big enough?

No plan survives contact with the enemy. A great team can assess,
learn and adapt quickly to survive and thrive. A good CEO pivots… a
great CEO pivots in a capital efficient way.

The Importance of Due Diligence in Angel Investing

Team is by far the biggest focal point of my inquiry. Other factors are important, but none has the
make-or-break importance of questions around team quality. The issue comes down to a simple
realization that an “A team” with a “B plan” will outperform a B team with an A plan every time. Rising
market “tides” do help all boats, but not enough to save boats with holes in them or boats with no
captain. How do A teams do it? An A team is reading the market all the time. They can tell that it’s not
coming together. They pivot before they’ve gotten themselves into such a capitalization hole that there’s
no way the company can ever perform for investors. A good CEO will pivot, but a great CEO will pivot in
a capital-efficient way. She will recognize that the data and the progress are just not there and start to
move early and decisively before the company has raised and spent so much money that the cap table is
just irretrievably screwed up. That takes vision, courage, humility, communication skills, analytical skills,
listening skills, business management savvy, leadership skills, tenacity in the face of disappointment, and
grit and determination. Plus maybe a sense of humor and some healthy perspective. These are the the
things you are looking for. Team chemistry and dynamics are also key - a group of high functioning
individuals is different from a high-functioning team.

Secondarily, I focus on market size and segmentation with a particular attention to the number of
potential customers for whom the company’s solution is a top pain point and a top buying priority. Too
many diligence efforts stop at “yup, I am satisfied that there are lots of people out there who would buy
this.” The question is, where does it lie in their priority list? Are there enough of them who view it as a
“need to have” rather than a “nice to have” that reasonable market share represents a big market?

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 Why Do We Do It?
A well executed diligence effort increases angel investment returns

Median: 20 hours

Avg: 26% involved more than 40 hours

Overall Multiple for High Diligence 5.9X (4.1 years)

Overall Multiple for Low Diligence 1.1X (3.4 years)

Mistakes are unavoidable, but racking up easily avoidable mistakes

will hurt your overall returns.

Returns to Angel Investors in Groups (Robert Wiltbank and Warren Boeker)

This study is based on the largest data set of accredited angel investors collected to date, with
information on exits from 539 angels. These investors have experienced 1,137 "exits" (acquisitions or
Initial Public Offerings that provided positive returns or firm closures that led to negative returns) from
their venture investments during the last two decades, with most exits occurring since 2004. Analysis of
the data revealed important details of the investment outcomes for angel investors connected to angel
organizations. To assess the role of due diligence, each respondent in a survey was asked how many
hours of due diligence he or she performed for each investment. Angel investors reported the median
length of due diligence prior to investing was twenty hours. Enough investors went far beyond the
median that the mean (average) length of due diligence was sixty hours per investment. For comparison,
formal venture capitalists may spend several months on due diligence, though the actual number of
hours spent working on diligence for a single venture investment is less clear. It is worth noting that
length of time may not be the only important factor in due diligence; future research may explore
methods to assess the quality of due diligence rather than just the quantity.

Spending time on due diligence is significantly related to better outcomes. Simply splitting the sample
between investors who spent less than the median twenty hours of due diligence and investors who
spent more shows an overall multiple difference of 5.9X for those with high due diligence compared to
only 1.1X for those with low due diligence. Sixty-five percent of the exits with below-median due diligence
reported less than 1X returns, compared to 45 percent for the above-median group. The differences
become more stark when comparing the top and bottom quartiles of time dedicated to due diligence. The
exits where investors spent more than 40 hours doing due diligence (the top quartile) experienced a 7.1X
multiple.

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 10 Key Risks in Early Stage Investing

Risk is an inherent part, and necessary ingredient in all successful

companies
The question is whether you understand the risks the company is
taking, and have strategies to mitigate them

Without risk there can be no reward.

Key Risks in Early Stage Investing

Risk is impossible to avoid in business - it is an inherent part, and necessary ingredient, in all successful
undertakings. You shouldn’t be afraid of risk and allow it to turn you away from great investment
opportunities. Instead, you should focus on understanding what critical risks are involved with an early
stage company and the degree to which they have been mitigated with resources, smart planning and
preparation. Understanding the adequacy of these plans is an important skill to develop for all investors.
Risk is not bad; a lack of strategy for dealing with risk is. Remember, without risk, there won’t be a great
reward!

You are looking for companies who are going to challenge incumbents, shake things up and overcome
inertia, but in a clever and calculated way.

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 Team Risk

Conduct a thorough leadership assessment

● Review resumes
● Perform provided and “blind” reference checks
● Spend one-on-one time with the CEO
Look for people with integrity, tenacity, book learning and street
smarts

I’d rather invest in an A team with a B plan, than a B team with an A

plan.

Key Risks in Early Stage Investing

Assuming we are not talking about a team that is incomplete, totally lacking in skills, or has terrible
chemistry - you would give a quick “no” in those situations - most team risk comes from the personality,
temperament and character of the individuals themselves. A high functioning team is more than a group
of high functioning individuals, but you need to start with high functioning individuals as building blocks.
You are looking for people with integrity, tenacity and both book learning and street smarts. And having
a CEO with leadership charisma is also crucial. We talk in more detail about these themes in the team
discussion, but suffice it to say, if you are alert, you can generally tell when you are in the presence of
teams that are not working or are composed of lackluster individuals. Remember, during diligence you
are in the honeymoon period - everyone is on their best behavior. If you see even the slightest hint of an
issue, it is best to dig in a little further and get to the bottom of it. If there is trouble at this stage, it will get
far worse when the stress and pressure of operating a start-up mounts.

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 Technical Risk

Does the widget exist yet? If not, is there a chance that it may be
impossible to build?
Customer benefits matter. Benefits should approach a 10x
improvement for the typical user.

A company that can hold their own in a detailed product roadmap

review has a lot less technical risk than one that can’t.

Key Risks in Early Stage Investing

When we talk about technical risk, we are asking “Does the widget exist yet, and if not, is there any
chance that it might not be possible to build?” If a software product is in customer hands, even at a V1.0
level, the technical risk is low - it clearly can be built. If you are trying to build a silicon chip that needs to
attain very stringent cost and performance benchmarks, or you are trying to get engineered microbes to
create a substance at commercially feasible concentrations, and you have not achieved either, then
technical risk is high. Technical risk really boils down to a question of whether you have a competitive
offering built, or whether you are still trying to build it.

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 Market Adoption Risk

Ask customers and prospects the following...

● What problem does this product solve for you?
● Where does solving this problem fall on your priority list?
● Is your company generally an early adopter or late adopter?
Look for genuine demand or “pull” from a large enough segment of
customers

If you build it, will they come?

Key Risks in Early Stage Investing

Market risk is also called “market adoption risk” - it is the risk that customers will not want the product.
Will the dogs eat the dogfood? Market risk is easy to begin to probe at - get some demos of the product
into customers’ hands - but extremely difficult to accurately assess. For example, if you survey a bunch
of customers about something innovative and relevant to them, of course they are all going to say they
want it. But…

● At what price?
● At what cost of sales?
● At what level of buying priority?

Market risk is about trying to assess whether there is going to be genuine demand or “pull” from a large
enough segment of customers at a reasonable price, with an acceptable cost and length of sales cycle.
It’s a lot harder than one initially thinks. Many investors have been burned by failing to recognize “false
traction” at the beta customer stage. Market risk and market size are closely related - as you go up in
customer buying priorities, you generally go down in market size - since more people feel a problem
generally than acutely.

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 Future Financing Risk

Know the macro market for financing

Know the benchmarks applied by those providing future capital
Look beyond the current round of financing, and ask the following:
● How much additional financing will the company need?
● Where will that money come from?
● Will it be available on reasonable terms?
● Who are the right investors for the company going forward?

Build a reasonable plan with the current financing round that allows
some room for error.

Key Risks in Early Stage Investing

Financing risk is about future financing needs. We can take care of the immediate financing needed to
get to the next few key milestones, and likely the next financing round as well, but …

● How much additional financing will the company likely need?

● Where will that money come from?
● Will it be available on reasonable terms once the company has used up the current round?
● Who are the right investors for this company going forward?
● What will the market be like for financing in 18 months? 36 months?

These are issues we discuss when we talk about financing risk. And the only way to really address it is to
know the macro market for financing and the benchmarks applied by those likely to be providing the
capital. Then you can build a reasonable plan with the current financing round that has some room for
error to get the company to relevant benchmarks for the next round.

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 Regulatory Risk

Are there any necessary permissions (e.g. FDA approval) to operate

this business?
Not all regulatory situations introduce risk - sometimes they provide
tailwinds; new rules may hasten adoption of a company’s solution.

Regulatory approvals take time and money. Understand what is

involved and watch for possible changes in the regulatory
environment.

Key Risks in Early Stage Investing

Not all regulatory situations introduce risk - sometimes they can provide tailwinds; new rules may hasten
adoption of a company’s solution. But more often they are a form of permission you need to obtain, such
as FDA-clearance or other certified vendor or standards-compliant status. These necessary permissions
take time and cost money. And they pose the risk that the permission will not be forthcoming. Sometimes
they come not from regulatory bodies, but out of the blue from Attorneys General, such as in the case of
grey area undertakings like the Fantasy Sports sites, DraftKings and FanDuel. Understanding what is
involved to successfully receive regulatory approval or avoid enforcement scrutiny is critical to
understanding the regulatory risk. And then there is always the risk that the regulatory environment might
change suddenly and unpredictably in an adverse manner, so it is important to understand the landscape
of possible changes.

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 Competitive Risk

Understand the company’s relative attractiveness alongside their

competitors, and carve out a space with some enduring value
Competitors help educate the market, but they also
● Drive up the length of the sales cycle
● Undermine pricing power and compress margins
● Drive additional spend on R&D

Show me an entrepreneur with no competition and I will show you an

entrepreneur with no market.

Key Risks in Early Stage Investing

Competition is not a problem per se. A favorite joke of mine is “show me an entrepreneur with no
competition and I will show you an entrepreneur with no market.” Competitors can help legitimize a
product category, bring press coverage and help defray the cost of educating customers. But competitors
do affect your business: (1) They can drive up the length of the sales cycle by introducing fear,
uncertainty and doubt in the minds of customers with future product announcements. (2) They can drive
up the cost of sales by creating a lot of noise and counter-selling you have to overcome to be heard. (3)
They can undermine pricing power and compress margins. (4) They can drive you to have to spend more
on R&D to stay competitive. (5) And, even competitors with a worse solution but access to capital can
use brute force marketing and selling techniques to take your market share by sheer effort and saturation
techniques.

Understanding competitive risks is about understanding the relative attractiveness, both current and
projected into the future, of your company’s offering, and understanding who the other players are - both
now and in the near future. Other things to consider include: (1) Are the competitors all similar-sized
peers looking to co-exist in a market large enough for all? (2) Or, are they deep pocketed giants who feel
that domination of the market is strategically important and will give away a product if they need to? (3)
Are there big players in adjacent spaces who could easily jump over into your space once it is validated
as an attractive market? At the end of the day, you want enough running room that you can grow faster
than the market and get enough of a strategic toehold. You are trying to carve out space with some
enduring value.

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 Intellectual Property Risk

A lack of awareness and sophistication about IP can be an important

risk factor in diligence
Defensive analysis: Are they free to operate without infringing on
someone’s IP?
Offensive analysis: Can they build IP to protect their space and block
competitors?

Can the company develop patents as counter-claims or trading cards in

case of an attack on the company?

Key Risks in Early Stage Investing

There are two aspects to the IP analysis. The first is a basic defensive analysis: is there some white
space here amongst everyone else’s claims? Are we free to even operate at all without infringing
someone’s intellectual property? The second is offensive: can we build some IP that allows us to protect
our space and block others from competing using our methods? A third aspect to consider with patents,
particularly in crowded spaces, is whether a company can develop some patents that can be used as
trading cards or counter-claims in case someone tries to attack the company.

Beyond the basic strategic offensive and defensive questions, you also need to do a tactical review to
make sure the company is using 3rd party IP such as open source software and other licensed tools
correctly, is perfecting ownership in employee-created innovations, and has proper controls to protect
confidentiality - of the company’s information as well as information entrusted to it by partners. A lack of
awareness and sophistication about IP can be an important risk factor in diligence.

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 Legal Risk

What legal issues might be critical for this early stage company?
● Capitalization & Ownership
● Intellectual Property
● Regulatory Compliance
● Third Party Contracts
● Employment Matters

Does the company have its house in order? Is there enough attention
being paid to important details?

Legal Issues for Startups

IP: Verifying IP ownership is critical. Make sure the company has secured appropriate assignment of
invention and NDAs with all past and present founders, employees, consultants or otherwise. If using IP
from a third party (e.g. a university) ensure company has sufficient rights (incl. duration). Understand the
economics of any licenses as well. And finally, make sure the company has freedom to operate relative
to patents belonging to third parties.

Corporate Capitalization: Document each component of the cap structure, including prior financings,
the vesting of employee equity, and the history behind stock to non-founders. A cap table provides a
strong “fossil record” as to the prior financing history, potential issues with legacy founders or promisees,
and the current incentive structure.

Third Party Contracts: Review any exclusive or restrictive contracts. Early stage companies sometimes
do desperate/foolish things to secure revenue. Look for provisions that: (1) grant third-parties exclusive
rights with respect to technology (2) divest from the company rights around a particular field of use (3)
limit the territory in which a company can compete.

Employee Agreements: Verify that key employee agrs and at least barebones policies and procedures
are in place. Watch out for promises of deferred salary and bonus to severance agreements to purported
grants of equity. Often, in courting prospective employees, a naïve company will make informal promises
to individuals that can form the basis for real lawsuits in the future.

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 Alignment Risk

How do you make sure the goals of investors and company founders
are in alignment on the following key issues?
● Long term objectives
● Use of funds
● Long term financing path
● Exit assumptions and strategy

Is everyone singing from the same page of the hymnal?

Verifying Goal Alignment

Long term objectives: You need to discuss and confirm agreement on what you are building. Keep in
mind, goal alignment is not a “set it and forget it” proposition. Your goals may be in sync at the time you
first invest, but you will need to check in on a regular basis to ensure they stay in alignment.

Use of funds: Where and how fast the company is planning to spend the cash we are investing? Are
we in alignment on issues such as compensation for the management team, key initial hires and
marketing spend? Do we agree on what we need to learn about product / market fit before we pour on
the gas? Is there a consensus about how many new markets we will enter simultaneously?
Management compensation is often the most difficult financial/spending conversation you will have with a
CEO. Just because they have foregone salary for a while, or used to make a lot in a corporate job, does
not mean they can draw a big salary out of a lightly capitalized startup.

Long range financing plans: Key diligence questions: (1) What is the Financing Risk: What is the
timeline to growth funded by cashflow? Does the company need to raise capital from bigger investors
down the road? If so, how likely is it for the company to attract these investors? (2) What are the
Expected Returns: How will the dilution created by any future rounds of financing affect the returns of
the early stage investor? Capital efficient businesses tend to have a greater variety of exit options,
including some with faster times to exit. Work with the founders to develop a realistic long term funding
plan (or plans) that will lead to a profitable exit for investors & founders. Make sure the investors and the
CEO agree on the point at which the decision will be made to switch plans and understand the risks and
rewards for each strategy.

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 Exit Risk

Exit Strategies
● What are the exit opportunities for the company?
● Who will buy this company?
● When will they buy them?
● What will they value them for?

Equity investment is a loan the ultimate buyer of the company is

expected to pay back.

Building an Exit Strategy

Exit strategies need to be discussed with the founders early on. Do they want to flip the company in a
few years or are they building a big business? And, make sure they are not looking for a lifestyle
business! Starting the exit strategy discussion early on is an important part of setting up the company
(and investors) for success. Startups rarely survive without being a part of a larger ecosystem and it’s
this ecosystem that plays the central role in an exit. What are some goal alignment disasters leading to
disappointment for early stage investors? The biggie? Not making money on your investment!

When you decide to invest in an early stage company, you are primarily investing because you believe
you will make a good financial return on your investment. In most cases, when a company makes an
acquisition, it’s because they believe it will produce a good financial return for their business. There are
numerous scenarios where a large company makes an acquisition, but the following 5 cases are the
ones that create the most value for the acquirer.

● A new product that complements a fast growing product line of a large company
● A disruptive product that has the potential to damage a larger company’s market position or
become difficult to “sell around”
● A new product that fills a newly emerging gap in a big company’s product line
● A new product with strategic patents that a buyer cannot risk having fall into a competitor’s
hands
● A new product that is clearly constrained by lack of sales and would be instantly accretive
and profitable in the hands of a larger sales force.

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 Develop the Investment Thesis

Potential - How big is the potential theoretical opportunity?

Probability - How likely is the company to achieve breakthrough
success?
Period - How long are you going to have to wait?

All things being equal, we want companies most likely to be the biggest
in the shortest amount of time.

How to Apply the 3 Ps to Selecting Angel Investments When you are forming an investment thesis, you
are building a likely scenario in your head. The Three P’s can provide a useful framework: Potential,
Probability and Period.

POTENTIAL: Start with an awareness of the strategic buyers; ever-changing competitive landscape and
the overall market of buyers of comparable companies. What is hot right now? What is cooling down?
Where are big competitors likely to feel threatened and decide to make a defensive acquisition? If this
company scales and succeeds, who will it be stealing sales from (i.e. “if my company wins, who loses or
is inconvenienced or annoyed?”) Look for strategic buyers motivated to buy the entire company; perhaps
for its strategic position, the threat it represents, the great brand it has built, or the number of customers
or eyeballs. Deals where a strategic buyer is looking for just for a single product, technology, feature or
some engineers will yield much less for investors.

PROBABILITY: In some ways it is easier to start by evaluating likelihood of failure. You can recognize
certain problematic patterns and evaluate what they mean. If that meltdown risk feels pretty low, or there
are some “soft failure” modes where you could recoup your money and maybe a small return, that can be
some comfort. Turning to the success side, you can look at the diligence, gauge the customer buying
priorities and resulting market size, and try to construct a mental map of a couple pathways to success.
In doing so it is essential to evaluate the assumptions you are making. If the only maps you can build
describe really winding routes and assume many things that just are not likely to occur, you are probably
rationalizing the investment and need to be honest with yourself about the low probability. You might still
choose to invest if the potential is high enough but you need to be honest with yourself about the lower
probability of success.

PERIOD: The analysis starts with who the likely buyers might be a few years out. What are the required
milestones before those buyers are even interested? How long is it going to take this company to
achieve those milestones? It always takes longer and costs more, so you should also circle back and
look at the assumptions of what it is going to take and what resources are assumed in reaching those
milestones. Make sure those resources will not only be available but the ultimate buyer will pay enough
to deliver a good multiple on the consumed resources.

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 Acknowledge “What Needs to Be Believed”

Core of this exercise is a test… we must ask ourselves:

● Have we identified the key risks?
● Do we understand the premise of the deal (i.e. the investment
thesis)?

Are we fooling ourselves, or is there some kind of balanced logic to this

deal?

An Investor’s Guide to Due Diligence in Early Stage Companies

Acknowledge “What Needs to Be Believed” to Invest: Once we have a handle on the key risks, and
we have built an investment thesis, we need to synthesize them into a workable company hypothesis.
The best way to keep yourself honest when doing this is to take the trouble to acknowledge and actually
list “what needs to be believed” for the investment to make sense. Thus, when we get to the final stage of
our due diligence effort, and we write up our very brief report, we make sure we know and prominently
document right at the beginning “What Needs to Be Believed” or WNTBB. If an investor just cannot get
comfortable that something on the WNTTB will come true, then maybe this deal is not for them.

24
 Learning the Hard Way

A handful of avoidable due diligence mistakes

● Team: Confusing likability or prior accomplishments with the
competence needed to pull off the current task
● Market: Confusing early adopter excitement with true market
pull
● Timing: Is this the right time for this idea?
● Product: Incomplete understanding of the dynamics in the
target market

Experience is what you get when you don’t get what you want.

Due Diligence Mistakes

Confusing likability or prior accomplishments on the part of an entrepreneur with the competence
needed to pull off the current task. Great guys or great gals who have accomplished good things in their
prior career endeavors, may be completely over their heads and unable to adapt when driving a new
opportunity. Think hard about what skills the opportunity will require, and make sure the entrepreneur
has, or is willing and able to get, those skills.

Confusing early adopter excitement with true market pull. “Anybody can get the first 10% of a
market.” You need a big enough market of willing buyers who can be accessed affordably (relative to
their LTV). The true market is limited customers for whom the purchase is a top pain point/top buying
priority. Marginal improvement on a marginal cost is not enough in any but the earliest of adopters.
Recognize when you are looking at false traction and do some further digging.

“Is this the right time for this idea?” Dependence on key enabling technologies that do not exist, cost
structures which cannot be achieved, or buyer awareness that is not there are a sure path to failure.
Make sure that the CEO understands what the whole product solution needs to look like and has a
credible plan to deliver it.

An incomplete understanding of the dynamics in your target market. Many companies solve real
problems that unfortunately are not high on the buyer’s priority list. In other words, the company is selling
aspirin or jewelery, not oxygen. Make sure the focus is on one of the top 2 or 3 problems that the target
customer has.

25
EVALUATING INVESTMENT
OPPORTUNITIES
Appendix

26
 Resources - Due
Diligence Checklist

Designed as a quick reference guide to help steer you

through the various aspects of diligence. This due
diligence checklist covers key items such as:

● Information and documents you need to

request from the company
● Tasks your due diligence team needs to
perform
● Questions you need to ask of management,
customers, references and partners

Download
Checklist
bit.ly/Due_Diligence_Checklist

We have written quite a bit about the importance of thorough diligence and a professional and efficient
overall diligence process. A key element is having a good diligence checklist. Here is the Due Diligence
Checklist we use and recommend. This checklist was developed after many years of investing at
Launchpad Venture Group. Working closely with one of our best deal leads, Gail Greenwald, we put
together this checklist to help guide our internal due diligence process.
 Resources - Due Diligence
Report Template

The due diligence report template is focused on 11

major topics that should be researched and
understood when performing due diligence on an
early stage technology company.

For each topic, we provide you with an explanation of

the topic as well as example questions that may make
sense to discuss in the remarks column.

Download
Report Template
bit.ly/DueDiligenceReportTemplate

This report template is very structured in a three column format. That might feel limiting at first to the
uninitiated, but it is deliberately designed as a table to force the authors to be concise. Experience
conducting hundreds of diligence projects and leading dozens and dozens of syndications has taught us
that it’s important to be succinct in your diligence summary. Otherwise, you will end up with a long report
that investors won’t read through, thus defeating the purpose of the report. If you have important detail or
documents that you feel must be included in your findings, you can make them into appendices and refer
to them in the report, but it can be a slippery slope toward an excessively long package. A better
approach is to keep primary research materials and memos in a cloud folder and make the folder
available to the minority of investors who want more detail.
 Resources - Management
Team Assessment

Questionnaire designed to help guide you through

your team reference checks

Focus on questions related to the CEO’s:

● Strengths and Weaknesses

● Communications Skills
● Coachability
● Stability
● Domain Expertise
● Complementary Skills on Management
Team

Download
Questionnaire
bit.ly/ManagementQuestionnaire

During the due diligence process, personal reference checks are a critical step to help prospective
investors learn more about a CEO and his/her team. Some of the references will be from contacts that
the team provides to you. Other contacts should be “blind” reference checks with people in your network
that know the team. This type of background information is useful if you ask the right questions. At
Launchpad, we have a well-defined set of questions we use for our interviews. It makes a handy
guideline you can use when calling the references; feel free to share it with your due diligence
colleagues.

These questions help us uncover red flag issues that we need to keep an eye out for, and it helps us
apply resources to help the CEO be successful. This questionnaire is designed to get the story behind
the CEO and his/her team. If you are able to make enough reference calls, you should be able to find
similarities and differences to help you paint a pretty good picture of the team you are investing in.
 Resources - CEO
Performance Review

Questionnaire designed to facilitate the CEO’s annual

performance review

This best practice is one of the corporate board’s

most important responsibilities

● Helps build alignment between board

members and the CEO
● Improves Board/CEO communications
● Facilitates the future growth and success
of the CEO

Download
Performance Review
bit.ly/CEOPerformanceReview

CEO Performance Review

One of the best ways to facilitate the CEO’s future growth and success is by providing her with an annual
review detailing how she is doing in the job. It is the responsibility of the board to conduct this review
since the board is responsible for hiring and firing the CEO. A well done review offers tremendous value
to the CEO. It should highlight the CEO’s strengths and weaknesses as a leader and strategist.
Ultimately, a successful CEO will embrace the feedback, both positive and negative, and apply what she
learns to improve her overall performance.

All directors on a company board hold a fiduciary duty to the company. At the core of this duty is the
requirement that a director must exercise good business judgment in the guidance of the business. A
well thought-out performance review supports this duty in 3 very important ways:

1. Build alignment between board members and the CEO: Determine whether the board and
the CEO agree on the near and long term strategy for the business. Building a successful
company is hard enough without having the CEO and her board pulling in opposite directions
on fundamental topics!
2. Improve Board/CEO communications: Help expose situations where directors are frustrated
or concerned by the quality and frequency of communications between the CEO and the
directors. Better communications will result in better outcomes.
3. Develop the CEO: By outlining weaknesses in a CEO’s performance, the CEO can focus on
areas to improve in the coming year.
 Resources - Customer
Reference Checks

Questionnaire designed to help guide you through

product-related questions

Focus is on questions related to solving a customer’s

key problems:

● Problem Being Solved and Priority for

Solving
● Purchase Reasons and Goals
● Expected ROI and Value to the Customer
● Competitive Factors
● Impressions of the Company and Its
Product

Download
Questionnaire
bit.ly/CustomerReferenceChecks

Customer Reference Checks

During the due diligence process, you need to verify customer demand and assess the overall size of the
market opportunity. The best way to do this is by reaching out to current customers and prospects for the
company’s product. During our customer/prospect calls, we focus some of our initial questions on
understanding the customer’s key pain points and try to discern their buying priorities. At Launchpad, we
have a well-defined set of questions we use for our interviews. It makes a handy guideline you can use
when calling the references; feel free to share it with your due diligence colleagues.

At the core of this questionnaire are a series of questions that will help you distinguish whether the
company is selling aspirin, oxygen or jewelry. And, you can find out a bit more about the size of the
potential market opportunity.
 Continue Your Angel Education
and Improve Your Investing Skills

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investing decisions, minimizing risk and improving returns

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Diligence Diligence
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Books from Seraf

Fundamentals of Angel Investing

A Guide to the Principles, Skills and Concepts Every
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Valuation, Capitalization, Portfolio Construction
and Startup Economics

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Advanced Techniques in Deal Leadership and Due
Diligence for Early Stage Investors

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A Guide to Fund Formation and Management

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