Is Diligence Worth It?
How investing in diligence helps an angel investor make better decisions
I’m an Angel Investor. Is Diligence Really Worth It?
Yes. Here’s why.
The Observer Express
Don’t have time to read the entire post right now? No worries, here are the main points:
Most startups, even the ones that look most promising, fail or return close to nothing for their investors. My simplified personal estimates (based loosely on findings from this report) suggest 1% of typical angel deals will 20X, 7% will 10X, 40% will 1X, and 52% will return nothing.
Diligence helps us by rebalancing the probabilities for each individual investment as we uncover new information. It can make what initially appears to be a good deal look better or worse, depending on what is discovered.
Angels who split their investable capital into a portfolio of smaller checks often rely more heavily on network-provided diligence resources, so it’s essential for angel groups to provide some measure of support in this area despite being structured in a lean fashion.
Portfolio Theory
Let’s assume we have $100,000 in capital to deploy in angel investments this year.
We could invest it all in one deal, or we could split it across several deals.
Let’s consider each case.
One Shot
Assuming we want to write one check, what are the possible outcomes associated with our investment?
Most startups, even the ones that look most promising, fail or return close to nothing for their investors. A select few hit it big. So let’s assume that the best angel deals have a set of weighted outcomes looking something like this (source):
With a $100,000 investment into a single deal, this table indicates that the most likely outcome (90%) is that our investment returns equal to or less than our original investment. However, in the event that the deal is a winner, there’s a small (7%) chance we hit a 10X MOIC (Multiple On Invested Capital) and an even smaller chance (1%) we receive a 20X on our money.
The outliers are (obviously) what we’re aiming for with any angel investment, and are what drive the majority of the 30% expected return we’re seeing in this particular estimate.
Now let’s consider why due diligence is worth allocating some time and/or money to.
ROI of Diligence?
We only have $100,000 to work with. Therefore, with such a high likelihood (90%) of failure, we need to be very confident the investment we’re considering meets or exceeds our expectations for a winner. So let’s assume we decide to pay a diligence firm $1,000 to run a light analysis for us, plus we spend some of our own valuable time reviewing and digging a little deeper.
How does this help us?
It helps us by rebalancing the probabilities.
Here’s what I mean.
Rebalance
It’s very difficult, if not impossible, to un-invest in a private deal. Therefore it’s essential we have as much information as possible before investing.
By default, we consider the possible outcomes for any “strong” investment candidate based on the probabilities I showed above. Diligence, which is defined as “research and analysis of a company or organization done in preparation for a business transaction,” helps us refine those estimates further.
For example, consider the fictional startup “Rocketships, Inc.” Say I like the company, and think they’re a strong candidate aligning with my typical outcome expectations. However, after reviewing the background check results from the team diligence section, I realize the Rocketships founder has multiple hits for criminal activity within the last few years. Do my probabilities stay the same? No. I might adjust them to look something like this (note my investment has been reduced to $99K to account for the $1K I spent on the diligence report):
I still think it’s possible the deal could go to the moon, but clearly, I don’t feel as confident that this is as likely to occur as I would have otherwise. And the expected returns on the deal are now significantly lower, which suggests I may be better off passing on this one and saving my cash for the next deal.
Now, what if, on the flip side, I notice in the traction diligence that one of the company’s existing investors is an old friend of mine? A phone call and conversation with that friend is not going to make the decision for me. But, since I know and trust my friend’s process, I might adjust my estimates to look something like this:
In this case, I’m still fairly conservative with my projected outcomes, but the probability adjustments I made based on the new information I gathered do make the opportunity appear more compelling.
Now, does the same concept apply if I’m splitting my investment into multiple deals?
Yes, but the “Diligence” Needs to Look Different
Let’s assume we decide to split our investment across 10 companies. We approach each one with our “probability estimator”, which baselines a 30% expected return. We only complete this analysis for deals we’re seriously interested in, and we follow the same approach as just discussed for Rocketships, Inc. Although we can’t realistically afford to spend as much time or money evaluating each one as we could in the “one shot” case, we still perform some measure of diligence each time. Theoretically, we can apply our “total diligence allocation” divided by 10 to each of the 10 deals.
In most cases, angel groups will offer some level of diligence support or preliminary analysis that is shared with members, and this is often covered by a portion of membership dues (which I’ll discuss more in a moment). For now, let’s assume that $1,000 of our membership dues goes toward diligence of some kind. After a year we might end up something like this:
What do you notice? We passed on deal #4 because our diligence process revealed information that caused us to re-evaluate the expected return. As a result, we were able to get in on Company 11, which we otherwise would have missed.
When Being Lean Hurts
Most angel networks are intentionally designed to run very lean. The purpose of the network is to help members invest in promising startups, and the vast majority of member capital is set aside for this purpose.
However, most angel networks also charge a membership fee. This fee is typically in the range of $1,500 - $7,000 per year depending on a variety of factors and helps cover the operations of the network. These dues primarily go to supporting administrative work, covering event expenses, and other basic operational needs.
Here’s the problem.
As we just discussed, allocating some amount of resources toward diligence can help angel investors more accurately assess the risk of any investment. When writing large checks, investors can often afford to invest more heavily and do much of this work on their own.
However, when they take the “multi-deal approach”, investors tend to rely more on the network to help facilitate this diligence since they’re not investing as much time or capital into each deal (in our example, approximately 1/10 of the “one shot” investor). When networks focus too much on “running lean,” they can easily fall into the trap of failing to provide adequate diligence support. This leaves members in a tough situation where they’re forced to either rely on their gut or over-invest in their personal diligence processes despite the small check size.
Final Thoughts
Diligence is a high value activity, and allocating some portion of investable capital and time towards it enables better decision making and can dramatically improve an investor’s odds.
Early last year, I interviewed about a dozen angel investors. Through those conversations, I discovered that the typical investor is comfortable allocating between 3-5% of their investment towards “closing” costs, such as diligence, legal, and other fees. There are always exceptions, but if you or your members are consistently above or below this benchmark, it may be worth considering why.
What would happen if every angel group increased their membership dues by $1,000 per member and delivered far more robust diligence support services in exchange?
What do you think?
How does your angel group support members throughout the diligence process? Do you have any crazy stories about new information discovered that helped you close or kill a deal?
Weekly Observations: 3 Lessons Learned
When the team is aligned decisions get made fast.⚡
“What’s important to us? What is our strategy? What is our vision? Why are we here?” Keeping the answers to these questions front and center with the team is essential to allowing quick decision-making. This week our executive team held our quarterly meeting, and we spent some time re-aligning around our mission and objectives. Two days later a client raised a question that we would have normally spent hours debating. But since we had just taken the time to get aligned around our objectives, it was a clean and simple decision to make.
Money isn’t in the bank till it’s in the bank.🏦
This week I spoke with two founders who shared stories of investors who backed out at the last minute. They had, naturally, been *banking* on those financiers, and when the commitment dried up at the 11th hour, they both had to scramble to come up with a way to survive. It wasn’t pretty, and I was at a loss for how to help them. Lesson learned: always have a backup plan, especially when it comes to capitalizing your business.
Know your value.💵
This week I was asked to consider taking on a significant project pro bono. Since we’ve already pre-defined the market price for each of the subcomponents within the project, it was very simple for me to do some “napkin math” and communicate the immensity of what was being requested. That was very helpful for redirecting the conversation and driving home the value of our work.
Thanks for reading, have a great week.
-Andrew
If you enjoyed this post, please share it with a friend, colleague, or anyone else who may benefit.
P.S. - I recently finished creating The Angel Network Toolkit: 90 Resources for Cultivating a Thriving Community of Pre-Series B Investors, and I’m sharing it with anyone who refers a friend.
How did I do this week?
About Me
I cultivate flourishing.
I'm also the CEO of PitchFact, where we help angel networks conduct efficient and collaborative diligence. I'm a proud husband, aspiring father, and grateful friend. My love languages include brisket, bourbon, and espresso.