Middle-of-the-Road
What is the Right Amount of Diligence for the Average Angel Investor?
Due diligence is hard work.
Everyone wants it done, yet very few (if they’re honest with themselves) enjoy doing it.*
It’s thrilling to meet high-energy, visionary founders. It’s exciting to learn about new technologies. It's intoxicating to consider “what if things go right”, and it's all too easy to become entranced by the idea of supporting the next big thing.
It is not so thrilling to ask tough questions. It’s hard work to dig beneath the thoughtfully constructed veneer produced by the passionate founder sitting across the table from you. Diligence takes effort, intentionality, and (most painfully) it takes time.
And yet diligence is one of the most critical parts of the angel investment process. A report published almost 15 years ago by Robert Wiltbank and Warren Boekr studied the performance of 539 angel investors. Guess what they found? “More hours of due diligence positively relates to greater returns.”
But, what exactly is due diligence? And what’s the point? How much diligence is necessary for the average angel?
Excellent questions. Let’s dive in.
*Note: there are those crazy people out there like us who actually love this stuff.
What the Heck is Due Diligence Anyway?
“Diligence” and “due diligence” are common words in the early-stage investing world. Yet they are rarely explained. It can seem as though they mean something different to everyone, so let’s take a moment to review the formal definitions according to Merriam-Webster:
Diligence: “steady, earnest, and energetic effort: devoted and painstaking work and application to accomplish an undertaking.”
Due Diligence (in the context of business): “research and analysis of a company or organization done in preparation for a business transaction (such as a corporate merger or purchase of securities).”
Ok, that’s the definition. But what’s the point?
In our view, the purpose of due diligence is to help prospective investors maximize confidence in their decision. Whether they choose to proceed or walk away, the point of all this “research and analysis” is to help a human being make a call. This is critical to keep in mind. It is easy to become distracted by the interesting discoveries uncovered along the way and to forget that the end goal is to decide.
Ok, so what does this mean for the average angel investor?
Tension. Endless tension.
Here’s what I mean.
Cost/Benefit Analysis
Benefit of Increased Diligence: I make better decisions. If I spend more time on diligence, I should (in theory) receive a larger return. I will be well-informed about each investment and can make better decisions as a result.
Cost of Increased Diligence: Opportunity cost. Massive opportunity cost. Every moment spent performing extra research is a moment NOT spent billing my services or performing my day job. It’s a moment NOT spent with my family, developing a skill, or enjoying a hobby that I love.
Investors are constantly forced to choose between spending their time diving deep to (hopefully) generate better returns or doing other stuff. In economic terms, the way each individual chooses to spend their time is driven by the concept of utility maximization which, according to the Corporate Finance Institute, is “…the concept that individuals and organizations seek to attain the highest level of satisfaction from their economic decisions.” When a decision involves a tradeoff, humans tend to go with whatever maximizes their personal satisfaction.
Ok, so what does that look like in the context of real-world angel investing?
Two Strategies: Big Shot and Hip Fire
In the real world, there are many types of angel investors, and each is suited to varying levels of diligence. To keep things simple, let’s consider two of the more common types: the “big shot”, and the “hip fire” investor.
The “big shot” investor intends to deploy a large check (large is very subjective, but for the sake of conversation let’s say large means more than $100,000) into very few companies each year – perhaps one or two. This investor is likely to spend more time “diligencing” each deal they seriously consider. Why? Because their risk is more concentrated with each investment.
In this case, the benefits of spending their time diving deep tend to outweigh the sacrifice required. Their utility is maximized by spending buckets of time evaluating each interesting deal. Though the investor is exposed to increased unsystematic risk by focusing their investments on a few companies, they are less exposed to the effects of information asymmetry (basically meaning they know a lot about each company).
In contrast, the “hip fire” investor’s strategy focuses on deploying many small checks (again, this is subjective, but for the sake of conversation let’s say around $5,000) each year to diversify their risk. This angel is far more likely to run with a simple, repeatable framework consistent with their investment thesis over time. They don't dive deep into every deal that hits their desk. Instead, this investor simply considers their basic criteria and invests if the deal checks all the boxes.
In this case, the benefits of spending time diving deep tend NOT to outweigh the sacrifice required. This investor’s utility is maximized by spending very little time evaluating each interesting deal. Though the investor is exposed to less unsystematic risk by spreading their investments across many companies, they are more exposed to the effects of information asymmetry (basically meaning they know relatively little about each company).
Ok, but… what if I’m somewhere in the middle?
You’re Normal
Good news: most angel investors (at least, the real live ones I’ve met) tend to land somewhere in the middle between these two strategies. Perhaps a bit of diversification is important to you, but you’d also like to plug a decent chunk into each investment, especially if you really believe in the founder, mission, market, etc. This is where things get tricky when it comes to diligence.
Middle-of-the-Road
So what’s the utility-maximizing amount of diligence for someone in the middle?
Great question.
It’s one that many angel networks struggle with since most angel investors with a blended strategy tend to benefit from membership in a group. While in theory, this allows members to lean on one another, distribute the load of diligence, and share expertise, there’s still one small problem.
Diligence takes time.
So networks rely on a blend of staff, student interns, and highly committed volunteer members (“super members”) to complete formal diligence efforts. This usually involves meeting(s) with the founders, researching various topics of interest, and drafting a formal diligence report or memo. This approach is “cheap” and provides a great opportunity for members to “get their hands dirty”. Yet I’ve seen that the process can drag on for 8 weeks, 12 weeks, 16 weeks, or more. Sometimes there’s not even a formal conclusion – engagement dies off and the founder is left wondering where they went wrong.
After meeting with dozens of angel network leaders, we’ve come to believe that the best way to serve middle-of-the-road angel investors and to enhance the founder experience is to deliver front-loaded diligence focused on the most important questions and to facilitate a clear structure that drives members towards an investment decision post-pitch. Too many deals die today because no one has time for due diligence. Members get distracted. Networks over-rely on students, volunteers, and support staff to complete mission-critical research. Everyone suffers as a result.
In contrast, the “front-loaded diligence” approach allows members to quickly digest key information that normally would only become available to them after entering the abyss of “formal diligence”. This reduces the amount of time that each individual needs to spend evaluating a deal while still achieving the same level of knowledge. It maximizes the value of pitch day since investors are armed with thorough research ahead of time and can dive deeper when the founder is in the same room. It allows post-pitch diligence to focus on the specific questions that remain, rather than a generalist review of the business.
Final Thoughts
Diligence is crucial to strong performance in angel investing, but the right amount is difficult to pinpoint. We believe that a tight, front-loaded diligence process allows middle-of-the-road investors to achieve the benefits of a robust research process without the need to devote excessive amounts of time to researching each deal. This approach benefits founders, investors, angel networks, and the entire ecosystem.
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.
About PitchFact
PitchFact helps angel networks conduct efficient and collaborative diligence.
Learn more at pitchfact.com.