Editor’s note: This is the final installment of three articles by Kenneth Knoll on due diligence. Click here to read the first and second articles on the subject.
Optimism is the mantra of entrepreneurship. Founders often spend a lot more time thinking about what can go right than what can go wrong.
However, an interesting thing happens when successful entrepreneurs become angel investors and participate on due diligence teams.
They don’t necessarily shed that entrepreneurial bias for optimism, but they do become more focused on ferreting out pitfalls — probably because they’ve overcome or fallen prey to similar risks in the past.
This practical pessimism really comes into play during due diligence as interested angel investors look for reasons to not invest.
Entrepreneurs can help themselves through this process by thinking like an investor. If an investor has engaged in due diligence, they are already interested in deal. So, what are the red flags that would cause an angel NOT to invest in this company?
- Concerns about the entrepreneur’s ethics or character. There are the big things — prior bankruptcy, lawsuits, arrests or convictions. There are smaller things — receiving conflicting information or partial truths from the entrepreneur. Angels have high standards. They invest in the entrepreneur first and the business plan second. They have lots of opportunities. There is no reason to fall in with anyone who raises the slightest doubt.
- Non-coachable entrepreneur. Unless the angels knew an entrepreneur from previous ventures, due diligence is their first opportunity to assess the entrepreneur’s coachability. Angels invest in entrepreneurs who recognize they don’t have all the answers and are able to accept suggestions and feedback from others. Stubbornness, inflexibility, a hyper-active ego — any one of these will deep six the deal — as will a reluctance to hire people who can do what the entrepreneur admittedly can’t.
- Issues with licenses or intellectual property. It may be that the company has patent applications that aren’t yet approved or licensing agreements that aren’t yet finalized. IP rights may be rock solid or in dispute. Whatever the situation is, the entrepreneur must represent it as accurately as possible, recognizing that even when the investors like everything else about the deal, if the rights to the technology are cloudy, the deal may fall apart.
- Harmful pre-existing agreements. These may be with employees, vendors, partners or shareholders. For example, a cap table that has 50 friends and family members holding founders shares is too much trouble for most investors to want to deal with. An agreement granting exclusive distribution rights can be problematic.
- Insistence on non-disclosure agreements. Short and sweet. Investors don’t sign them.
- Entrepreneur’s unwillingness to get in the game financially. Investors look for entrepreneurs who put their own money in the deal first — or if they don’t have assets to invest, who accept below market salary. Investors don’t get excited about funding large near-term salaries. Foregoing a higher salary today better aligns with the mutual goal of long-term returns.
Each of these objections is within the entrepreneur’s power to improve or fix before the company reaches the due diligence phase.
When you follow the letter and intent of the law, be up front about weakness and risk, and remain open and honest in all dealings with investors, you make it harder for an investor to say no.
