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What is this “due diligence” thing anyway?

One of the least understood, yet most important, parts of the investment business is due diligence. Everybody has a different idea of what it is, why it exists, and how it should be conducted.

For many entrepreneurs and brokers, due diligence is the enemy. They fear due diligence will be used as an excuse to kill or renegotiate a deal. For lawyers, accountants, and many consultants, due diligence is manna from heaven. It’s the reason that they make most of their money.

For investors, the desire and need for due diligence is balanced by their fear of scaring away good deals if they develop a reputation for being too difficult. As someone who spent nearly 16 years as a professional investor for various institutions here are my notes on what I think due diligence is, is not, and should be:

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  1. Due diligence is a process by which investors of various types, including lenders, institutions, angels and fund managers, conduct a more thorough evaluation of a potential investment against what they expected it to be when they first screened it and decided it was worth pursuing in the first place. Due diligence basically is about verifying and checking what the investor initially thought about the investment. This review and analysis can include everything from background checks on management, an audit of financials, discussions with customers, market analysis, verification of intellectual property or other property rights, and review of proprietary technology, equipment, real estate or other valuable assets. Sometimes due diligence is very limited and can be concluded in a few days to a couple of weeks by one to a few people and costing a few thousand dollars. In other cases, depending on the size and complexity of the deal, it can take months and involve hundreds of people costing millions or even tens of millions of dollars.

    The scale and scope of due diligence is determined primarily by the size of the deal and if the investor is an institutional investor, lender, corporation, or individual. Generally, everything else being equal, individuals do the least due diligence because they don’t have a bureaucracy, they don’t want to spend as much money because it’s their money, and they feel more confident about what they’re doing. Due diligence by corporations, lenders, and other institutions is usually directly proportional to the size of the corporation, lender, or institution. Bigger organizations typically do more due diligence. This is not always true, but it is typical.

  2. Due diligence is typically not a scheme to renegotiate or kill a deal. Yes, it can be used in that way and unethical investors will use it for that purpose. This less than honest use of due diligence is more often true in industries that are more zero sum oriented such as real estate, finance and entertainment than in technology, for example. It may seem if you are trying to sell your business or your asset that due diligence by the investor or buyer is the enemy, but it shouldn’t be unless you have something to hide. The reality is that due diligence exists for a good reason. Many sellers of businesses and assets lie about things in order to get a higher value than they deserve to get from the investor or buyer. This is not just outright fraud, which is common but not nearly as widespread as simply wanting to put the best face on everything and not going out of their way to disclose things that might be viewed as negative. The bottom line is that investors who conduct serious due diligence typically make more money than investors who don’t. This is not always true. Sometimes you can make money just by gambling or closing your eyes and hoping for the best, but that doesn’t work over a long period of time and many investments. Similarly, you can do the best due diligence and still lose money. You cannot predict the future or understand every possible risk involved in an investment.
  3. Due diligence should be something that you, or your organization, do for yourselves. You should not rely on other people to do your due diligence for you. Having said that, one of the reasons people typically invest with people they know or famous people is because the involvement of those other people they know or admire makes them feel more comfortable and allows them to do less real due diligence. This is a big mistake. Yes, it is better to invest with people you know and better to invest with people who have been successful investors, founders, or managers in the past. No, that is not at all a substitute for doing your own due diligence on the investment. This is why the concept of crowd sourcing and crowd funding investments has major problems with it. It encourages a process of investing that already has a tendency to produce a herd mentality and a madness of crowds leading to mindless speculation with no due diligence and makes that process even more likely to be dysfunctional. It would seem like this would benefit company founders and only hurt the investors, but it actually hurts both sides. Instead of capital being allocated to the best fundamental investments, it gets allocated to the investments that seem “hot” or “popular.” It is investing on the basis of TV style ratings or American Idol style voting. This is historically a recipe for disaster in the investment business.

Remember that due diligence is absolutely critical to making any sound investment, it is not a trick or a game to renegotiate or kill a deal, and it should be something that you or your organization should do for yourselves rather than relying on the supposed wisdom of others to do it for you. CapLinked provides tools for networking, meeting investors, advisers, and companies, screening deals, conducting due diligence, closings, and reporting to investors and other stakeholders after the investment is made. Check us out and be careful out there. Investing in private companies is anything but safe or easy, but it can be very rewarding if done correctly.

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