A great deal of investors tend to lose out on their investments, which begs the question: how many investors really do commit due diligence to their full capacity?
Due diligence, in the simplest of terms, is the process of gathering information and insights that allow us to make quality decisions. Outside venture capital, you can see due diligence as the same approach used in reading up reviews on a restaurant, checking recorded accidents on a used car, or even looking up the Facebook profile of someone you’re seeing for the first time.
Investing is no different. Plenty of due diligence is required for every deal. Performing due diligence is like peeling off layers to get to the heart of an informed decision. Some of those layers include analysing financial data, evaluating the management, comparing what the management promises and whether those targets are achieved or are close to fruition, and understanding the dynamics of the market in which the business operates.
The better the quality of due diligence performed, the higher the probabilities are of outsized returns. Without proper due diligence, investors can lose serious money.
The entire due diligence process can be quite long and poses hundreds of questions. Here, we’re going to point out some of the most basic questions that you need to address when performing due diligence.
Understand the market
You, as an investor, should have a firm understanding of the industry in which a business operates. Before digging into anything else, you need to know the size of the market and look over its competitive landscape. Focusing on these two will let you know what your potential investment is up against, and if it has what it takes to step up to competitors.
Ask the company’s team about their market research and probe into their findings. Additionally, besides reading into the materials you are provided with, spend extra time doing some additional market research on your own. This can be accomplished with an hour or two of going on the internet and looking for facts and figures to get a better understanding of the industry and its many ups and downs.
While you’re at it, look into how modern-day challenges – most recently, the Covid-19 pandemic, which has impacted businesses worldwide – might work to temper those rosy projections. Did the startup team account for such eventualities?
Align your goals with those of the founders
A high-quality business idea paired with an excellent management team is a dream combination for any investor. Get to know the founders and what motivates their product or service. Knowing what the company and its founders stand for, what change they want to make, and how they plan to make it, is crucial in determining if it’s an idea you can personally stand behind. Monetary returns should not be the only reason you’re making an investment.
You need to know how a potential investment fits with your broader personal goals. Perhaps you are investing because you want to help find a solution to climate change. Maybe you have a desire to mentor and help young entrepreneurs. Whatever your goals are, you need to ask questions to the founders to understand their vision and see how your goals fit with theirs. Only then will you realise your investment’s true potential.
Know your margin of safety
The margin of safety relates to how safe your capital is from permanent losses. This is the gap between the point in which a business’ sales decreases, and the point that it is deemed unprofitable.
Reflecting on the current Covid-19 situation, ask yourself these questions before investing: will the business be able to survive losses from a pandemic such as this? What about other unexpected events such as market crashes or natural disasters? You might want to give these factors some consideration.
The margin of safety is also the difference between the amount of expected profitability and the point of breakeven. To calculate the margin of safety, you need to divide current sales, minus the breakeven point, by current sales.
In investments, the margin of safety is the difference between the intrinsic value of a security against its prevailing market price. A business’ security, intrinsically, has ‘value.’ Although this intrinsic value is subjective, it can be quantifiable albeit through assumptions. Therefore, as an investor, you need to calculate this value and see how it pans out next to the security’s current fair market value to determine if making an investment is viable.
Investors need to know this margin of safety because fair value is difficult to accurately predict. Safety margins protect you from downturns in the market and serve as a safety net against errors in calculation with regards to the company’s initial valuation.
Valuations and a study of a company’s balance sheet are two ways you can build a margin of safety. If you are making your first investment and are unsure of determining a business’ margin of safety, consult a financial analyst in order to make a better-informed decision.
Draw up your exit strategy
Many beginner investors tend to overlook this, but knowing the exit strategy of a company, and figuring out how to exit an investment is a key part of the due diligence process. Nothing lasts forever, therefore you need to know exactly what to do once judgement day for your company comes.
An exit strategy is a conscious plan to liquidate an investment once certain profit objectives have been met and/or the business is or is soon-to-be deemed no longer profitable. Companies‘ exit strategies include initial public offerings (IPOs), acquisitions, or buy-outs. In the worst case of a failing company, an exit strategy may also include a strategic default or filing for bankruptcy.
An effective exit strategy will minimise losses for both you and the business owner. A particularly good exit strategy will allow you, the investor, to cash-out of an investment, reducing risk and ensuring a healthy exit should the company flop. Before making an investment, after studying your assets and liabilities, you have to set a point at which you want to sell for a loss, as well as a point at which you will sell for a gain.
Investments, especially in startup stage companies, can be risky. Putting in the time and doing your due diligence before putting money on the table significantly lowers risks and will lead to higher chances of success.
Given the recent worldwide quarantine situation, the next few weeks (if not months) will give you ample time to do your due diligence. In doing so, remember to study the market, fully understand the founders’ goals, calculate your margin of safety, and draw out an exit plan in order to secure your future and ensure a successful investment.