Articles • 02 March 2020
In the world of private investments and startup investing, the role of due diligence is more important than ever.
Proper due diligence—the research process by which investors evaluate the suitability of an investment by thoroughly studying the data available to them—is the cornerstone of successful investing. This is even more so in the world of private investments and startup investing, where not only is there less publicly available information, but also fewer legal protections for the more sophisticated investor. Nowhere else does the principle of caveat emptor (buyer beware) apply more.
Yet, while the concept of due diligence is simple, its execution can be anything but. There are too many factors that could influence an investment’s outcome to account for—which is why venture capitalists make sure to spread their risk across different investments.
Nevertheless, there are accepted best practices to follow. And that’s what this guide is designed to teach: the core aspects investors should analyse when assessing any potential private investment, from financial statements and business models to market analyses and exit opportunities (particularly important in a world where companies are staying private for longer).
The First Stage of Due Diligence – Defining Investment Criteria
The startup investment universe is vast, and not all investors may be interested in its entirety—making defining investment criteria the first stage of any due diligence process. A few common ways to define investment criteria are:
- By fundraising stage
- By deal size
- By industry and sector
- By geographic region
Factors that can influence an individual’s chosen investment criteria would include their risk tolerance levels, financial goals, and sector familiarity or expertise. Fundnel enables accredited investors to select their preferred investment criteria upon signing up, with the most relevant deal opportunities highlighted for them.
The Second Stage of Due Diligence – Evaluating High-Level Opportunities
A good starting point to tackle the nitty-gritty work is understanding the ‘high-level opportunities’. What are some primary reasons that act as impetus, motivating one to make an investment? These ‘company highlights’ are not difficult to find—they are usually presented prominently in a company’s marketing materials.
Of course, that is far from an objective source, and at best, it represents the optimistic scenario. But it is a useful launch pad for deeper analysis. The job of the investor is then to do the necessary research to determine whether those primary reasons are plausible. In fact, given the higher-risk nature of startup investing, investors should actively seek rationale for why the provided reasons might not hold water.
At Fundnel, we do this on behalf of our investors by distilling the salient information of a company’s thesis in a summarised ‘Investment Highlights’ section. More importantly, having already taken important due diligence factors into account, we present an objective view of the company’s potential. This enables our investors to better gauge a company’s offerings at a glance.
The Two Main Components of Due Diligence
After investors define their investment criteria and understand a company’s fundraising requirements, the real due diligence work begins. The following sections will delve deeper into the two main components of due diligence analysis an investor should carry out prior to investing—sector-level and company-level analysis.
This is the ‘big picture’—the sector and industry a startup is operating in. The purpose is to assess the sector and industry’s potential and characteristics. When performing this analysis, here are some key points to investigate:
Drilling down to the specific industry
Each sector/industry has its own subparts. An investor needs to be clear about which specific subsector a company is really competing in. Take for example, the financial services industry. There are various niches within it: payments, lending, investments, insurance etc.
This is particularly important in startup investing, as startups will likely need to be able to gain traction in a specific subsector before being able to expand into the broader sector. Keep in mind also that many startups operate in even more narrowly defined niches. Consider ‘insurtech’—it does not compete with other fintech verticals (e.g. wealthtech, regtech) as it is just too niche a space.
Some startups may also be industry-definers, like Uber or Airbnb. Although they were part of the broader transportation and hospitality industries, they each carved out their own unique niches within the space with no established competition. This is sometimes called the ‘Blue Ocean Strategy’ (as opposed to competing in the ‘red ocean’), but even among startups, such companies can be difficult to find.
Evaluating market opportunity
Figures on the estimated size of an industry (and its projected growth rates) are not very hard to find. However, investors should be cautious of conflating market opportunity with the size of the overall industry, or even sub-industry.
To better assess actual market opportunity, investors should pay attention to three useful acronyms: TAM, SAM, and SOM.
- Total Available Market (TAM): The highest-level figure that will likely be the easiest to obtain. In general, this will be the estimated industry or sub-industry size figures
- Serviceable Available Market (SAM): A subset of TAM that describes the part of the total market that the company is targeting
- Serviceable Obtainable Market (SOM): Describes the subset of the SAM that the company can realistically capture. This is a more subjective figure, and the company and potential investors might arrive at different conclusions
Finally, growth rates must be considered in the context of the stated growth drivers as well. When looking at the reasons driving projected growth rate figures, investors should ask themselves whether such drivers can reasonably apply to the company they are evaluating.
At Fundnel, we save our investors time by providing relevant and concise data points on industry overviews, projected growth rates, and market opportunities for deals on our platform.
Assessing the competitive landscape
The level of competition is a huge factor in determining the chances of a startup’s success. Investors should look at the major players in the space and try to determine their market share. Research should also be done into any entrenched advantages such incumbents might have like network effects, relationships with suppliers, or brand recognition.
On a more micro-level, investors should also review how similar competitors’ products or services measure up to the company in question—aka substitution risk. At Fundnel, concise graphical summaries on the competitive landscape are provided for our investors to make quicker and more accurate assessments.
Examining the barriers to entry
A market’s barriers to entry largely influence the current and future competitive landscape. Common barriers to entry include regulations, patents, and capital requirements. On one hand, lower barriers to entry will make it easier for a startup to penetrate the market. On the other, it might also mean more intense competition in the future. Both perspectives should be considered when studying a market’s barriers to entry.
The Porter 5-Forces Model for Analysing the Competitive Environment
While not strictly necessary to the due diligence process, the Porter 5-Forces Model, developed by Harvard professor Michael Porter, is a useful analytical tool that investors can use to quickly gauge a company’s competitive position within a market. Porter believed that the following five forces are the fundamental determinants of a company’s competitive standing.
Investors should treat this model as a broad framework for analysing the ‘balance of power’ in a marketplace. It is not a checklist that can definitively determine a company’s suitability for investment. But by providing defined categories, investors can use the 5-Forces Model as a helpful base for carrying out their market-level analysis.
After performing due diligence on the broader marketplace, investors should then move on to the company. This is also the stage in the startup due diligence process that can be the most challenging due to a lack of information, which stems from three main factors:
- Private companies face far less reporting requirements compared to publicly listed ones
- Companies seeking private funding are typically newer, and thus have much less historical information that investors can base their analysis on
- In some cases, the companies seeking funding may be incentivised to provide overly optimistic projections to potential investors, necessitating a greater degree of scepticism
Company-level due diligence can be broken down into the following parts:
Investors should take particular care to ensure they fully understand the company’s business model. This is especially the case in the startup realm, where business models may be totally novel or are a highly innovative spin on an existing one. This has significant overlap with the previous market-level due diligence—failure to adequately comprehend a company’s business model will lead to a flawed market-level analysis.
A key point to look out for in this step is scalability—can the company’s business model achieve meaningful scale?
Beyond merely understanding the business model, the fundamental question investors must continuously ask themselves throughout the entire due diligence process is: does the company have the ability to execute upon its business model (and what factors may prevent it from being able to do so)? While this is obviously a very broad question, it is one that investors can use regardless of the type of company they are analysing.
Exit opportunities refer to the potential methods the investors in the company will be able to exit their investment and thus realise their paper gains. The most common exit opportunities are via mergers and acquisitions and initial public offerings (IPOs). Depending on the company, investors may also receive dividend distributions while awaiting such opportunities.
One way to gauge the probability for such exit opportunities is to look at the broader sector. Search for evidence of similar mergers, acquisitions, or IPOs in the sector and measure their incidence rate—the higher the better. At Fundnel, we research the number and details of previous exits and investments in the sector—also known as precedent transactions—and outline them to our investors for their easy perusal.
In light of the longer runway most companies require prior to a traditional exit (coupled with the trend of companies staying private for longer), we also offer existing private investors the option to partially or fully exit their investments even before such an event occurs. This is done through our secondary marketplace, which enables our investors to monetise their primary investments through our platform.
Company Finances and Projections
While historical financial statements are probably the main document investors use to judge companies in public markets, their utility is less pronounced in startup investing. This is not only because of their relative newness, but also because startups are more often than not loss-making in their nascent stages. Nonetheless, when reviewing a company’s financial statements, here’s a list of metrics investors should investigate (although keep in mind that some may not be as relevant to certain business models).
- The burn rate: The amount of money the startup is ‘burning’ through in a month to sustain its operations aka its negative cash flow. It can be divided into: (1) ‘gross burn’—total monthly operating expenses; and (2) ‘net burn’—total monthly net cash spent (includes cash inflows). The burn rate is a crucial figure because it determines how much ‘runway’ a startup has: the amount of time before it runs out of cash. This will help investors gauge the company’s sustainability and its need to raise future funding (which would result in a dilution of current investors’ holdings). The company’s cash flow statements should provide the necessary information to determine the burn rate.
- Revenue and revenue growth: Unless investors are coming in at the early angel/seed funding stage, companies, even if still loss-making, should have recorded revenues. Investors should study metrics such as: revenue growth rates, number of customers, and revenue per customer.
- Gross margins: Most startups are loss-making, meaning net margins are negative. But gross margins (gross profit/revenue) should still be positive and in line or better than peers. The higher the gross margins, the quicker a company will be able to reach its breakeven point and the faster it can generate free cash flow.
- Customer acquisition costs (CAC): Refers to the dollar cost amount needed to be spent to acquire a single customer. Another way of looking at it is the incremental revenue per marketing dollar spent. This cost needs to be compared with the estimated lifetime value per customer (LTV). In many cases, this cost often exceeds the initial revenue per customer in the earlier growth stages until some critical mass is achieved. However, customer LTV should still (eventually) significantly exceed CAC.
- Breakeven point: This is the point at which a company can actually generate net profits. This depends on the company’s cost structure (fixed and variable costs) and its gross margins. The general formula for calculating the breakeven point is Fixed Costs/(Unit Sales Price – Variable Cost Per Unit). Since one way for investors to get a return on their investment is from dividends (which necessitates profits), this is an important metric to calculate.
- Free cash flow generation: Free cash flow is the amount of cash a company can generate after accounting for both its operating expenses and its capital expenditures. It is the ‘free’ cash the company can either reinvest into the business or pay out as dividends—one of the methods by which investors get a return from their investments. Free cash flow figures are not typically reported in standard financial statements, but they can be calculated from figures that are.
- Debt obligations: Does the startup have any debt on its books? In the earlier stages of funding, the answer is likely to be no. However, investors looking to potentially invest in a company’s later funding rounds should be on the alert for such encumbrances. Excessive debt may negatively impact the company’s future cash flow as well as its ability to raise future funding.
Projections/Forecasts and Reality Testing Assumptions
Projections can almost always be structured in such a way to show favourable outcomes. Especially when investing in startups, investors should never take them at face value. Instead, they should dive deeper and explore the underlying assumptions that go into the projections to judge their soundness. Things like overly optimistic growth rates and customer acquisition numbers should alert investors to re-evaluate the value of the company’s projections.
A poorly managed company, despite a superior product or service, will struggle to go far. This is even more the case in startup investing, where product or service development is often still in the nascent stages and investors are typically buying into the company’s founders and management team’s ability to execute on the company’s vision.
Because the success of startups ride so heavily on the founders, in many cases—especially in earlier funding rounds—investors are largely investing on the strength of the founders alone.
The track records of the company’s founders should thus be closely scrutinised. Beyond what the company’s website states about its founders’ capabilities, here are some common sources investors can tap into to get a clearer picture about the founders’ (as well as its board of directors’ and advisors’) track records.
- The Referrer: The person or persons who recommended the deal to the investor. Investors should not hesitate in asking their referrers for more information regarding the viability of the opportunity. In Fundnel’s case, our Investments Development team is always on hand to field investor queries.
- LinkedIn: Chances are the company’s founders would have a LinkedIn presence. This is a good avenue by which to see which companies they have been involved in before, as well as their educational background, association memberships, and other achievements. LinkedIn’s mutual connections feature can also prove useful; investors may want to reach out to them to garner more information.
- Google: A simple Google search of the company’s founders can be very revealing. Google can be used to cross-reference information with that found on the founders’ LinkedIn profiles. Tip: take the time to look past the first two pages of search results, as this may yield lesser-known but even more helpful insights into the founders.
- Company Commissions/Registers: Investors can peruse official company registers to glean further information about the full list of company directors and their involvement in past companies. For instance, in Singapore, company accounts are filed at ACRA, while in the UK, they are filed at Companies House. It can be used as a cross-checking reference for information found via LinkedIn and Google, although it is certainly the most time-intensive method.
Much like the Porter’s 5-Forces Model described above a SWOT (Strengths, Weaknesses, Opportunities, and Threats) Analysis is a simple analytical matrix for better gauging the viability of a company’s business model.
Like the 5-Forces model, the SWOT matrix should be used as a broad framework instead of a definitive checklist. Here are a few examples of the strengths, weaknesses, threats, and opportunities a company might have.
- Strengths: intellectual property, industry knowledge, scale, brand power
- Weaknesses: lack of market share, low marketing budgets, negative publicity
- Opportunities: changing lifestyle and consumption patterns, new technologies
- Threats: high number of established competitors, regulatory changes
At Fundnel, we identify the potential risks of an investment (i.e. threats and weaknesses) upfront using our ‘risk matrix’. When assessing a deal, our investors will be able to not only see its key risks, but also the estimated probability of each one occurring, as well as their potential impacts.
How Fundnel Adds Value to the Due Diligence Process
Only select deals are listed on the Fundnel platform. We actively screen potential deals using our proprietary data-driven algorithm that amalgamates >1,500,000 data points across 50 parameters and sub-parameters per company to determine funding viability. In this manner, our investors are only presented with deals that are relevant to their investment mandate.
On top of that, we compile the results of our analysis into concise readable formats that help our investors make quicker and better investment decisions. Our Investments team clearly lays out the investment opportunity while listing the key points for the sector-level and company-level analysis. Investors can then conduct further due diligence as laid out in this guide, while using our summary analysis as their starting point.