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31-03-2017 - - 0 comments
Crowd-sourcing Due Diligence

It’s a puzzle.  Venture capitalists get very excited by innovation and disruption when it comes to companies we invest in, but there isn’t much innovation of our own business models.

Due diligence, the work we do to assess a prospective investment, is of critical importance to investors.  It has a direct bearing on the ultimate success or failure of an investment – unless, of course, you count “spray and pray” as an investment strategy.

A difficult question, particularly where amounts invested are relatively small or innovative technologies are involved, is how to conduct due diligence without loading up the prospective investee company, or the investors, or both, with costs out of all proportion to the amount being invested.

At Par Equity, our innovative step was to come up with a model that sees us crowd-source business skills from within our investor base.  The result is cost-effective assessment of the commercial aspects of potential investee companies by well-qualified individuals.

 

The Nature of Diligence

We divide due diligence into financial, legal, technical and commercial.

Early-stage companies are usually uncomplicated from a financial perspective, so financial diligence is often straightforward.  The typical problems that arise on the legal side are generally well-known and understood and usually capable of being resolved, one way or another.

Technical and commercial due diligence present greater challenges.

While the nature of technical due diligence varies from company to company, it typically involves understanding what the technology is for, how developed it is, what technical challenges remain in bringing it to market or refining it for broader distribution, how robust it is and, perhaps most importantly, how protectable it is (and what has been done to protect it).

Technology can also be assessed as part of the commercial diligence, if it forms part of or underpins the company’s key products or services.  Does the technology address a market need?  Is it readily consumable?  How is it implemented?  Technology aside, commercial diligence involves understanding a company’s business model and value proposition, its target markets, how the management team are going to access those target markets, and the competitive landscape they will face in doing so.  It’s also important to form a view on where the most likely routes to exit lie.  After all, a return on investment is the ultimate objective.

At its simplest, we need to answer not only the question of whether something can be done, but also why it should be done and whether it can be done profitably.

 

The Costs of Diligence

Robust assessment of a company can be a costly process, in terms of time and money.  Accountants and lawyers are plentiful and the work they do on due diligence is important but relatively routine, so the market for their services functions pretty well.  Technical and commercial diligence can involve much more specialist insight.

Internalising specialist skills and experience within the investment team builds costs that must be recovered through investment management fees and can result in a narrow investment focus.  Renting skills and experience as needed reduces the investment manager’s overheads, but there is still a cost to be borne, cash that would otherwise be used to build the company’s business.  It can also take a while to find reliable and effective experts.  Furthermore, consultants don’t have a financial interest in the investment out-turn, unlike the investment team, who stand to gain from performance fees or carried interest.

Finally, due diligence is a process that can leave management teams feeling bruised.  They may feel that they’ve been put to a lot of trouble answering sometimes dumb questions from people who they don’t necessarily see as having much relevant experience.  Entrepreneurs may see diligence as a necessary evil that’s worth enduring if there’s investment at the end of it, but they’re unlikely to relish the experience.

 

The Par Model

As founders with a range of business backgrounds, we took time to think about the strengths and weaknesses of the traditional venture capital model when we started Par Equity.  One way in which we decided to innovate was by involving business angels in our investment model.  We think business angels bring a lot of desirable qualities, not least understanding of businesses, sector experience, contacts, willingness to become involved operationally and, of course, investment appetite.  In short, they’re a force multiplier for the core investment team and really help with technical and commercial due diligence.

As we invest our EIS fund alongside, and on the same terms as, those investors, there is a clear benefit for investors in the fund.  Fund investors have the opportunity to build a portfolio of companies that have been assessed by domain experts as well as the core investment team, meaning that the fund benefits from a lot of high quality intellectual input from successful business people that’s effectively provided for free.

By involving investors in the diligence process, not only does the process benefit from the breadth of experience and insights they offer, we often find that entrepreneurs are happier.  They feel that they are dealing with people with credibility, often because they have been in their shoes.  The entrepreneurs are also investing in a relationship, as they are dealing with people who, if they invest, will continue to be on hand as the company grows.

The point about a long-term relationship is also important.  It’s the nature of growth companies that management teams are often over-stretched or overwhelmed, facing challenges they aren’t equipped to deal with.  Often, these challenges have been identified as risks on the way in and can be managed better as a result.

 

Of course, most venture capital firms have access to specialist expertise.  The crucial difference is that our investor network puts its money where its mouth is, investing in the companies that they think make the grade.  This means that our investors, whether active or not, benefit from the cumulative skills, experiences and contacts of successful business people helping evaluate investments and applying valuable commercial judgment to them, enhancing investment returns in the process.

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