Start Diligence

Essential Due Diligence Steps for Angel Investing

Dec 10, 2024

Want to make better startup investments? Start with due diligence. It's the process of analyzing a startup's team, market, finances, and legal standing before investing. Here's what you need to know:

Team Review: Evaluate the founders' track record, leadership, and team dynamics.
Market Analysis: Validate market size, growth potential, and competition.
Financial Check: Assess cash flow, revenue projections, and funding needs.
Legal Review: Inspect contracts, IP ownership, and compliance.
Leverage AI: Use tools to speed up analysis, flag risks, and validate data.

Investors should spend at least 40 hours per deal on due diligence to uncover risks and opportunities. This structured approach ensures informed decisions and better alignment with your goals.

Due Diligence for Angel Investors

Steps to Evaluate a Startup's Potential

When considering a startup for investment, angel investors should focus on three main areas that influence long-term success. Here's a closer look at each.

Reviewing the Founders and Team

The founding team plays a critical role in determining a startup's trajectory. Using the Berkus Method [*], investors can assess the following:

| Assessment Area | Key Elements |
| --- | --- |
| Leadership & Track Record | Experience with prior startups, industry knowledge, professional reputation |
| Team Structure | Core skills, clearly defined roles, and hiring plans |
| Cultural Fit | Team dynamics and shared values

AI tools like TRACT can simplify background checks by compiling information about founders' professional histories and identifying potential risks.

After evaluating the team, the next step is to dive into the startup's market prospects and competitive positioning.

Analyzing Market and Competition

Market analysis involves looking at both the current landscape and future growth possibilities. Key areas to focus on include:

Total Addressable Market (TAM): Verify the startup's market size claims through independent research. For instance, if a startup targets the global AI market, compare their projections with established market research data.

Once the market size is validated, assess the competitive environment. Look into competitors' market share, pricing models, and barriers to entry to understand how the startup is positioned.

Growth Opportunities: Seek evidence of market demand and scalability. This could involve examining:

Customer adoption rates and feedback
Emerging market trends and regulatory factors
Opportunities for geographic expansion
The product development roadmap

After understanding the market dynamics, attention shifts to the startup's financial health and growth potential.

Checking Financial Stability

Financial due diligence is essential to gauge both the startup's current standing and its future projections. The Angel Capital Association suggests focusing on [*]:

Current Financial Position:

Cash reserves and burn rate
Revenue growth, cost structure, and profit margins
Outstanding debts

Future Financial Planning:

Revenue forecasts and underlying assumptions
Cash flow projections
Capital needs for growth
Exit strategy and potential returns for investors

To analyze financials effectively, compare the startup's metrics with industry benchmarks. The First Chicago Method [*] is a useful framework, combining traditional discounted cash flow (DCF) analysis with scenario planning to evaluate various potential outcomes.

Using AI Tools for Better Due Diligence

How AI Helps with Financial and Risk Analysis

AI tools simplify due diligence by automating tasks like data collection and analysis, making decisions quicker and more informed. Platforms such as TRACT offer insights into a startup's potential by automating processes like data aggregation and risk evaluation.

| Analysis Type | AI Capabilities | Investor Benefits |
| --- | --- | --- |
| Financial Health | Real-time data collection and ratio analysis | Quickly spot financial warning signs |
| Market Analysis | Automated trend detection and competitor tracking | Validate market size with greater accuracy |
| Risk Assessment | Pattern recognition across large datasets | Identify potential problems early

This streamlined approach allows investors to review more opportunities without sacrificing thoroughness. Beyond financial metrics, AI also supports other key areas of due diligence, like legal checks and evaluating team dynamics.

AI Applications in Startup Assessments

Today's AI platforms bring specific features to enhance startup evaluations. For example, TRACT examines three key areas:

Legal and Compliance Checks: AI scans extensive legal records to flag issues like pending lawsuits, bankruptcy filings, or regulatory violations.

Team Background Analysis: AI validates employment history, credentials, industry connections, and past involvement in startups.

Market Intelligence: Advanced algorithms analyze market data to deliver:

Real-time insights into the competitive landscape
Customer sentiment analysis
Predictions for industry trends
Identification of growth opportunities

While AI speeds up the process, its findings are most effective when paired with traditional evaluation methods for a well-rounded analysis.

Legal and Compliance Checks

Reviewing Corporate Structure

A detailed look at a startup's corporate structure is a key part of legal due diligence. Here are some critical documents to examine:

| Document | Key Focus Areas |
| --- | --- |
| Articles of Incorporation | Verify legal establishment and operational scope |
| Shareholder Agreements | Check ownership details, voting rights, and control mechanisms |
| Board Minutes | Review governance practices and decision-making processes |
| Licenses | Ensure compliance with industry-specific regulations

When evaluating the board's composition, independent directors are worth noting. Their presence often signals stronger governance and impartial oversight.

AI tools like TRACT can simplify the process by analyzing governance documents efficiently and flagging risks. This ensures the startup is legally sound, minimizing potential investor risks.

Examining Contracts and Risks

Contract reviews should focus on these areas:

Supplier Agreements: Look at payment terms, exclusivity clauses, and termination rights. Identify any supply chain risks that could disrupt operations.
Customer Contracts: Check revenue recognition policies, service-level agreements, and liability limitations.
Employment Agreements: Confirm proper worker classifications, enforceability of non-compete clauses, and intellectual property assignments.
IP Protection: Assess the startup's intellectual property (patents, trademarks, trade secrets). Watch for disputes, unclear ownership, or missing documentation.

"The discovery of an intellectual property dispute during due diligence can significantly impact investment decisions. In such cases, investors may require the startup to obtain a legal opinion or negotiate a settlement. For instance, if a startup is found to be infringing on a competitor's patent, investors may require the startup to obtain a license or modify its product to avoid infringement." [*]

AI-powered tools can help flag ambiguous terms or missing clauses in contracts but should always be paired with expert legal review. This approach allows legal professionals to focus on high-priority risks.

Combining a strong legal review with financial and market assessments gives investors a clearer picture of a startup's potential.

Evaluating the Team Through Interviews

After addressing legal and compliance matters, the next step is assessing the startup's team. This group plays a key role in executing the business strategy and hitting financial targets.

Standardizing Interview Questions

Structured interviews are essential for evaluating the team effectively. Using a consistent framework ensures thoroughness and fairness. Here's an example:

| <strong>Assessment Area</strong> | <strong>Sample Questions & Insights</strong> |
| --- | --- |
| Vision & Strategy | <em>"What specific milestones do you aim to achieve in the next 18 months?"</em> - Reveals their roadmap and planning skills. |
| Problem-Solving | <em>"Describe a major business challenge you overcame."</em> - Shows their decision-making process and how they handle challenges. |
| Team Leadership | <em>"How do you handle disagreements within your team?"</em> - Offers insight into conflict resolution and emotional intelligence. |
| Market Understanding | <em>"What metrics convince you this market timing is right?"</em> - Highlights their market awareness and ability to back decisions with data

Stick to these core questions for all team members to spot any inconsistencies in vision or alignment.

Using Team Assessment Tools

Interviews are just one part of the process. Advanced tools like psychometric assessments provide additional insights into team dynamics, communication styles, and problem-solving abilities. These tools add measurable data to complement interview results.

When reviewing the team, pay attention to:

Skills and expertise that complement each other.
Potential collaboration challenges.
Gaps in critical areas.
Leadership potential and the ability to scale with the business.

"Due diligence is the practice by which each party of a transaction takes steps to confirm that all information disclosed by the other party is accurate." - StartUpNV, Investment Due Diligence [*]

Modern platforms can also verify claims made during interviews by cross-checking professional histories and legal records. This combined approach helps predict how well the team can handle pressure and grow alongside the business.

Summary and Next Steps for Investors

Recap of Key Steps

Conducting thorough due diligence involves a detailed review of potential investments, often taking investors at least 40 hours per deal [*]. This process blends traditional evaluation techniques with modern AI tools to focus on these crucial areas:

| Assessment Area | Key Considerations |
| --- | --- |
| Financial Analysis | Cash flow, revenue projections, burn rate |
| Team Evaluation | Leadership skills, track record, team alignment |
| Market Analysis | Market size, growth trends, competitive positioning |
| Legal Review | Compliance, intellectual property, contracts

These steps form the backbone of a structured approach to investment evaluation.

Due Diligence Checklist

Here’s a step-by-step guide to streamline your due diligence process:

Document Collection and Review
- Collect essential documents like financial statements, cap tables, and incorporation records.
- Analyze the business model and financial projections.
- Use AI tools to speed up document analysis and identify key insights.
Team Assessment
- Perform background checks using reliable tools.
- Conduct structured interviews with a consistent set of questions.
- Assess team dynamics and leadership effectiveness.
Market Validation
- Investigate market size and growth opportunities.
- Study the competitive landscape to understand positioning.
- Confirm customer demand and validate the revenue model.
Legal and Compliance Review
- Review the company's corporate structure and governance practices.
- Verify intellectual property ownership and protections.
- Ensure regulatory compliance and identify any liabilities.

Utilize AI tools and the evaluation techniques outlined earlier to ensure your due diligence is both comprehensive and efficient. This approach not only saves time but also helps uncover critical insights that could impact your investment decisions.

FAQs

How do you do a market analysis for a startup?

Market analysis is a structured way to evaluate opportunities, test assumptions, and identify risks. Here's a practical approach designed with angel investors in mind:

Define the Market Size
Start by estimating the total market size (Total Addressable Market or TAM). Then, narrow it down to the segment the startup can realistically capture (Serviceable Obtainable Market or SOM). AI tools can help by analyzing industry reports and automating these calculations.
Understand Market Dynamics

Look at growth trends, potential opportunities, and regulatory hurdles. Keep an eye on industry shifts and barriers. AI tools can also assist by providing real-time insights into competitor pricing and market changes.
Validate Customer Demand

Gather insights through customer interviews, surveys, and behavior analysis. AI tools can process large volumes of customer feedback, making it easier to spot patterns and priorities.
Analyze the Competition

Identify both direct and indirect competitors. Assess barriers to entry and monitor competitors’ strategies. AI-powered tools can simplify this by tracking competitor activities and providing valuable insights.

AI tools are a game-changer for modern investors. They can process massive datasets quickly, helping to:

Gather competitive intelligence
Analyze customer feedback
Spot emerging trends
Validate growth estimates