Learning the Hard Way - Due Diligence Mistakes

This article is the fourteenth in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.

Due Diligence Mistakes
Image by H. Beauty

It is easy to talk about due diligence in the abstract, but it is much harder to practice what you preach. One of the hardest things about early stage investing is that it is really risky - if you don’t have some suspension of disbelief, and you obsess too much about cataloging every risk, you will never get a deal done.

On some level you need to accept the fact that:

  • Every early stage company will have some warts

  • Things will happen that cannot be foreseen

  • A significant portion of your investments will be unsuccessful no matter what you do

  • It is necessary to put some trust in great teams and the power of shared benefit alignment that comes with equity investing

  • Sometimes you just have to take a deep breath and jump into the water.

Given that leaps of faith are necessary, mistakes are bound to happen. One has to be somewhat philosophical and roll with the punches. Christopher likes to use humor in these situations, pointing out that “experience is what you get when you don’t get what you want.”  Or asking “you are investing in a young team you’ve just met, with an unproven product in a market that does not yet exist.  What could possibly go wrong?”

As a way of wrapping up this series of articles with a review, let’s take a look at a few common mistakes and see what we can learn from them.

Q: Christopher can you describe a really big issue you missed during the diligence process that ended up coming back to bite you when the investment failed a few years down the road?

The most painful issues I missed have clustered around two core areas:

(i) Confusing likability or prior accomplishments on the part of an entrepreneur with the competence needed to pull off the current task. I’ve lost money with entrepreneurs who are great guys or great gals and had accomplished good things in their prior career endeavors, but were completely over their heads and unable to adapt when driving the new opportunity. As a result, I try to think hard about not what skills are required now, but what skills the coming opportunity will require down the road, and make sure the entrepreneur has, or is willing and able to get, those particular skills.

(ii) Confusing early adopter excitement with true market pull. It has been said that “anybody can get the first 10% of a market” and Geoffrey Moore’s Crossing the Chasm stands for that proposition, but the key to growing a company is finding a big enough market of willing buyers who can be accessed in an affordable way (relative to their lifetime value). The product may be good, and there may be lots of people who might buy it, but unfortunately a company’s true market is limited to those customers for whom that purchase is a top pain point and a top buying priority. Often a marginal improvement on a marginal cost is not enough to drive buying behavior in all but the earliest of adopters.  So the key is to recognize when you are looking at what is sometimes called false traction and do some further digging. There is no substitute for talking to real customers and prospects before doing the deal in these situations.

Subscribe. Get Seraf Compass articles weekly »

Q: Ham: what are some mistakes you have made that related to your evaluation of the business and the plan?

Well… that’s a really long list, and will make for a great book some time in the near future! So, I will keep my answer short and simple with a couple of examples.

The first mistake I will highlight relates to timing. We covered this issue during an article on exits. The gist of the article focuses on the question, “Is this the right time for this idea?” Many times I’ve been impressed by a CEO’s ability to spin a great story of how her company will change the world. They build a great product and it demos well. Prospective customers love the prototype. But, if the company relies on others to provide a key part of their product/service (e.g. high speed broadband or long lasting batteries), and that key part doesn’t exist, then the company will fail. So make sure that the CEO understands what the whole product solution needs to look like and has a credible plan to deliver it.

The second mistake relates to an incomplete understanding of the dynamics in your target market. At Launchpad, we’ve invested in several companies that built products for the restaurant industry. The products work well and they solve a real problem. Unfortunately, the problem is not high on the restaurant owner’s priority list. In other words, the company is selling aspirin, not oxygen. A savvy CEO (and investor) will make sure that they are selling a product that solves one of the top 2 or 3 problems that the target customer has.

Q: Christopher, what are some mistakes you have made with your evaluation of the team?

The worst diligence mistake I’ve ever made in the team area had to do with taking someone else’s word for it.  It was a large and splashy deal with a lot of investor momentum and the CEO was pretty polished. Two groups claimed to have done significant diligence, and had written reports. So we based our decision on those reports and the time we spent with the CEO. Because they were from a neighboring state, we never met the rest of the team. Turns out the CEO really didn’t have much control because there were huge personality issues and undisclosed in-law relationships at the company. Predictably, the company was clumsy, slow and indecisive and failed to change its strategy in time to save itself. The CEO was happy to listen to investor input, and seemed to understand it, but was basically powerless to really drive an agenda. That company took several million in angel dollars with it to its grave.

Another mistake I have made a couple times is what I will call the “grown up supervision” mistake. You invest in a company in part because you are reassured that they have already brought in an experienced pro who has been to the rodeo before. You figure, this is very refreshing - here is a team that is self-aware enough to know they need a real CEO. The hired-gun CEO is great at raising money and has a good resume, but as things unfold, it becomes clear that he is not very good - or at least not good at the things this young company needs. Perhaps the CEO took the job because he was washed out or burned out in his career, or perhaps he didn’t want to work hard enough at the startup, or perhaps he didn’t have founder-like passion for the company’s mission, or perhaps the chemistry between him and the founders wasn’t great.  Regardless of the reason, the company predictably never gels, there is no esprit de corps, the commitment levels are low and the tensions are high and the company just cannot zig and zag fast enough to adapt to its reality. It is flat-footed, befuddled and increasingly embattled. And of course the company’s demise is hastened by the cash drain of having to pay a mid-career executive with a mortgage and a picket fence.  

Q: Ham, what’s a mistake you have made with the investment itself?

As an angel investor, I get to look at companies at a very early stage. Sometimes, I really like the CEO, but I want to see more progress before I pull the trigger and make an initial investment. In most cases, waiting hasn’t been a problem because the company came back to me a year later and I invested then. But… there have been two cases where I took a pass the first time around, and I regret my decision to this day. In those two cases, each company made tremendous progress with their seed financing. When they went back to raise additional capital, large VCs lead the round and didn’t allow any new investors to join the round. Both companies went on to achieve great exits for their investors. So based on these two experiences, I changed my approach. Now, when I really like the team, I tend to invest a small amount so that I am on the Cap Table and have rights to invest additional funds in future rounds.

Q: Christopher, what are some mistakes you have made when evaluating possible exits and planning for exits?

The biggest mistake with exits is not establishing with certainty that the team is focused on exits, and understands that they are driving toward one someday, and that they know the steps and the path they need to go down. Too many companies end up in comfortable situations where the company growth slows and the company drifts along while paying the management team nice salaries and holding the investors’ money hostage. It is easy to see how it happens because once a CEO builds a business with $5-10M in revenue, the weaker ones can start to feel conservative, like there is something real at risk in undertaking daring strategic shifts in search of growth, and they doubt their ability to pull it off or they fear they will never have it this good again or never get another CEO job again, so they just drift. I am not a fan of redemption rights windows, but in recent years I have started to favor using an accumulating dividend on the preferred in deals with smaller more mature markets where there is a greater possibility of that happening. It can at least put management’s feet to the fire knowing the value of the company’s equity is slowly shifting to investors over time. The other thing I focus on more now is making sure the board keeps exits top of mind all the time.

The next biggest mistake is lack of diligence on the terms of a specific exit opportunity. You are impatient to exit so without thinking it through, you end up agreeing to take private company stock and/or agreeing to an earn-out (or what I like to call seller financing!) Sometimes you have no choice, but it is almost always a disaster - very few M&A transactions are actually successful, so you have just converted your stock in a nice little company into the stock of a company that just did a bad acquisition.  And they are likely going to mismanage the new business so the earnout won’t get paid. So I try to insist on at least enough cash to get the principal back and a decent return.

Speaking of plugging your nose and accepting a marginal exit, this brings me to the third biggest mistake, which is a failure to do your diligence on market conditions and competitive pressures and passing up a relatively poor deal in the hopes of getting a better deal, and then ending up with no deal at all.  Sometimes you have to be realistic and know when you are beat, and just unload the company when the chance is presented. And this is not just limited to small deals - I’ve seen it plenty of times in that context, but it also happens in big deals. We once sold a portfolio company to a high-flying pre-IPO company (for stock, of course) and the pre-IPO company faltered, could never get their billion-dollar IPO done, so they dithered around trying to optimize the exit for the various VCs in the deal and finally got acquired for about $400M. Buried in the disclosure documents was the fact that while they were messing around chasing their billion dollar deal, they turned down an offer of $800M. Talk about not doing enough homework to recognize when someone is handing you a life preserver...

Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.