Step 3: Conducting Due Diligence

Once you’ve identified a deal from the pipeline that you are interested in exploring, the due diligence period commences. This process is by far the messiest and most subjective—and thus received the most commentary from those we interviewed.

In general, due diligence is an investing imperative, and an iterative process. It brings discipline to the investment process and it helps you get the important things right.

Practices employed by early-stage investors are quite diverse. While some like to make a small initial investment to get to know how the entrepreneur operates, other members follow a rigorous due diligence process before they consider deploying any capital.

1. General advice

  • Share the burden. One of the major benefits of the Toniic network is due diligence sharing. This allows potential investors to divide up the work and focus on their area of expertise.
  • Make sure you and the entrepreneur have a shared set of values and enterprise objectives. Lack of alignment is one of the more frequently cited reasons for an investment derailing.
  • Know the environment of your prospective investment—the cultural, political and regulatory landscape can pose significant risk to your investment, despite a strong leadership team and solid business and impact proposal.
  • Match depth to capital commitment. Members were quite adamant that the depth of due diligence should strike a delicate balance, collecting enough data for rigorous analysis and providing value while not exhausting the entrepreneur in the process. Your due diligence process should focus on information that will get you to a decision and be commensurate to the size and type of capital you are planning to deploy.
  • Be part detective/investigative reporter. You want to investigate and ask questions about what is driving the opportunity, and what can go wrong. Pay attention to common early-stage challenges. Seek numbers and specifics, ask the whys, be skeptical, look for supporting evidence, and be prepared to get it wrong.
  • Take a portfolio approach. Apply an asset allocation strategy to your investment capital—paying attention to your liquidity needs, risk, and tax implications. Early-stage investing is considered high risk, so by definition it needs to be an intentional portion of your overall strategy with the inherent risk factored in to your return expectations.
  • Verification. When all is said and done, take time to independently verify the information collected during the due diligence process. Much of what investors hear from the investee is self-reported, thus underscoring the importance of verification.
  • Use an escrow fund. Avoid the trap of writing an investment check that is then immediately cashed prior to an “escrow” of funds being filled-out to sufficiently fund the business plan. Setting up an escrow account is an easy solution.

2. Organizing for Success. Since the due diligence process is your first interaction with the entrepreneur or team, Toniic members suggest that you follow the following general basic guidelines to organize yourself and your co-investors in order to approach the process in an informed way.

  • Be the lead or empower a lead. Identifying one point person who manages interactions with the entrepreneur simplifies communication lines between the investors and entrepreneur and helps clarify team roles and responsibilities from the start.
  • Set team norms. Create ground rules and time frames that you will adhere to as an investment team. How will you communicate and how often? One, quick initial conversation about norms will go miles in building trust and responsibility within the team.
  • Establish the critical path needed to get to a deal decision. List deal-breakers so no time is wasted. Avoid analysis paralysis by identifying what information is critical to make a decision and what can go unanswered. Also note capacity-building needs for the enterprise to get them past any investment hurdles, or provide a conditional letter of interest, saying you would review them again if they can address specific factors in the future.
  • Stage your questions. Each question from an investor typically means work for the entrepreneurs—and time away from running their business. Using your questions wisely can increase the efficiency of your due diligence and improve your relationship with the entrepreneur. For example, Toniic member Miguel Granier of Invested Development focuses on answering critical questions for each stage before going deeper. John Kohler shared that in his work with investors, he observes that “they usually employ a cascading set of screens to stage both their work and the entrepreneurs’s work at stages of interest.”
  • Treat diligence as capacity building. Andy Lower (formerly with the Eleos Foundation) tries to add an hour of value for each hour he asks of the entrepreneur. Lisa Kleissner provided significant technical assistance to SMV Wheels in helping craft their business plan as part of her diligence. The entrepreneur should feel like you added value even if you don’t invest.
  • Get to know the other investors. If you are a minority investor, who is the majority investor and what is your relationship with him or her? If you are syndicating a deal, who are the potential co-investors? Do you know what their values and motivations are?
  • Consider outsourcing due diligence to a professional. Bruce Campbell of Blue Dot Advocates recently assisted two investors with a deal in Nairobi. They hired Open Capital Advisors to perform an in-depth on the ground diligence that was shared with other investors and eventually led to funding the enterprise.


3. Evaluate your legal constraints and opportunities before you dive into a new geography. Blue Dot Advocates suggests investors ask themselves the following questions prior to making an investment:

  • Is the investment prohibited or restricted by the investor’s country of citizenship either because (i) the country in which the company is operating is subject to sanctions or other legal action or (ii) because a company founder is on a list of persons with whom citizens of the investor’s country cannot do business (e.g. a terrorist list)?
  • Is the investment restricted or prohibited by the laws of the country in which the company operates?
  • Is the investment subject to registration in the country in which the company operates and/or is there some other process that must be followed in order to make the investment enforceable? In some countries, for example, a stamp duty may be optional, but failure to pay the tax makes it harder for investors to enforce their rights.
  • Has the investor group engaged local counsel to perform basic legal due diligence on the company’s corporate and tax status, as well as its legal authority to enter into the proposed transaction?
  • What are the tax implications of the foreign investment? Most countries have relatively complicated rules for the taxation of foreign investments due to concerns about hiding income and assets offshore.
  • Will the investment return be subject to a withholding tax in the country in which the company operates, and, if so, at what rate? How is the withholding tax treated for purposes of the investor’s tax obligation in the investor’s country of citizenship, e.g. will the investor receive a full credit for the foreign tax paid?
  • Does the investment documentation include a commitment that the company will comply with applicable anti-bribery and anti-money laundering laws, including the laws of the investor’s country of citizenship that may apply?

4. In-depth. Once you’ve organized a process and completed basic document review and phone calls, Toniic members suggest including the following critical elements in your review:

“Start with having a beer or cup of tea with the entrepreneur. Investing is a journey, not a transaction; you are likely to be working together a long time. It helps tremendously to have a basic level of trust, respect and admiration for one another’s hopes and dreams.” —Bob Pattillo, Gray Ghost and First Light Ventures “What I’ve learned from 20 years of investing is that a lot of time highly mission-motivated entrepreneurs are confused about the priorities of running their businesses.”
—Stuart Davidson,
Sonen Capital

“Look for teams that bring unique insight to a problem and who learn quickly. Great teams versus good teams learn at a magnitude faster.”
—Tabreez Verjee

“In early-stage, it is overkill to do six months of due diligence. Angel investors need to have a willingness to take risk.”
—Miguel Granier, Invested Development

“Have the hard discussions first. Impact investors tend to fall in love with the entrepreneur and the business then lose their discipline around financial due diligence.”
—Liesbet Peeters, D. Capital

  • Conduct an onsite field visit – essential prior to any investment, performed by you or a trusted peer.
  • Respect cross-cultural styles by partnering with an in-country potential investor or respected intermediary.
  • Perform reference checks as provided by the enterprise and directly sourced from the community the enterprise serves.

Peer Wisdom. A Toniic investor, after researching an investment theme, found an enterprise that seemed to meet his impact goals. He began the due diligence process to assess the viability of the business and the capability of the entrepreneur. Based on interviews he conducted with peers in the community where the business was located, he discovered that the target business was being promoted by an entrepreneur with excellent social acumen, but a poor business record including multiple failed startups that the entrepreneur did not disclose. This lack of transparency and managerial and business operations experience raised a red flag and the investor opted not to move forward.

  • Perform an eco-system analysis as well as an enterprise-only financial analysis. Who are the businesses’ suppliers, partners, or competitors? Who will be most threatened if they are successful? What are the regulatory and legal constraints that could change their model over time? (For a useful framework for this analysis, see Cultivate Your Ecosystem. Note, the examples are nonprofits, but the analytical framework is valid for any impact entrepreneur.)
  • Perform an initial impact assessment. An initial impact assessment should aim to understand the intentions of the entrepreneur around impact, the status of their operations in terms of staying accountable to that mission, and an assessment of the tracked impact of the venture. Taking a GIIRS online assessment survey will take most English-speaking entrepreneurs 2-5 hours, and allow investors to benchmark their impact intentions and performance against global peer groups. Note that GIIRS is working on a new assessment process targeted at early-stage enterprise. For now, it recommends that start-ups (with less than one year of operation) focus on completing the Impact Business Model. The assessment has been translated into Spanish, Russian, Portuguese, and Mandarin, with a French version coming soon. New research shows that “mission lock” makes a difference for enterprises already dedicated to impact—it can correlate with higher growth and better financial performance. Therefore, an initial assessment of impact during due diligence is worthwhile.
  • Make a clear final decision. A quick “no” is better than a slow “maybe”. But of course for the entrepreneur the best answer is yes; the second-best is no; and the worst is maybe. You’ll want to be extremely clear with the entrepreneur throughout the process and let them know immediately if the answer has turned into no. If you are part of a diligence team, work to respect other investors’ constraints, personal intuition and choices. For some investors, once all the data is in, their final decision may be a gut decision that does not align with the data. This is the nature of this data driven, but ultimately very personal decision-making process.