How to conduct due diligence on investors

The expectation that an investor will scrutinise an entrepreneur’s business thoroughly during the due diligence process is common.

However, it's important to understand that this process should be reciprocated.

Entrepreneurs looking for investment should also investigate potential investors for any warning signs and gather as much information as possible.

This knowledge is not only beneficial for business reasons, but it's also essential to ensure that you're not unintentionally aiding in any financial illegal activities.

Entrepreneurs seeking funding are frequently in a vulnerable position.

They’ve decided that their business, into which they've poured time, energy, enthusiasm, and resources, requires additional financial backing for further growth.

As a result, they may become overly eager to accept funding from any source, which can potentially lead to less than favourable circumstances for both the business and the entrepreneur.

This is why it's critical for business owners to conduct thorough due diligence on potential investors interested in supporting their company.

In this article we’ll examine some of the ways business owners can evaluate their prospective investors through due diligence and avoid making the wrong decision or falling victim to a scam.

What is due diligence?

Due diligence refers to the comprehensive assessment of a company or individual to verify their credibility and suitability for business transactions.

In the context of angel investing, this involves confirming the investor's identity and their capacity to provide the support they claim they can.

The due diligence process informally begins when you first interact with a potential investor, as this is when you start forming an opinion about them.

However, it only becomes an official procedure once their interest is confirmed.

In this regard, due diligence serves as an integral component of investor relations.

It isn't necessary to conduct a full due diligence for every investor you speak to.

However, when the relationship evolves to the stage of meeting and discussing deal terms, it becomes crucial to thoroughly understand who you are interacting with.

The due diligence process should be completed before any contracts are signed.

Why is due diligence important?

There are a number of reasons for business owners looking to attract investment should conduct due diligence on any potential investor, including:

Ensuring the right fit

Given that investors often bring more than just funding to the business, making sure that the investor is someone the entrepreneur can work with is crucial to getting the most out of the relationship.

A good investor for a business will ideally have knowledge of the industry, a network of contacts that could help the business grow, and could even act as a mentor to the business owner as they move forward on their growth journey.

A poor inter-personal relationship between business owner and investor, different visions of success for the business, or differing strategies for how to get there can all lead to trouble.

Protecting against conflicts of interest

Likewise, it’s a good idea to fully understand what other companies the investor may already be involved with.

This is important to avoid any conflicts of interest as the investor will be a key voice in the future decision-making process of your business.

Ensuring compliance

When you agree to an investment being made into your business you may also need to comply with Know Your Customer and Anti Money Laundering frameworks if your business operates in certain sectors such as financial services, estate agency, or the art market.

Even if your business doesn’t operate in these sectors, it’s still a good idea to carry out due diligence checks to protect your business from financial crime or unethical business practices.

Know Your Customer checks are designed to validate the identities of your customers and investors.

These checks also assess their financial activities and potential risks they might present to those engaging in transactions with them.

The Anti Money Laundering framework is structured to counteract money laundering, terrorist financing, and threats that could compromise the financial system's integrity.

This comprehensive set of Anti Money Laundering laws, regulations, and procedures serves as a deterrent, preventing the integration of illicitly acquired money into the financial system and averting other potential financial crimes.

How to conduct due diligence on an investor

There are a number of possible ways you can go about due diligence when evaluating possible investors.

Have conversations with the investor

It's a good idea to communicate openly with the investor about your intention to conduct due diligence on them.

Many entrepreneurs hesitate to do this, fearing it might deter potential investors.

However, a reputable investor will not only understand your need for verification but will also appreciate it.

It reflects your professional approach and thoroughness.

Keep in mind, they also want to ensure their trust in you is well placed before investing in your business.

An investor's response to your desire for research can be quite revealing.

If they assist you by providing links to their online profiles and contact details of their past associates, it's a positive indication.

However, if they express discomfort or resistance, it may imply they have something to conceal - a definite warning sign!

Speak to other entrepreneurs the investor has worked with

A credible investor should willingly disclose their past and present affiliations with other entrepreneurs, providing you with means to get in touch with these businesses.

Thus, it's important to request this information.

Ideally, you’ll want to talk to people whose business was at a similar stage to yours when they began working with the investor.

In addition to the references provided by the investor, consider conducting independent research with others who may not be on the investor's referral list.

Look to gain insights into the investor's work style, any potential conflicts that may have arisen in the past, and how these were handled and resolved.

Where possible, try to conduct these discussions face-to-face as it often elicits more comprehensive responses.

Evaluate their finances and experience

It's important to inquire about the investor's industry experience and past investments, both from them and any contacts they introduce you to.

This can provide insight into their credibility as an investor and their potential value to your business beyond just monetary contribution.

Moreover, it's crucial to understand the source of their investment funds.

Funds from offshore accounts should generally be treated with caution unless the investor can provide a valid explanation that can be confirmed by a legal expert.

In addition, conducting standard credit and criminal background checks is a prudent step in your due diligence process.

Do desk research

Many investors maintain an online presence through various platforms such as websites, blogs, and social media profiles on LinkedIn, Facebook, and Twitter.

They might also be featured in articles or have authored articles themselves, which can be readily found via Google search.

However, the extent of their digital presence may vary depending on their geographical location and age demographic.

Therefore, these factors should be taken into consideration while conducting your research.

Speak to other investors and brokers

If possible, engage with other investors, irrespective of whether they have invested in your business.

Solicit their opinions on the potential investor you're considering.

The reputation of an investor, whether favourable or unfavourable, often precedes them, and insights from other investors or brokers in the industry could offer valuable perspective.

Be wary of upfront fees

A significant red flag to consider is when an investor requests preliminary fees prior to making their investment.

Scam investors often concoct seemingly reasonable explanations for these charges.

However, without exception, such requests should always be disregarded.