3.2 Hygiene vs Insight NACO Academy Module 103: Adding Value Through Due Diligence identifies two major categories of due diligence activities: hygiene and insight. A hygiene review ensures the company is clean, there are no skeletons in the closet and the record-keeping is acceptable. Here the goal is to avoid bad investments, and Angels need to ensure a clean due diligence binder (see feature below) by checking things like articles of incorporation, shareholder agreements, share capitalization table (the “cap table” or list of who owns stock), financial statements and other documents. Good hygiene ensures the company passes the “smell test.” If it stinks, other investors, as well as clients, partners, employees and acquirers will avoid the company. Other red-flag hygiene issues include founders who lack self-awareness, fail to understand their weaknesses, are excessively defensive, lack transparency or are immature. Check your gut. If your intuition says something is wrong, it is easy to move on to the next opportunity. Peter Weiss gives the following advice: “I trust my gut. Do not trust your gut if it says to invest. Trust your gut absolutely if it says don’t invest. Even if you can’t put your finger on the reason(s).” (Maher) The Due Diligence Binder The due diligence binder contains all the critical company documents and records in one place. A company without good record-keeping is virtually uninvestable. Binders can include incorporation documents, a capitalization table, business plans, financial statements, board minutes, shareholder agreements, banking and loan agreements, leases, employment agreements, trademarks, domain ownership, patent ownership, purchase and sales agreements, contracts, option agreements, and other documents that have a bearing on the business.
Unless you are a passive investor, Angels should spend more time developing insights that will identify key risks and how to manage them. These insights set you up to add value and support the companies you invest in. If you are spending more than 20% of your time on hygiene, it’s a red flag.
Hygiene vs Insight
Insight
Insight
Insight
Hygiene
Hygiene
Hygiene
Don’t expect perfection. These are early-stage, high-risk investment opportunities, and you will normally be a minority shareholder.
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