- The Diligent Observer
- Posts
- Return on Diligence
Return on Diligence
How a 4% investment in due diligence could yield a 100% increase in returns
Limits
We all have them.
Angel investors, in particular, have financial limits.
Each one only has so much investable capital (or dry powder) at their disposal.
So, investing in one deal means not investing in another.
That’s why due diligence is so important.
The Observer Express
Don’t have time to read the entire post right now? No worries, here are the main points:
Primary interviews suggest angel investors are comfortable allocating between 3% - 5% of their invested capital towards due diligence.
The value of due diligence lies in its capacity to improve decision-making and drive better portfolio returns.
We walk through an example whereby investing 4% of our investment in diligence, information is revealed that results in “passing” on a bad deal and including a good deal instead. This improves overall returns by more than 100%.
How Much is Angel Due Diligence Worth?
That depends.
Some think it’s not worth the effort - they see the investments as too small and opportunities too risky to merit anything more than cursory analysis.
In many cases, I agree.
In others, however, I couldn’t disagree more.
After interviewing dozens of angel investors about due diligence and asking “What would you pay for this?” I realized that the “right” answer depends largely on the overall check size they intend to write.
3% - 5%
I found that, on average, investors were comfortable allocating anywhere from 3% - 5% of their invested capital towards “closing costs” like due diligence.
That means that, on average, if an angel intended to write a $25,000 check, they’d be comfortable spending between $750 - $1,250 on diligence. For a $5,000 check, that number is between $150 - $250, and for a $100,000 check, the number is between $3,000 - $5,000.
Clearly, if the check size is small, there’s little/no budget for any “meaningful” diligence. But as we approach or exceed the $50,000 level ($1,500 - $2,500 diligence allocation), a budget begins to emerge. *Note: this does not consider the potential for funding due diligence by sharing the cost with entrepreneurs.
This all begs the question: why are investors willing to pay for diligence? Where does the value of diligence come from?
Opportunity Cost
Because committing to one deal means not investing in another.
There is a real opportunity cost to consider.
The savvy angel allocates a fixed percentage of their investable portfolio (usually less than 10%) to direct angel investments each year.
If, say, I have $100,000 earmarked for angel investments this year, and I want to write 4 checks for $25,000 each, that means I only get to take four shots.
If I choose to allocate 4% of my investable capital ($4,000) towards some kind of professional diligence support, I significantly reduce my downside on those four shots.
How?
By making better decisions.
Let’s look at the math by comparing two scenarios:
A. No Diligence
B. With Diligence
$39K Der Deal
Let’s assume I have 5 deals to choose from: Fluxify Data, Snapster Social, FizzyPop Soda, Plumify Finance, and Glimmer Beauty.
After personal review and consideration, I decide to go with the first 4 and skip Glimmer Beauty.
In 2022, the median MOIC (Multiple on Invested Capital) for observed exits was 1.55 (2023 Angel Funders Report, Page 57).
If we assume this MOIC applies to the average deal, then we can estimate each of the opportunities I consider is potentially worth $38,750 ($25,000 * 1.55). This is composed of my $25,000 investment plus the $13,750 in returns I expect on each deal.
Assuming all 4 investments I make hit at 1.55X and I spend zero money on 3rd party diligence, the expected value of my “perfect” portfolio is $155,000. That’s fantastic.
But, what if one of these 4 deals exits for less than 1.55X - say 0.3X?
Scenario A: Not Terrible
Things aren’t terrible, but not quite as pretty.
In this case, which I’m calling “Scenario A,” Snapster Social flopped - it exited with a 0.3X MOIC. I end up with a return of -70% on that deal. Thankfully since my other 3 were solid (1.55X), I’m still sitting with a 24% return on the portfolio ($124K total value), but that one mistake ate about half my expected return. Ouch.
Here’s a breakdown of how my portfolio looks.
*Note: For simplicity, I’m ignoring the time value of money, and consider Time 0 as “today” and Time 1 as “at exit” whenever that ends up being.
But what happens if I invest in diligence?
Scenario B: Much Better
For Scenario B, let’s assume that I decide to carve out 4% of my investable capital ($4,000 in this case) for due diligence across all the deals I consider. That leaves me with $96,000 left to invest, or 4 $24,000 shots.
Let’s also assume that the investment bears fruit: I see something about Snapster Social while reviewing the diligence material that gives me pause before investing.
Maybe I discover a close competitor with more traction.
Maybe I recognize the market is much smaller than expected.
Maybe I notice something strange about the cap table that makes me uncomfortable.
Whatever the reason, I ultimately decide to pass on Snapster Social, and instead take my 4th shot with Glimmer Beauty.
How does the portfolio look now?
As you can see from the below numbers, even though I’m investing less per deal ($24,000 instead of $25,000), since I’m able to avoid Snapster Social and pick up the benefits from Glimmer Beauty I end up doing much better. This portfolio is valued at about $149K, versus the $124K in Scenario A.
Final Thoughts: 100% Better
As we can see from the summary comparison below, Scenario B delivers more than double (105%) the return of Scenario A, with a 20% portfolio MOIC improvement.
Said another way, by spending $4,000 on diligence, we ultimately improved our returns by over $25,000. That’s 6.26X what we spent ($25,050 / $4,000).
It is important to note that all these numbers and outcomes are simply for illustrative purposes.
Diligence efforts (especially if poorly executed) don’t always unearth decision-transforming information, and even the best-looking opportunities are still likely to fail. Startup investing is one of the riskiest forms of capital allocation, and while diligence can help, it doesn’t eliminate that risk.
Analysis like this can and should be performed by each individual investor and investor community as they consider how to best equip themselves for effective decision-making.
However, I sincerely hope this exercise helps provide a clear understanding of how and when due diligence, which is often perceived as an “unnecessary expense,” drives real, tangible value and ROI for the savvy investor.
What do you think?
How do you think about the value of due diligence?
Weekly Observations: 3 Lessons Learned
Marketing is hard.📣😓I’ve been working on updating our brand positioning and preparing for a few upcoming conferences this week. It’s a lot of work. I’ve realized that I have a ton to learn about how our product is perceived by the market. On that note, I could use your help: what’s important to YOU when it comes to due diligence? Fill out this 1 question survey and as a thank you I’ll send you the Angel Ops e-book I’m working on as soon as it goes live.
Bad sales is a bad time.🙅♂️This week I got angry. I had a problem, spent time online to find a company I thought could solve it for me, scheduled an intake call with the sales team, and spent the first 7 minutes of our call explaining to the sales guy the full background and exactly what I was looking for. Pretty big investment on my part. He then proceeded to completely ignore everything I had just said and walk through what was obviously a cookie-cutter sales script, most of which was completely unnecessary. All I wanted was for him to say “Yep, we can definitely help. Here’s how to get started.” But I felt so unheard, and the conversation felt so gross that I decided there was no way I could work with this company.
“Unique, One-of-a-Kind Experience” is an incredible value proposition.🥃This week Dani took me to Oak and Eden in Bridgeport, TX for my birthday. Their “secret sauce” is an in-bottle finishing technique where instead of finishing the whiskey in a second barrel (the usual “double barrel” approach) they finish by dropping a 5” wood spire into the bottle and leaving it for a couple of months. What’s cool about it is that they’ve come up with dozens and dozens of spire variations or “flavors”, and allow guests to essentially build their own whiskey by choosing the base and spire they like best. I think it’s genius and a great example of how to stand out from the crowd. In case you were wondering, after tasting a few variations, I went with the 116-proof bourbon base and a French oak spire with a cherry liqueur infusion. Ask me how it turns out in 2 months.
Weekly Links: 3 Things I Found Interesting
Thanks for reading, have a great week.
-Andrew
Special Opportunity for Readers of the Diligent Observer
Interested in plugging into the Texas angel investing scene? Join the Aggie Angel Network’s Texas Startup Showcase on March 22 from 10 am - 12 pm CT and consider 4 exciting Texas-based angel investment opportunities. Membership is normally required ($1,750 per year), but this special event is available at no charge.
If you enjoyed this post, please share it with a friend, colleague, or anyone else who may benefit.
P.S. - I recently finished creating The Angel Network Toolkit: 90 Resources for Cultivating a Thriving Community of Pre-Series B Investors, and I’m sharing it with anyone who refers a friend.
How did I do this week?
About Me
I cultivate flourishing.
I'm also the CEO of PitchFact, where our mission is to cultivate flourishing specifically through efficient and collaborative early-stage diligence. I'm a proud husband, grateful father, and honest friend. My love languages include brisket, bourbon, and espresso.