We have all worked in the investment industry for the past 15 – 30 years. Much of our time has been spent on the client-facing side of the business. So we’ve had much opportunity to listen carefully when investor clients are voicing concerns. Sometimes, the biggest help we can provide is to help investors focus on what’s actually important to them, rather than on the ostensible reasons for their dissatisfaction.We talk a lot in Angel Capital Group about the benefits of deal syndication: We’re frequently advertising the benefits to investors of sharing deals with other angel groups and aggregating capital from outside investors in local deals. But it seems to me–and we’ve had a lot of discussion about this “behind the scenes” regarding how to perform due diligence effectively.

Another way of phrasing this concern would be that investors wants to become more confident in their own skill at evaluating local and regional investment opportunities, so that your fund spends as little time as possible sorting through low quality deals in order to have more time to evaluate the most promising companies.

We break down the process of due diligence into “descriptive” and “predictive” elements, but that’s simply our own way of describing the workflow. Scott Ewing started 35 years ago as a real estate market analyst, and later became an operational intelligence officer/analyst in the Navy. Eric Dobson became a high growth entrepreneur that migrated to the investor side of the table. Steve Mercil has worked in economic development and private equity for 30 years. Jim Hart is a very successful entrepreneur that built an international business from scratch. Now, we work on data analytics and business intelligence all day, every day. And, one thing we have learned is, no matter how you phrase it, the old rules still apply. For instance, you might want to pick up a copy of a very short book written by Herbert Meyer, former Special Assistant to the Director of the CIA: How To Analyze Information by Herb Meyer.

For anyone interested in performing due diligence, it is a critical primer. Meyer’s Step One is to “Figure out where you are.” Meyer states: “You cannot make sense of information unless you know where you are when you look at it.” Step Two is “Be sure you are seeing clearly.”

“Because these first two steps of the analytic process are ‘invisible’ most people aren’t even aware that they need to be taken before moving on to the next ‘visible’ steps in the process. So they skip these first two steps and start with the third. It isn’t provable with statistics, but I’m convinced {writes Meyer} that the cause of most bad decisions lies in the failure to recognize that Steps One and Two exist and must be taken.”

What ACG calls “descriptive analysis” involves consciously taking Meyer’s first two steps before performing Step Three (“Decide what you need to decide”), Step Four (“Determine what you need to know”), and Step Five (“Collect your information”).

The ACG “predictive analysis” commences in Meyer’s Step Six–“Turn information into knowledge.” Note that you must have gathered the information (descriptive work) before you can turn information into knowledge. Step Seven (“Add the final ingredient”) is adding your own judgment–the sum total of who we are; the “combined product of our character, our personality, our instincts and our knowledge.”

Meyer elaborates: “Because judgment involves more than knowledge, it isn’t the same thing as education. You cannot learn judgment by taking a course or by reading a book….” We would add, ACG cannot teach “judgment” to investors; yet, many times when investors ask us for training or mentoring in due diligence, what they really are asking for is for judgment. It’s investors wanting to skip learning Steps One through Six, hoping for the network’s direct assistance in performing Step Seven.

That may sound cynical. It’s not meant to be, but realize that we’ve had dozens years of experience with hundreds of investors in the retail and private placement markets. We’ve experienced the same from too many individual investors not to have noticed the recurring behavior. And so, I want to return to Meyer’s Step One and ask you (on behalf of your investors):

Do investors GENUINELY want to learn to perform due diligence as a multi-step analytical process, or are they in reality more interested in viewing deals in a sort-of “board room experience?” We use the expression “board room experience” to mean the type of setup you see on TV’s “Shark Tank.” The Sharks appear to perform brief Q&A on pre-screened deals that are all interesting enough to have been selected to be on national television. The Sharks enjoy the opportunity to pose tough questions, and to exercise their authority, with the result being a simple up-or-down vote. If the vote is “Yes,” the Sharks presumably hand off the detail work of performing investment analysis onto support staff.

Be honest in answering that question, and we’ll share with you that after our working with hundreds of angel investors, we’ve concluded that many angels, in fact, want the “boardroom experience” rather than to spend time learning to be proficient through the steps of performing analysis. Many angel investors, by the fact that they are professionally accomplished and financially secure, are accustomed to making executive-type decisions. The boardroom experience appeals to them; whereas, spending time learning what are perhaps new or enhanced skills does not.

The reality is nether Angel Capital Group or the Appalachian Angel Investor Alliance is staffed or resourced to support us providing a boardroom experience wherein we provide all the require diligence. That would mean a completely different cost structure that is not feasible with microventure funds. We believe that the optimal breakdown of diligence is a split (50/50) between the fund performing what we think of as descriptive diligence and ACG spending its time and energy on the predictive diligence. That is what we excel at doing, providing context to the best judgement based on the best possible information. Simply put, by supporting this division of labor, we can collectively do a more comprehensive job of diligence.

The reason we believe this is the best case is simply that your fund needs to build its own following in your community. You need to be interacting with budding new entrepreneurs as well as gray-haired successful business people. Mentoring those in your region is critical to creating an ecosystem of entrepreneurship. And, you will always know the people and ventures in your region better than we could hope to do so. However, we have the ability to organize, syndicate, and value-add your work so that all in the network can participate with the best available information possible.

If you want to be the best investor you can be, it is critical to develop skills that lead to judgement on investing in what is a very high risk asset class. Bear in mind that only 20 hours of diligence, which should be spread over a diligence committee of 3 to 5 members, has been show to demonstrate a 65% greater chance or capturing returns of an angel investment. That is a small price to pay for such a large increase in likelihood of returns.

This is published under the Appalachian Regional Commission POWER Grant, PW-1835-M.

Copyright Appalachian Investors Alliance, Inc. 2018
@angelcapitalgr | @appalachianinvestors | www.appalachianinvestors.com | www.theangelcapitalgroup.com | www.facebook.com/angelcapitalgroup