Tuesday’s Open Angel Network was led off by a presentation by Kevin Castello of the Baylor Angel Network on the topic of due diligence.  He was kind enough to provide some interesting handouts, and I think you’ll benefit from my reporting some of his insights.

Coincidentally, today’s WSJ has an article about how Nick Saban keeps ‘Bama at the top of college football, and it’s all about recruiting.  The headline above is a quote on how he and his coaches talk to family and friends of a prospective player to gauge mental strength.  And, they are astute enough to notice subtleties like raised heels in a lineman’s stance that can indicate a lack of flexibility.  Saban’s success certainly gives him the pick of the litter nationally, but it’s his decisions on which supernatural athletes to choose that keep him in the championship hunt.  If you watched Trent Richardson play last year, you saw the fruits of that selection process.  Roll Tide!

These stories are intertwined in my view in that due diligence means one thing when you are evaluating an investment in a company that has some history, such as, for example, actual numbers, products, and customers.  Kevin distributed a very thorough document request list that is designed to ferret out any hair on a deal.  Having all the required corporate records in place, well organized, and easily producible is a good indication that management has its administrative act together.  (Although one investor in the room said it might also mean that a deal had been shopped so much that the company may have had too much spare time to get its act together!)  The importance of all this is to insure that there are no clouds on the company, like IP issues, surprise liabilities, or control shortcomings that might thwart a future exit.  It’s a bit of a CarFax procedure with a far more complicated subject.

On the other hand, we see now so many bootstrapped, lean, and rapid development startups that go from idea to product in a few days or weeks that due diligence may require a different approach when time comes for outside funding.  Odds are good that a preoccupied management team has paid little attention to administrative matters, but with such a short history they’ve also had little time to make big mistakes that can’t be corrected.  I think early stage investors in this situation tend to favor letting the market do the due diligence.  If the product is out there and has gained that proverbial “traction,” then the company will probably pass muster.  Here the bet is much more on the team, and with many teams so youthful they really don’t yet have backgrounds to check (other than felonies perhaps).

These early stage companies require Saban-like intuition to ascertain which teams are likely to find a way to succeed.  Even if they have demonstrated traction, there will be the inevitable pivots and pitfalls along the way, and you need to make sure the core leadership has the motivation and intelligence to deal with those.  They need to be “all-in” – no playing around on the side but fully committed to the venture and with plenty to lose if it doesn’t work.  They may not have an inheritance at risk, but they’re certainly risking irreplaceable career time, and they have an opportunity cost versus taking a real job.  (The latter is something often hard to explain to Mom and Dad who paid the tuition.) My friend Paul Stamatiou now in the Valley via GA Tech and Y Combinator recently wrote a Tech Crunch post with a title not suitable for my family friendly blog, but his thesis was that entrepreneurs should be singularly focused on their businesses and not just playing at the game.  There’s a networking event every night, and it’s easy to fool around on Twitter, but if you are running a real startup, the less time you have for all that the better.  I encourage you to read Stammy’s post.  If I were doing due diligence on an early stage startup, I’d look for these telltale signs that are like the heels up in Saban’s reviews.

Kevin showed a statistic that from the Kaufmann Foundation that due diligence of 20 hours or more increases your likely return by a factor of 5 or so.  That’s not a lot of time.   He talked about quantitative, qualitative, team, and subject matter analyses, all of which are important.  But, in my book team is at the top.   Relevant experience, or at least access to subject matter knowledge is important, but to me that’s less important than raw “git ‘er done” skill sets.  I was once tapped as president of a bank in which I had invested and was on the board.  The chairman and I visited the head federal regulator for our charter; he explained that he wanted me to be CEO even though I had zero banking experience, and her exact words were:  “If he can keep the loan-to-deposit ratio below 80%, I don’t give a @#$%.”  With that ceremonial approval, we said Thank You Mam, and I was a bank president.   Maybe the OCC did some background check on me later, but I’m not even aware of that.   They collected enough personal information on each regular exam anyway.  That was a successful turnaround with a great exit for the investors, and I thought it was a benefit that my mind was uncluttered by any relevant experience.

Saban has the advantage of doing his due diligence and then calling all the plays through the season.  As an investor you don’t have and don’t want the play calling job, so you are more dependent on getting the “seven deep” data up front and putting yourself in business with a team you can both trust and enjoy working with during the life of the venture.