The Art and Science of Due Diligence in Private Capital Investing

Leonardo da Vinci is famous for combining art and science to produce exceptional paintings such as “The Last Supper” and the “Mona Lisa.” His mathematical ratios and anatomical studies enhanced his artistic talent. In private capital deals, we look to integrate science and art with similar success through due diligence. What is often thought of as only a systematic process for an investment decision is a delicate balance of facts, impressions, and experience. It is possible to make a sound investment with facts alone, but adding artistry to due diligence can potentially maximize returns for both investors and founders.

Defining Due Diligence

While the common understanding of due diligence is the investigation and verification of key facts to minimize risk, we cannot reduce it to simple fact-checking. No investment is risk-free, and investment firms/investors must do a deep dive into the founders, operations, industry, current market, and forecasts. When looking at a company, we always consider whether the business is truly scalable and what we can bring to the table to help the company grow meaningfully. Due diligence is an expectation from any entrepreneur with a pitch, but we begin due diligence before we even meet with the founders.

In a nutshell, due diligence is a comprehensive process that is a blend of art and science, or instinct and logic. 

Financial Due Diligence

The financial history and future forecasts of a company are vital parts of the due diligence process. The financial statements should be accurate, and forecasts should project positive outcomes and the potential for growth. If these components are not present, it may indicate a poorly operated business or a weak market – or worse, unprepared founders.

Legal Due Diligence

A strong business relies on a good legal team to identify possible liabilities early, preventing setbacks while protecting an investment’s worth and investors’ trust. For example, if the value of a company is dependent upon its intellectual property, it is important to understand the company’s intellectual property assets, rights and potential risks.

Management and Operational Due Diligence

When conducting due diligence on a target company, it is important to understand how it manages its operations. Taking a hard look at operations can reveal additional risks and areas for improvement. For example, focusing on a company’s supply chain logistics and inventory management might uncover inefficiencies in how goods are acquired or stored, signaling opportunities for streamlining processes. This may be an area where an investment firm could improve efficiency or add lucrative knowledge. 

Market Due Diligence 

Performing market due diligence involves examining the company’s business plan to see and pressure test strategies to capture market share. It also means looking at industry regulations and looking at market trends. As a former Chief Growth Officer, this is where I spend a large portion of my time when evaluating whether we should invest in a company.

I thoroughly investigate signals that the company is achieving early signs of product market fit. Although each type of due diligence is integral to the overall process, a company cannot succeed if there is no market for it. 

The Due Diligence Process

due diligence process infographic
Preliminary Assessment

Before Solyco goes into a deep dive to consider any investment, there is analysis to determine if the company’s market and operations complement the investment. This includes investigations into the company’s culture and current financial statements (unless it is a pre-seed investment). For example, we will look at the company profile, press releases, and industry reports. We perform an in-depth review of information that can be obtained without inside access, so we can identify potential risks and strengths in the investment.

A preliminary assessment helps to make diligence more efficient because we develop questions and concerns prior to further meetings with the founders of the company. We will have first impressions and conversations with subject matter experts. This gives us an initial idea of whether there is solid understanding of the technology and if it makes sense in the market.

In-Depth Analysis

The deep dive into the company occurs once we have insight into its financial health, operations, regulatory compliance, and liabilities. Not only do we consider ways to mitigate potential risks, but we also look for areas where our team can improve the company’s strategy. Fine-tuning our understanding of the market also occurs here, as well as determining if we have applicable knowledge to ensure success. In-depth analysis varies based on the maturity of the offering.

Risk Assessment

Throughout the preliminary assessment and in-depth analysis, we are considering risk and opportunity. Things we will include in this phase of the assessment are risks to the industry and the company itself. If the company has legal issues or is going to face the challenge of new regulations, we will look at ways to mitigate these risks. Public image consideration may also matter, such as embracing eco-friendly business practices. The risk assessment in due diligence is where all the reasons we should not invest are identified and where there is proactive planning to mitigate any risks post-investment. 

Investment Decision

The bottom line is whether we have the potential to earn our investors the right type of returns. This part of the decision has to do with an evaluation of risk vs. reward and how the investment would fit into our current portfolio. Some risks are worth the potential for large gains, while others simply don’t make sense. Due diligence is what investors use to make these same decisions. 

headshot profile photo of Ajoy Sharma

Our team believes strongly in ongoing due diligence as part of the process of deciding where to invest. Our capital is patient and [is funded?] based on our portfolio companies meeting certain milestones. My partner, Ajoy Sharma, shares in-depth about why patient capital is both investor and founder friendly, and the reasons we choose to invest in one company over another.

The Science of Due Diligence

The science in due diligence involves research. Meetings with founders, financial statement analysis, forecasts, and group testing data give investors what they need for a strong investment thesis. We will assess a company’s IP, the size of the market, and the company’s competition. The science part of due diligence is essential, but science doesn’t guarantee a sound investment. 

The Art of Due Diligence

The art of due diligence is what keeps investors in the industry. It is about first impressions, excitement, and opportunity. It is backed by science, but the art of due diligence is where facts and figures meet experience and strategy. 

I recently heard an interview with a GP from Benchmark Capital, and he described the art of due diligence with a great anecdote from a sailboat company. He explained that a founder may try to sell his sailboat company to investors by explaining the quality of the boats, but the quality of the product is only as good as its market. Instead, founders who can sell the wind are more apt to sell their product because they have created a bigger market. The wind creates more opportunity to sell the boats. It isn’t that product quality doesn’t matter, but success is more dependent on the wind. Ships will sail if the wind is there.

Artistry in due diligence is about figuring out the wind, or the bigger opportunity for the business. Both founders and investors should look for “the wind” in order to identify the hidden gems in private capital deals. 

Leveraging Science and Art

Due diligence from private capital firms such as Solyco Capital involves leveraging both science and art to decide upon the best investments. The science is undeniably valuable, but the art is what takes capital investment to the next level.

The information contained in this article is for general informational purposes only and should not be considered financial advice or a recommendation or solicitation to buy, sell or hold any securities or financial products.

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