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The importance of due diligence

Due diligence is a term given to the process of assessing a company before you invest in it. Unless you count “spray and pray” as an investment strategy, due diligence is of critical importance to investors in driving portfolio returns. The difficult question is, how to conduct due diligence properly but at reasonable cost?

The Par Equity Model

Par Equity is a venture capital firm founded by people with a range of business backgrounds. Early on, we decided that involving business angels in our investment model would be a good thing. In our experience, business angels bring many desirable qualities – understanding of businesses, sector experience, contacts, willingness to become involved operationally and, of course, investment appetite. In short, it’s a force multiplier for the core investment team and it really helps with technical and commercial due diligence.

These experienced business people come into their own during the origination and evaluation stages of investment. Par Equity benefits from the breadth of experience and insights they offer – as do investors in our EIS fund. Of course, most venture capital firms have access to specialist expertise. The crucial difference is that our investor network puts its money where its mouth is.

The Nature of Diligence

We divide due diligence, into financial, legal, technical and commercial. On the plus side, early-stage companies tend to be uncomplicated from a financial perspective. Legal diligence, although usually fairly straightforward, is important. We generally do that towards the end of the investment process. Technical and commercial due diligence present greater challenges, because this is where specialist knowledge really counts.

The nature of technical due diligence varies from company to company, but typically involves understanding what the technology does, how developed it is, what technical challenges remain in bringing it to market or refining it for broader distribution, how robust it is and, perhaps most importantly, how protectable it is. The strategy around protecting intellectual property is a critical factor.

Commercial diligence involves understanding a company’s business model and value proposition, its target markets, how the management team are going to access those target markets, and the competitive landscape they will face in doing so. It’s also relevant to informing a view on where the most likely routes to exit lie. An exit, where investors sell their shares, is after all the ultimate objective.

The Costs of Diligence

Assuming that robust assessment of a potential investment is not optional, the problem is that due diligence tends to be a costly process.

Internalising the skills and experience by hiring the necessary talent into the investment team builds costs that must be recovered through investment management fees and can result in a narrow investment focus. Renting the necessary skills and experience from consultants when you need it reduces the investment manager’s overheads, but there are still fees that need to be paid by someone – generally the investee company. This is cash that would otherwise be used to build that company’s business.

Par Equity’s approach of using angel investors as part of its investment model is a creative solution to these problems and, because the angels are investing their own money, their interests are aligned with those of investors in Par Equity’s EIS fund.

Article supplied by Par Equity

For more information on Par Equity please contact pauline.cassie@parequity.com

 

TL Dallas offer due diligence services – providing insurance and risk due diligence services for investors, banks, lead advisors, NXDs and corporate clients relating to mergers, acquisitions, disposals and re-financing transactions.

For further information in this area please contact Bernard Dunn on 0141 204 0300 or email bernard.dunn@tldallas.com