Defining Due Diligence

Defining Due Diligence

by John Murray PhD, Research Director, Linqto Inc.

The Linqto team explains and defines Due Diligence, as it pertains to the field of private investing.

When individual stock market investors need to seek out dependable information about publicly-traded securities, many will turn to traditional business media like Dow Jones or Morningstar, or ratings agencies like Moody’s or Standard & Poors, to aid in their investment decisions. Similarly, investors in mutual funds often rely on the individual fund management and marketing firms, as well as financial newsletters, podcasts, and the like, to provide pertinent background and performance data.

In most countries, authorized financial advisors and broker/dealers must be licensed and well-informed about prevailing regulations before offering their services to investor clients. In the same way, publicly-traded companies are also required to conform to numerous industry regulations, such as restrictions on insider trading.

However, when it comes to investing in privately-held companies, all — well, most — bets are off, and more careful analysis of each individual company is generally necessary. Sharp-eyed viewers of business reality TV shows like Shark Tank or Dragon’s Den will notice some clarification and disclaimer text during the closing credits, which typically indicates that the on-camera deals are subject to contract negotiations and appropriate due diligence.

What is Due Diligence (DD)?

Webster’s Dictionary defines DD as “comprehensive research and analysis of a company done in preparation for a business transaction, such as a corporate merger or purchase of securities by investors.”

Venture capital firms and angel investor groups usually carry out their own due diligence and/or rely on prior investor DD work, which should be updated as the business develops and evolves. To support this process, companies soliciting investments in private capital markets generally provide investors with access to a broad range of corporate documents and financial reports via an online database, frequently referred to as a data vault or deal room.

The organization of deal room resources varies considerably from company to company, but typically includes many of the following categories of information: management team and board members; corporate structure and financing history; technologies and products, including patents and trademark information; business and revenue models; and marketing plans, such as sales partnerships, etc.

In addition to reviewing these documents and analyzing the data provided, a due diligence team will often compile checklists of topics to be addressed by the company. Such lists may include specific requests for materials like finance reports, tax returns, credit ratings, proof of insurance coverage, as well as business agreements and contracts, employee relations matters, property owned/rented, licenses and permits, litigation issues if any, and regulatory compliance required.

Usually, investors are also keen to understand the broader ecosystem surrounding a company, including marketplace competition and alternative approaches, as well as potential exposures to risk from vendors, service providers, and supply chain problems.

Accreditation of Investors

As a further protection for the general public, financial regulations in most countries mandate limitations on access to deal documents and fundraising information. The idea is to restrict participation to potential backers and sponsors who are sufficiently well-informed or affluent enough to handle the possibility of losing most or all of their investment.

In the United States, the designation of accredited investor has long been restricted to individuals whose net worth is at least $1M, aside from the value of their home, or an annual income of at least $200K. The result is that individual investors who do not meet these criteria have been denied the opportunity to invest in private markets, regardless of their level of financial sophistication.

Fortunately, a recent update to the Securities and Exchange Commission (SEC) regulations provides another route to gain accredited investor status. With these changes, interested individuals can now gain accreditation based on defined measures of professional knowledge, experience or certifications, independently of their income or net worth. Of particular interest in this respect is the Uniform Investment Adviser Law Examination (Series 65), which is administered by the Financial Industry Regulatory Authority (FINRA). The Series 65 test can be taken by anyone, and enables successful candidates to become registered advisers without the need for an employer sponsorship.

This provides an entryway to the investing ecosystem for those who merely lack sufficient monetary resources to qualify. Successfully completing the Series 65 exam requirements enables financially savvy individuals to access a company’s deal room documents and provides them with the basic knowledge to undertake their own due diligence analysis.

Linqto offers complimentary Investor Accreditation as part of our platform. To learn more, please visit our website.

Linqto’s platform is helping to democratize access to private markets. Linqto enables accredited investors to invest in pre-IPO unicorn companies in a matter of minutes using our App or web browser. We invite you to register on the Linqto website. You can also register on our free app on your Apple or Android device.

Bibliography:

Press Release: SEC Modernizes the Accredited Investor Definition. US Securities & Exchanges Commission, 26 Aug. 2020, www.sec.gov/news/press-release/2020-191.