Basic Rules of Due Diligence
Good investment decision-making begins with knowing and following a few basic principles:
- Define your financial needs, goals, and risk tolerance, and only make investments that are a good match for you. We explore how to do this in greater depth in the next section, How Much Should I Invest.
- Work with a team. Two (or more) heads are better than one, especially when your money is on the line! There are a few different kinds of due diligence teams, and you can use more than one to accomplish your goals. The first consists of your fellow local investors. If you are a member of a local investing group, you should have plenty of opportunities to join due diligence groups or committees that will focus on investments you are interested in. The group can split up the various tasks so that at least two people are working on each part of the process. These groups offer a diversity of knowledge and experience and generally don’t cost anything but the time you put in. One very important caveat for local investing networks: each person in the group should agree in advance (ideally in writing, as part of the network’s Membership Agreement) that everyone will make their own investment decisions, and won’t hold anyone else liable for the consequences of their own decisions. This does not apply to investment clubs, which make collective investment decisions. For more on these groups, read our guide on Local Investing Clubs & Networks.
- The second type of due diligence team consists of your professional advisors. Financial advisors, attorneys, accountants, bookkeepers, tax preparers, and bankers may be willing to help you evaluate local investments, even if it’s just offering a second opinion while you take the lead. It might be difficult to find local professionals that are willing to help, and they will likely charge for their services, but if their assistance helps you earn a profit or avoid a loss, you may well come out ahead by paying a reasonable fee.
- The third kind of team consists of anyone with investment or entrepreneurial experience in your personal network of family and friends that is willing to work with you on a more informal basis. You may need to offer some kind of exchange to secure their help, but having an experienced “personal mentor” can be an excellent way to learn about the process.
- Be patient. Start by looking at a variety of deals, without any pressure to invest. Don’t jump in until you get a better sense of what’s out there, and what makes some opportunities more attractive to you than others. It’s better to wait years for the right deal than it is to invest in the wrong one.
- Don’t let anyone rush you. Any business that needs money as soon as possible has obviously not done a good job of planning, and may even want to avoid being under the due diligence microscope, so you should be highly skeptical of people that need money fast. Ask as many questions as you need to fully understand every deal. If a business person will not answer all of your questions to your satisfaction, regardless of how many you have, politely decline the opportunity to invest.
- Dig deep into the investment and the people behind it. There is more at stake than just money, since you’re likely to have an ongoing relationship with these people outside your investment deal. How will your relationship be if the investment does not turn out as planned and you lose your money? What if that person’s life circumstances change, and they need to sell the business – what happens to your investment? Take some time to anticipate the unexpected. Often, business plans will feature rosy projections that are based on overly optimistic assumptions. Figure out what those assumptions are and question them. If you find yourself falling “in love” with a particular investing opportunity, and the temptation rises to skip the hard questions of due diligence and just pull out your checkbook, that is when you really need to slow down and commit to a thorough evaluation process.
- Think for yourself. Investors are subject to the same types of crowd behavior as any other group of humans. Every so often, when evaluating potential investments in a group setting, some investing opportunities will come up that everybody wants, and it seems like people are jumping over each other to invest. Or you might see the opposite situation, in which no one appears to have any interest in an investment, even though some people might actually be interested but don’t want to seem naïve or out of sync with the consensus. Sometimes, in a group, all it takes is one person with a loud voice or a big ego to drown out diverse, valuable opinions. Be wary of these crowd phenomena, because almost every time, the group is collectively skipping out on a more rigorous due diligence process that could yield a better result. These things happen because everyone assumes that everyone else has done their work and has their opinions for good reasons, but the reality is often that no one has done the appropriate work, and emotions like excitement or frustration have taken over. In a group setting, when you notice crowd behavior, speak up. Ask the group if there is an important perspective missing from the discussion, and try to find it.
- Trust your intuition. Due diligence involves more than just logic and reason. If you have done all the work, understand the risks as best you can, and something is still bothering you about a deal, don’t invest. If possible, take the time to figure out what exactly is bothering you, and try to resolve the issue with the potential investee. On the other hand, some investments just feel right, and these feelings can be valuable guides, as long as you’ve been diligent in your research.