An investment in a startup always carries a risk. An investor who wants to know about potential difficulties might decide to conduct one on the founder and his staff if any. That said, not all investors refer to this probe in these terms. Many call it due diligence instead. The extent of the probe depends on the investment amount they have pledged.
Investors who decide to do checks look at experience, criminal records, civil lawsuits, credibility, financial position, tax liens, and general signs of financial strain. Finances and loan defaults are a critical part of an investor screening. Typically, an investor will ask to look at payment history, a credit report, or existing accounts.
Criminal Record Review
Any investor will find criminal or civil court rulings concerning. Even small offenses will be placed under the magnifying glass. Such actions show bad decision-making and impulsive behavior.
An investor might look for information through FINRA, the watchdog for the financial industry. The SEC might also have information about people licensed to sell securities. Strict due diligence might unearth evidence of fraud that authorities didn’t detect. Investors have the right to know this information before making any financial commitment.
There are a number of areas an investor will probe into once they decide to run a background check, including:
- Criminal offenses
- Credit reports
- Educational records
- Driving records
The information below is normally not available:
- Records of arrests, civil suits, and civil judgments after seven years
- Accounts in collections after seven years
- Bankruptcies after a decade
- Paid tax liens after seven years
In general, a lot of negative information becomes inaccessible after seven years have passed with the exception of criminal convictions.
A criminal record check will reveal all convictions and non-convictions, including dismissed cases or cases that didn’t go to court. There is no time limit for convictions. A case that did not result in a guilty sentence will remain on someone’s record for seven years.
In dealing with a potential investor, it’s important to be open about any prior convictions. Chances are they’ll find out anyway and it will look worse. Lying about your past can ruin your chances of getting financial help in the future. A startup founder should be able to see themselves in a new light. They should be ready and willing to start over.
Due Diligence is not Mandatory but Should be Expected
Angel investors will tell you due diligence is less practical than calling startup users or clients. There are some, for whom even an entrepreneur’s being in prison wouldn’t be a deterrent. They would still invest in his company under certain circumstances.
That said, many angel investors Google startups and the people behind them. It is often relevant and very easy to do. Others will decide against it, focusing on the business plan instead. The smartest ones will do both.
Disclosure on AngelList is Recommended
Let’s say there is something vague or negative on your record and you’ve decided to launch a startup. You’re looking for funding. The best thing to do is share it on AngelList along with all of the positives about you and your new business. Provide details surrounding it and a convincing explanation that it’s no longer an issue.
The information available on AngelList tends to be insufficient, so once you get a venture capitalist’s attention, you can expect them to start with the due diligence process needed to justify the investment.
In this process, they will look into any claims about someone’s work experience and the size of their potential market. Once an investor shows real interest in pursuing your deal, the due diligence process will launch. When you get a term sheet, it steps up.
Don’t Rely on the ‘Gentleman’s Agreement’
In the formal diligence period, there is a proverbial “gentleman’s agreement”. In essence, this is an agreement that there will be a deal barring unexpected findings of an overlooked issue with the market or one with the startup founder’s character. Due diligence is meant to protect investors.
This is a sensitive period, in which things can go either way. The process is also somewhat asymmetrical, which doesn’t do a founder any good. Investors who lead founders on and drop them after the background check will get a bad reputation, but that’s of little comfort to a founder. An agreement falling apart over the results of a background check can be fatal.