Due diligence, the step between pitches and investor commitment, is often framed as a fact-finding mission, a methodical process where investors verify claims, evaluate financials and gauge market potential. Due diligence also involves speculation. Speculation can provide investors with a forward-looking perspective such as identifying emerging trends and potential opportunities. While speculation can be valuable, it also adds uncertainty. Over-reliance on speculation without solid fundamentals can lead to miscalculations and flawed investment decisions.
At its core, the first and most critical responsibility of due diligence is not just confirming what work, it’s identifying what can’t work. To borrow a line from the late John Huston, “Due diligence determines whether this is a fantasy we want to believe.”
I believe there are at least two stages in a due diligence process, if not more. The first stage of due diligence is identifying fatal flaws, the type one errors that no amount of capital, operational execution, or market fit can overcome. Insurmountable obstacles, like unachievable technical milestones, must be spotted early to avoid doomed investments. Identifying these deal-breakers saves investors from sinking resources into fundamentally flawed ventures. This stage is also a gauge for investment thesis fit. Simply, agricultural tech Investors aren’t going to consider a life science Investment and vice versa.
After clearing fatal flaws, due diligence moves into risk assessment, a dynamic process influenced by leadership. Investors must separate known risks from unknown risks. Risk isn’t binary like a fatal flaw. It’s a dynamic spectrum of outcomes that can be determined by the leadership team and its response to known and unknown risks. Investors must recognize and separate the two, weighing the likelihood and impact of each. Some risks are quantifiable—regulatory hurdles, market dynamics, business models, and competitive pressures. Others are more nebulous—team execution, team synergy or lack thereof, shifts in consumer behavior, and technological disruptions.
This phase evaluates whether the team can navigate risks successfully. Like skilled drivers adjusting for road hazards, strong teams identify risks early, adapt, and execute strategically to keep the venture on track rather than derailed. In due diligence, we the investors must understand where we think this risk is and whether or not leaders and their teams can navigate these potholes successfully without doing permanent damage. (Yes, Indianapolis, potholes need to be fixed ASAP!)
Ultimately, due diligence isn’t about eliminating risk. It’s about deciding which risks are acceptable and which could lead to failure. Every early-stage investment carries uncertainty, and the best investors distinguish between risks that can be mitigated and those that spell inevitable failure.
So, when conducting due diligence, ask yourself: Are you assessing the business in a static sense, or are you recognizing its potential to evolve? Equally important, are you betting on the opportunity as it is today—or on the team’s ability to transform risk into opportunity?
In the end, we all want to invest in a successful reality and not an unachievable fantasy.
If you have questions of comments about this post or the due diligence process, please reach out to Ben Pidgeon, Executive Director of VisionTech, among the Midwest’s most active angel investing groups with more than $32 million in deployed capital.