8 tough questions investors need answered before sinking money in any venture

Investors often put their trust in the people who make the deals for personal equity, venture capital and other alternative investment platforms, but how can you know for certain that these platforms are doing the best due diligence?

The bogeyman in the room is still FTX. The cryptocurrency exchange — once valued at $32 billion — collapsed dramatically in November 2022, leading to significant losses for many investors, even discerning high-profile ones like “Shark Tank’s” Kevin O’Leary.

Despite being a significant player in the cryptocurrency exchange market, there were glaring oversight issues and a lack of proper corporate controls within FTX that resulted in questionable financial valuation practices. Investors, including large firms like Sequoia Capital and Singapore’s Temasek Holdings, failed to identify these red flags during their due diligence processes.

This highlights the risks associated with investing in overhyped companies without rigorous due diligence. If large firms couldn’t identify potential issues, it might feel like everyday investors have no hope in performing thorough due diligence themselves. But that doesn’t have to be the case.

The evolution of investment due diligence: How to navigate new terrain

Years ago, underwriting was performed by certified people at regulated investment firms. Employees were typically required to have securities licenses along with track records of relevant experience. However, since the JOBS Act of 2012 and the crowdfunding boom in the U.S., many people who don’t come from traditional banking and capital markets ecosystems have entered the fray.

In addition, today, investors are told to believe that a computer can accurately analyze the viability of a company’s business plan and the management team’s ability to execute on that plan. These shifts are why it’s so critical for investors to perform their own due diligence.

To start, investors need to be on the lookout for conflicts of interest. Of course, all investment platforms make money through a combination of listing fees, transaction fees, and success fees. The conflict arises when platforms rely too much on listing and transaction fees rather than success fees.

Another red flag is when platforms assert that a company looking to raise capital can be up and running and raising money in 30 days.

Alternatively, if the platform makes claims regarding the strength of its deal flow and selection process but doesn’t clearly articulate exactly what that is or by what reasonable industry standard it is making this assessment, this calls into question the believability of the platform’s claims.

It’s also important to remember that there is a big difference when it comes to how investment platforms underwrite debt offerings and equity offerings. Credit risk and analysis is the bread and butter of all traditional lenders, and debt is underwritten using clear metrics regarding the borrower’s ability to repay.

However, underwriting an equity offering often requires a specialty firm that understands the specific nuances of that industry, the competitive landscape, market capitalization, current market conditions, forward-looking perspectives and the inherent uncertainty that comes with financing small to medium-sized companies. Generally, this is called “investment banking.”

With all this information in mind, here are some questions you can ask platforms and businesses before you invest: 

• Investment specifics: What am I investing in? Where is my capital going, and what do I get in return?
• Quality of investment products: Has the platform ever listed an offering for a simple agreement for future equity (or SAFE)? If so, what percentage of those SAFEs either never converted into equity or the repurchase clause was exercised?
• Insider offerings: Has the platform ever listed an offering where management or other insiders sold personal shares as part of the offering?
• Due diligence: How often does the platform perform site visits? What documentation does the platform request from the issuer?
• Underwriting: What processes are in place to review the financial models provided by the issuers? How many offerings are listed, absent a financial model? In addition to the required reviewed or audited financials, does the platform provide current financials? If so, have there been any adverse events, identifiable on the income statement and balance sheet, since those financials were stated?
• Valuation: How exactly does the platform determine — or otherwise challenge — the valuation of the issuer’s offering? Does the platform allow the issuer to make forward-looking projections that are abnormal, unusual, or otherwise out of character with comparable companies?
• Marketing communications: Does the platform understand the regulatory guidance, including what is and isn’t allowed? How does it enforce this on the platform? What is the compliance and review process? Have all claims presented by issuer offering pages been thoroughly vetted for accuracy and proper citation?
• Investor education: Does the platform provide educational materials to help retail investors understand how to do their research? If so, what information does the platform provide that can only be provided by the issuer that would be necessary for an investor to do their research? Does it provide original research on industry trends comparable by sector? Does it provide thorough information on the corporate entity, management team, and board of directors?

The landscape of investment is evolving rapidly, making due diligence more crucial than ever. The FTX debacle serves as a stark reminder of the pitfalls of insufficient scrutiny and the dire consequences of overlooking fundamental financial health and corporate governance. By arming themselves with knowledge, asking the right questions, and maintaining a healthy skepticism, investors can navigate the complex investment terrain more safely.

Whether dealing with emerging technologies or traditional investment vehicles, the principles of thorough due diligence remain the same: A critical, discerning approach is essential for safeguarding one’s investment against the unpredictable waves of market trends and hype.

Read more: How do bid and ask prices work in stock and other markets?