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Summary:

Whether you’re raising money or investing money, you’re signing up for a multi-year relationship with someone you may have just met. At some point, you may have to look that person in the eye and deliver bad news. How will he react? Good diligence can answer this and other questions.

We’ve all read horror stories about con artists and fraudsters who swindle millions from investors or entrepreneurs. Whenever this kind of news breaks, someone always asks why someone else didn’t do better due diligence.

It’s a valid question — good diligence can certainly prevent rip-offs. But that’s not all it’s good for. Whether you’re raising money or investing money, you’re signing up for a multi-year relationship with someone you may have just met. At some point, you may have to look that person in the eye and deliver bad news. How will he react? If a company veers off course, you may need that person to help turn things around. Will she be up to the task?

Good diligence can answer these kinds of questions. To shed light on this often misunderstood practice, here are some common myths and uncommon truths about due diligence.

MYTH #1: Only investors need to conduct due diligence, and they take offense when entrepreneurs turn the table on them.

TRUTH: All entrepreneurs owe it to themselves, their companies and any existing shareholders to conduct due diligence on potential new investors. Good VCs appreciate an entrepreneur’s due diligence because it’s the mark of a responsible manager, and it screens out undesirables who could wind up serving on the board with them.

MYTH #2: Due diligence is mainly about looking for accounting red flags and hidden legal liabilities.

TRUTH: Those are important aspects of due diligence but not the only ones. In addition, you want to find out about the people who make accounting and legal decisions. At a minimum, you’ll want to check criminal records, civil litigation, credit history, employment history and educational credentials, all of which require access to specialized databases, discreet interviews with human sources and, most importantly, knowing what to look for.

MYTH #3: Due diligence is sneaky and shady.

TRUTH: If you’re not comfortable with secrecy, consider telling your subject in advance that you’re doing due diligence, and seek his or her cooperation. Most people will understand. If you’re concerned about keeping your findings confidential, hire an attorney to oversee the investigation so that the reports will be protected by attorney-client privilege. Above all, know and comply with all applicable laws, including the Fair Credit Reporting Act and the Gramm-Leach-Bliley Act.

MYTH #4: Due diligence is mainly about talking to people who’ve known and worked with the subject.

TRUTH: People are often the best and only sources of non-public information about a person. They can also be some of the least reliable sources. Unlike photographs or the printed page, people misperceive, misremember, forget and sometimes just lie. They’re also highly susceptible to suggestion and will sometimes reconstruct memories based on what they perceive in the present. A skilled investigator knows how to conduct interviews that minimize errors in memory and perception. And of course, an investigator should corroborate, check, and double-check any disputable statements.

MYTH #5: I searched XYZ database and found that my subject was a defendant in a lawsuit in 1993. Gotcha!

TRUTH: Documents don’t lie, but the people who write them sometimes do. That’s especially true of court documents. Moreover, documents rarely tell the whole story. Just because someone was sued doesn’t mean the allegations had merit. Even if a judgment was entered against your subject, try to learn as much as you can about the circumstances.

MYTH #6: I spent the day at company X’s offices and was impressed by everyone’s professionalism. Case closed.

TRUTH: First-hand observation is one of the most effective ways to gather information about a subject. Just remember that the Heisenberg Principle applies: the act of observation will alter your subject’s behavior—that is, if he knows he’s being watched. In some cases, covert surveillance may be the only way to find out the truth about someone. Understandably, many people are uncomfortable with the idea of surveillance. But some subjects may have developed complex methods of concealing illicit behavior. If carried out legally and ethically by a licensed professional, surveillance can avert calamity without overstepping reasonable expectations for privacy.

MYTH #7: The Godfather of Silicon Valley told me my subject is a stand-up guy (or a crook), and the Godfather knows everything.

TRUTH: Never let someone else make a key decision for which you are responsible. If you do your diligence correctly, you will hear all kinds of conflicting stories and opinions. Don’t believe anything without evidence. Catalog the facts, then look at the whole objectively. In the end, the most important thing to remember is to think for yourself and make up your own mind.

Justin Hibbard is Principal at Quidnunc Group, an investigative services firm in Burlingame, Calif. (CA PI 26089). Contact him at hibbard@quidnuncgroup.com.

By Justin Hibbard

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  1. [...] has a post on 7 tips for conducting better due diligence one of the tips caught my [...]

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  2. Your points are well taken – caveat buyer, seller and lender alike. I would also suggest that effective “Leadership Due Diligence” includes an evidence-based approach to assessing prospective people who are to run or lead a going concern.

    There is substantial evidence, over the last 50 years, about what factors predict effective leadership, particularly around the “Full Range” leadership model of Bass and Avolio. There are also better ways to synthesize your decision making, using modern measurement (Rasch or Item Response Theory).

    Matt

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  3. Good points.

    In #6, I’m pretty sure you mean the Hawthorne Effect, not the Heisenberg Principle. That latter one would say that when visiting someone’s office for a first-hand look, you’d know where they are, but not what they’re doing. ;-)

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  4. i’ve been involved in a number of dd projects and all have been conducted in a reasonably open manner. more often than not, there is a strong focus on examining all operators (key people) and with technology, a hard dig into any black box magic and technology….if it’s of interest, i’ve written about this particular subject before for “competitive intelligence magazine” (articles are up at my corporate site, including ‘sizing up talent in a deal’ and others)

    i’m not always certain that a PI is most suitable for business research of any kind, though your own background lends itself well…the licensure rings of HP scandal and potential gumshoe approaches that violate business ethics and guidelines, but that’s a broad and sweeping generalization…

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  5. The due diligence practices I describe in this article would have prevented, not caused, the HP scandal. To begin with, HP’s legal department should have informed all of the board members from the beginning that an investigation was underway. And obviously, the PIs should have refused to render any illegal or quasi-legal services. Nevertheless, no one should hire an unlicensed investigator or consultant to perform investigative services, even if you are sure that the services are legal. Conducting investigations for pay without a license is illegal in most states. Most PIs are competent and ethical, and many state licensing boards have web sites for verifying PI licenses and checking disciplinary history. For example: http://www2.dca.ca.gov/pls/wllpub/wllqryna$lcev2.startup?p_qte_code=PI&p_qte_pgm_code=2420

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