If you scan the financial headlines on any given day, you’re almost certain to run across examples of bad acts carried out against unsuspecting investors by unscrupulous operators of every ilk. Fact is that investor fraud is one of the most common financial crimes perpetrated against individuals and even investor groups. More often than not, this is due to the failure on the part of the investor(s) to take proactive steps to ensure they know as much as possible about the people and companies in which they are investing.

Due Diligence – A Must

Be it private or public company investment, individual investors generally become aware of investment opportunities through family, friends, advisors or other connections. In such instances they often make the mistake of investing based on trust – an inexcusable and altogether avoidable mistake. No matter the investment type or the source advocating the opportunity, it’s imperative that investors perform comprehensive due diligence.

Key Steps

So what are the important components of a comprehensive due diligence process? While there are a countless number of things one can do when conducting due diligence, there are four key steps that should be part of any process, including;

• Obtain investment-related documentation
• Determine true interest and suitability
• Conduct background investigations
• Request financials and tax statements

Important Docs

The first step in the process is to obtain the important documentation detailing the investment opportunity, such as an offering memorandum, prospectus, deal sheet, or similar. For a private company, the investor should require a copy of the business plan being used to guide management.

The offering document should succinctly lay out the need for the investment (e.g., why the money is needed and what it will help the company achieve), the use of funds (personnel, cap ex, etc.), the exit strategy for the investor (e.g., loan repayment schedule, equity conversion), and the expected return to investor.

Interest and Suitability

After examining the business plan and offering memorandum, an investor can then make an informed assessment as to whether they still have an interest and if the investment fits in with their financial plans and goals. They must be able to define why it’s a good opportunity (in general and for them in particular) and determine if the return on investment (whether defined or projected) makes sense, especially given the level of risk. If this can’t be clearly articulated at this point then there is no need to proceed with the process or the investment.

Background Checks

A major part of the due diligence process is determining exactly who the investor might be dealing with. To do so requires learning as much as possible about the owner(s) and the company itself through the use of reports obtained through a reputable investigative firm. This can include reports on education, work experience, civil and criminal background checks, regulatory records, and credit checks of key principals and the company. Doing so ensures the owner(s) are who they claim to be, are of good character, and are capable and experienced in terms of operating the business. It also tells much about the manner in which the company has been operated and treats creditors, vendors and others.

Obvious disqualifiers would include a track record of litigation and/or regulatory actions, issues involving fraud, allegations of mismanagement of businesses in the past, misrepresenting educational or business background, and other matters that would raise red flags.

Additional Considerations

Once the key steps are undertaken, an individual should still attempt to learn more about the company from an investor’s standpoint. It’s important to ask to speak with past investors, if available. Their experience and insight can prove invaluable. It’s also important to inquire of the company the success of past rounds of investment.

And finally, an investor should compare this potential scenario with others that are available to make a final, informed decision as to whether this situation makes good sense and merits investment over other potential opportunities.