Doing your due diligence – what it is and why it’s important

Whether you’re new to investing, or already have a large investment portfolio, one of the most important exercises before making any investment decision is doing your due diligence.

Due diligence is the process of investigating or researching a matter before making a decision or entering into any form of agreement or contract. In an investment context, it’s making sure you’ve thoroughly understood a business and read all the information provided to you, before investing in it.

Investing always comes with a level of risk, but the important thing is to understand whether the potential returns justify the risk - and whether the investment fits with your overall risk appetite. Typically, the more risk you’re willing to take, the higher the potential for reward but the bigger the ups and downs can be along the way.

Investment decisions on traditional public stock markets are continuously influenced by analyst reports, market news, and public sentiment. As a regular investor, you’re unlikely to keep up with the information flow as quickly as professional investors do, who have teams of researchers working for them.

As an investor using the Catalist Public Market, listed businesses are required to give you all the information you need, clearly and concisely, to fully understand the investment you’re making. This is because the Catalist Public Market is a licensed stock market and regulated by the FMA, which gives investors similar protections they’d receive with a public stock market like the NZX.

In a Catalist Private Market you may not always receive the same level of information, but you should still make sure you’ve read and understood all the information provided and that you don’t have any outstanding questions. You’ll be able to access this information through your own investor account. Our periodic auction structure, where trading occurs at regular auctions rather than continuously, means you’ll have time to review the information provided and complete on a level playing field with professional investors.

Some of the areas to consider when reviewing information about a business you’re considering investing in are:

Make sure you understand the industry and the product or service offering. After reading the information provided, you should know what the business’s Unique Selling Proposition (USP) is, and how the business differentiates itself from competitors. Is there protectable intellectual property (IP)? What is the business model (how they make money) – and is it viable in the long term?

It’s also good to understand the Total Addressable Market (TAM) for the business. A business may have shown great growth so far, but how big could it potentially get? The types of businesses Catalist aims to work with are those that have already passed through the riskiest start-up phase, but still have a huge TAM that they’re not yet providing goods or services to – meaning better potential for growth. Take a look at competitors in the sector, too. If there’s a lot of competition, this may indicate a high demand and large TAM – but make sure you read the information to understand how the business has fared against the competition so far.

You can expect there to be a section of the information identifying any potential risks to the business - and of course, to your investment. No one can predict the future, but a business that is ready and prepared for future risks is more likely to withstand the ups and downs of business life.

You don’t need to be an accountant to understand the key financials of a business. Review the financial information and commentary provided and check you understand how the business is making money, as well as any underlying assumptions. Look at the amount of money already invested (including the level of personal financial commitment of those involved in the business), and the scale of any debt compared to the revenue (money coming in). Do you understand what the business will do with any investment over the next 12 months, and for the following 3 - 5 years?

Where the business is raising new money, check you understand their rationale for the use of funds - you want to ensure your investment is being used to fund growth or add value in some measurable way.

Ideally a management team will be diverse, knowledgeable, and with a track record of success. The quality of the team is essential. Quality factors include experience, industry credentials (“street cred”), and personal characteristics, including integrity. Are the team passionate about growing their business, and are they responsive to the market? You need to be confident the team will deliver on their promises and be adaptable to changing market conditions.

Now that you know about due diligence and are prepared to assess the information provided by businesses on each investment, you can get excited about investing in a smaller Kiwi businesses with the potential for high growth. The next step is to get signed up with an investor account and make sure you opt in for our newsletter so we can let you know whenever there’s new investment opportunities.

By Michelle Polglase