In today’s fast-paced and highly competitive business landscape, tech startups are emerging at an unprecedented rate. While these ventures hold immense potential for disruptive innovation and substantial returns, they also face significant risks, making due diligence crucial. Conducting thorough due diligence helps investors make informed decisions and enables tech startups to identify potential pitfalls and maximize their chances of success. This process becomes even more critical for tech startups as they often operate in rapidly evolving industries with unique challenges and opportunities. This article will explore the importance of business due diligence for tech startups in the ‘Problem and solution fit stage’ and….
Business Due Diligence for tech startups in the Problem & Solution Fit Stage
Most tech startups seeking angel investments are in this stage. At this point, a startup can get business due diligence right or spectacularly wrong. Thus, ‘Problem and solution fit’ becomes crucial for startups because it validates the viability and potential success of the business. It refers to the alignment between a startup’s product or service and the specific problem it aims to solve in the market. Problem and solution fit becomes crucial for startups because it validates the viability and potential success of the business.
A glimpse into why an investor may fail to invest in a tech startup in the ‘P&S fit Stage.’
Lack of Market Demand
If a startup’s service or product does not address a significant market need or fails to provide a solution that customers are actively seeking, investors may hesitate to invest. With a clear and compelling value proposition, where customer needs are prioritized, the startup may gain traction and generate sustainable revenue. A startup must differentiate between the’ Nice-to-solve’ problems versus the issues that a customer ‘needs to solve’ and prioritize the former.
Weak Business Model
A startup’s business model should outline how it intends to generate revenue and achieve profitability. Suppose the business model needs to be more precise, sustainable, and have a well-defined monetization strategy based on a well-defined customer segment with a well-focused go-to-market. In that case, investors may perceive it as too risky. Investors typically look for startups with a clear path to profitability and scalability and a compelling differentiator based on a clear understanding of their competition.
Inadequate Team and Leadership
Investors pay close attention to the founders and the management team, ‘Do they understand where they are? Do they accept it?’ If the team needs to gain relevant industry experience, a track record, or a clear vision for execution, investors may perceive it as a risk factor. A solid and capable team is crucial for successfully navigating challenges and driving the startup towards growth.
Important questions asked by investors in the ‘P&S fit Stage.’
To ensure a thorough understanding of a startup’s potential, investors sway conversations with founders to answer the following questions:
• Do they understand and accept the competition?
• Do they understand and accept the key uncertainties, risks, and issues?
• Do they do something to address them?
• Do they understand when a pivot is needed?
• Are they honest about their status? Can all their claims be verified?
• Are they searching for alternative answers?
• Are they cooperating in finding alternative solutions?
• Do they have the ability and willingness to change course?
• Are they coachable?
Beliefs about the future, with virtually no hard facts available and extreme uncertainty on the founder’s side, imply a high-risk venture for the investors. Thus a (business) due diligence at this stage should focus on the team’s understanding and acceptance of uncertainties, risks and issues and their ability to identify, prioritize and validate possible options (with associated assumptions!) on moving forward. Ultimately, this tests the team’s ability to pivot before they need to.
The best way to run a business due diligence: Issue-driven approach.
Starting with analyzing the business model to identify critical issues and then including other angles of analysis to get a complete picture of issues, that is alternative opportunities and options and their underlying assumptions. Allow the most critical strategic options and the most critical and uncertain assumptions to ‘drive’ the subsequent experimentation. This may lead to a pivot (key changes in the business model). In this case, there would be a gradual move from issues, via various solution ideas, to actions and planned experiments.
Combining brainstorming and prioritizations with a team of founders, mentors, board members and investors, covering all relevant areas for issues and opportunities becomes an effective and structured approach in rapidly identifying relevant issues and risks – and getting the mitigating actions in place.
“Will running such a process with the investors not reveal my most critical secrets?”
Any critical issue or risk is not problematic if understood, prioritized, and acted upon. The resulting shared view of prioritized issues and opportunities will place the investors and founders on the same page going forward:
• Forming a natural starting point for the next iteration of the business strategy.
• Minimizing the risk that the company’s and founders’ actions after the investment will not meet the investors’ expectations.
• Minimizing the risk that the investors’ contributions after the investment will not meet the founders’ expectations.
An ideal due diligence should be met with a unique product backed with a business model containing clear strategies and how to approach them. It should also highlight tactics for shortening the sales cycle and details of a realistic competitive strategy. Demonstrated traction with strong validation and ‘proof’ that the startup is on the right path to generate revenues/profitability, attraction, and retention, and a record of super-happy customers is an added credibility advantage for the founders. All this, backed by an ethical, passionate, problem-focused team with exemplary leadership skills and a track record of execution ability, is a recipe for multiple investments.
