If you’re reading this article, you’re most likely interested in finding out what potential investors look at during the due diligence process before deciding to invest in your business. The truth is, there is no standardized model for how due diligence is supposed to be done. Each investment firm has its own models and priorities. But, there are a few mistakes founders make repeatedly which often renders them uninvestable even though their products may be sound and perhaps even highly profitable. In this article we will discuss some of these common “pitfalls” and how to work around them. But before we do that, it is important for you to understand who you’re dealing with.
Understanding the VC model:
Investment firms are companies, just like yours, in competition with other organizations. These firms generally compete to attract outside capital to manage. In order to do so they offer various structures, terms and conditions for managing said capital. The most commonly known and talked about is the 2 and 20 structure. When a firm brings in a pool of outside capital into a so called “fund”, an annual 2% fee is incurred on that pool as a management fee as well as 20% of the upside generated by the investments made, also known as “carry”.
This is important for you to understand because the managing partners of an investment fund are making large sums of money in fees regardless of the success or failure of your startup. They obviously want you to succeed so they can bring in that 20% carry. Additionally, by showing a successful track record of investment, they can go on to raise a second larger fund to accrue even more fees, etc. So in theory, your company’s and your investors’ interests are aligned this way. The problem however is that not all businesses are created equal. It is extremely difficult to know ahead of time which investment will yield a lot and which one will fail down the line. And considering that there are only 24 hours in a day, a fund cannot possibly support every single investment made with unlimited resources and time. This is where the rubber meets the road.
#1 TODO – Know who you’re in bed with:
Your first task as a business operator is to find out as much as possible about the firm investing in (or acquiring) your company. You need to make sure that your interests align and that the resources you need will be available to you. This goes beyond just money. Investors can make or break your business. If you take on an investment from a passive fund, you can’t possibly expect them to hold your hand and help you with operational tasks. Similarly, if you take on an investment from an extremely active fund, one that checks in on you every week and wants to have some degree of operational control, you can’t possibly expect a hands-off approach with no weekly meetings or obligations to execute on.
The temptation for founders is to always take in capital at any cost, because well, we want to put food on the table and move our businesses forward. But it is often the case that the benefits of getting the correct strategic investor far outweighs the benefits of a larger sum from a less suitable investor. This trade-off presents itself in almost half of the cases I review in my work as a Due Diligence Consultant. Founders typically tend to go with the larger checks regardless of the investor in question, which I personally find to be an understandable but big mistake nonetheless. It is infact a mistake I have personally made in the past while raising capital for one of my ventures. Know who you’re in bed with and think long and hard before allowing anyone into your cap table. A little bit more money now can end up costing you a whole lot more down the line.
#2 TODO – Do not confuse hopeful projections with tangible goals:
There is this one sentence that keeps popping up when I engage with early stage startups:
If we capture x% of our TAM within the next N years we’d end up with a billion dollar company.
This is one of the biggest red flags there is. Yes, obviously capturing some x% of a large TAM would make you rich (obligatory “no shit Sherlock!”). Showing that in an excel sheet does not make it a reality. Having started a bunch of businesses myself, I understand why founders tend to feel the need to advertise that as a potential outcome. In reality however, stating something like that without an executable plan in place makes you uninvestable. This is simply because capturing a significant market share often entails the need for more capital injections, the establishment of logistical and support infrastructures, lots of hiring and management overhead, etc. Failing to account for all of these factors within an actual actionable and reasonable plan makes you sound “green” and inexperienced.
If you could demonstrate constant and decent growth for a longer period of time through actionable plans, you would instantly become more attractive to potential investors. This also works to your benefit in an odd way. An investor that would require you to grow at an astronomical xxx% rate for N years straight is most likely not thinking about the challenges you will be facing moving forward in terms of user acquisition cost, management, logistics, support, etc. This investor is probably only thinking about using your startup to increase their book value by marking up your growth in subsequent rounds. This enables them, as discussed earlier, to raise larger subsequent funds, and hence more fees, at the cost of the long term health of your organization.
#3 TODO – Tech stacks rarely matter. Your startup is a search function:
It is of course the case that your tech stack matters to a certain degree. But founders tend to put too much emphasis on using the latest shiney hip and cool thing rather than focusing on the utilization of stacks that enables faster production and deployment. The speed at which you iterate over your product is of extreme importance.
The truth is, in the vast majority of cases, your customers do not give a hoot about your tech stack. There are obviously some exceptions such as when working in highly regulated industries. But in general, your customers just want a product that works reliably, securely and with as little headaches or overhead as possible. People want their problems solved, they don’t care if your solution uses framework X or Y.
It is often the case that I encounter early stage startups with very small teams using stacks that shackle them down to the point where producing features and releasing updates could take months. With that comes huge hiring, management and infrastructure costs which are rarely fully understood by the founders. What is often forgotten in these organizations is that your startup is a “search function”. You are searching for product/market fit using customer feedback as a mechanism for approximating the final solution. By utilizing the incorrect search function due to technical overhead, your startup risks taking too long until it reaches its destination.
Stay lean, incorporate things as needed and move fast early on. These should be your goals. Using 20 different AWS products, 40 engineers and a multi-million dollar budget to create a solution that any competitor with a $1000 in digital ocean VPS spending can out-race you with is not a good long term strategy. The same thing applies to all kinds of startups, not just the ones in tech.
#4 TODO – Don’t hide risk factors. Your business plan is not a marketing document:
All businesses have risk factors associated with them. Some are external while others are internal. Founders seeking investment or acquisition offers tend to hide these risks. Not only is this a bad strategy because most of these risks will be uncovered during the due diligence process anyway, but mainly because acknowledging them and having a resolution plan in place shows a great deal of foresight and business acumen.
Investors want to put their money in the hands of founders they can trust. If your business is facing a problem, state it outright with a plan for how to solve it. This may occasionally result in you losing out on a potential investor in the current round. However, that level of transparency and honesty will help you get that same investor into your next round once you show that you’ve managed to execute on your plans. Besides, by elaborating on the challenges your business is facing, these investors may be more enticed to invest because they have the relevant competence or connections in-house to help you solve for them. This often makes for an extremely attractive proposition for active investment firms. They see that there is something they can actively do to help you overcome the challenges and that “arbitrage” makes for a unique opportunity.
#5 TODO – Technical problems are solvable, organizational problems persist:
One of the things I am often hired to do is to explore organizational problems within a startup. Your first few hires have a disproportionate effect on the outcome of your business. If you have a SaaS, dropshipping or any tech related business, which most businesses these days are in one way or another, getting the technical things right from the start should not be your primary concern. It is obviously the case that if you get the technical aspects of your product correctly things will be a whole lot better. But, it is far more important to make sure that you have the correct organizational structure in place to deal with challenges rather than trying to be a product perfectionist from the start.
No one cares if the first iteration of your product is written in Laravel, Ruby, Node or uses Shopify templates. What matters is having the right people and structures inside of your organization to solve problems when they arise. As you scale your business, you will be forced to make changes. You will be forced to reiterate on your product. You will be forced to migrate, rewrite, restructure and plan things over and over. If your employees are unable to adapt due to rigid technical structures imposed by some perfectionist ideals, you will most likely not make it.
When you increase complexity in your organization in order to cater to the technical aspects of your business, you inevitably pay for that later down the line in technical debt, high expenditures and/or slower time to market. Reduction in complexity should be your goal. The less complexity you have, both in terms of tech and organizational structures, the easier it will be for you to pivot, change and adapt. This gives you a priceless edge over your competitors. Hire the right people and imbue them with the freedom to operate with as little management overhead as possible.
Summary:
Know who you’re in bed with, have actionable plans rather than hopeful projections, treat your startup as a search function for product/market fit with the help of customer feedback, be honest and transparent, and keep your organizational complexity as low as possible.
These few and seemingly commonsensical themes tend to have a large effect on your viability as an investment candidate. Yet for some reason, a large number (I dare even say the majority) of early stage founders that I meet seem to dismiss or undervalue their effect. If you want the best results for your business, you owe it to yourself to take a few hours and examine these themes before initiating any investment talks with outside investors.
THE CONTRARIAN IMPULSE 