Due diligence questions for an early stage startup.

The purpose of this article

The two-fold purpose of this article is to:

  • Enable early stage startups, prior to scaling, to understand the due diligence questions they may encounter from an investor.
  • Enable an investor to structure a set of due diligence questions.

You may download a PDF of this article from: Due diligence questions for an early stage startup

There are three phases to an early stage startup

Startup

  • A startup is a temporary organization designed to search out a repeatable and scalable business model. Lots of learning experiments are carried out. The focus is on getting some delighted cash paying customers.
  • A business model describes how a company creates value for itself while delivering products or services to customers. What are you building and for whom? What urgent problems and needs are you solving?

Preparing to scale

The startup believes it has a business model which can meet the needs of a large number of cash paying customers. The focus shifts to putting in place cost-efficient and easily scalable technology, processes, and talent.

Scaling

The focus shifts to growing the:

  • marketing, sales, delivery resources and activities.
  • channels and distribution partners.
  • Customer segments.

The early stage due diligence questions are one of the inputs to the Investment Memo

The purpose of the Investment Memo is to recommend whether or not the investment is appropriate to proceed to the term sheet stage. The Investment Memo is based on:

  • The answers from the early stage company to the due diligence questions.
  • Additional facts gathered from third party questions.
  • Analysis of the collected facts.
  • Investor judgement, based on a variety of criteria.

The investor will have used simple criteria to quickly filter out early stage companies before devoting time in due diligence E.g.

  • After spending less than 5 minutes reading an emailed application.
  • After a 15-minute phone call or meeting.
  • After listening to a pitch at an event.

The  investor asks the startup six sets of due diligence questions

#1 How does the company create value for its customers and itself?  What is the company building and for whom?  What urgent customer needs and problems are being solved?

  • Target customers:
    1. Who exactly will you be creating value for?
    2. Who will pay you? What are the differences between users and customers segments, if any (e.g. Google – user do searches for free.  Companies pay to advertise.
    3. How will they recognize themselves?
    4. Who will be your most important customers?
    5. What is the market size? TAM (Total Addressable Market), SAM (Serviceable Addressable Market), and SOM (Serviceable Obtainable Market)1
    6. Who is your initial target segment?
  • Customer Value Proposition: A value proposition is the customers perception of value. This perception can be influenced by: facts, emotions, family & friends, social media, etc. The value proposition = (All the customer achieved benefits) / (All the customer incurred costs) All the customer achieved benefits can include problems solved, gains achieved, financial and non-financial (e.g. time savings, convenience, status, etc.) All the customer incurred costs can include financial (purchase costs, costs to switch to your company, other adoption costs, and ongoing costs) and non-financial (time, inconvenience, loss of status, etc.)
    1. What value will the customers perceive they will achieve? This is very different from your opinion as to what value you will deliver.
    2. What problems do your customers think you will solve?
    3. What customer needs will be fulfilled?
    4. Why does the customer believe the value of your solution is better than the status-quo or the competition?
    5. What does the customer believe will be the impact of your solution? E.g. 10 times improvement in something?
    6. What is your MVP (Minimum Viable Product)? What is the smallest set of urgent problems and needs you can solve for a target customer segment, while delighting the customers, and having them pay you?
    7. What is the path to enhance your MVP until you believe you have a solution that can be scaled to meet the needs of a large customer segment?
  • Customer Relationships: What type of customer relationship do your customers expect to have with you?
    1. How will customers be acquired, kept, and grown?
    2. Why type of relationship does each customer segment expect you to establish and maintain? ? g., if it’s a software product, how often will there be updates with new features?  How easy will it be to install a new version?  Will customer service be a chatbot or a live person?
    3. What types of relationships have you already established?
    4. What is the cost of each type of customer relationship?
    5. What is CAC – customer acquisition cost?
    6. How many customers are you losing – churn rate?
    7. What is LTV – lifetime customer value? In the initial startup stages, LTV will be less than CAC, because of the need to obtain an initial pool of customers by doing inefficient things that don’t scale.  As the startup is getting ready to scale, it will have figured out how to make LTV exceed CAC.
  • Channels: Channels are how to connect the value proposition to the target customer. There are three different types of channels. Communications – used to communicate with potential customers.  There may be many communications channels. Sales – where customers and sellers agree on the transaction. Usually there are fewer sales channels than communications channels. Logistics – how to deliver the solution to the customers.
    1. Through what types of channels do the customers want to be reached? In other words, what channels are most effective? E.g. website, app, social media, face-to-face, marketplaces, etc.
    2. What channels already exist?
    3. Which channels are most cost efficient?
    4. Which channels are integrated with customer processes?
  • Key Partner: A channel may also be a partner, if the answer is “yes” to one of the following questions: Is the partner a leading entity with a brand and market position that adds to your credibility? Does the partner add expertise and resources to your solution in a way that increases the value of the solution for the end customer? Is the partner (and their brand/expertise/resources) required to land a contract with the key target customers?
    1. Who are the key partners?
    2. Who are the key suppliers?
    3. What key activities, supporting your value propositions, to your partners perform?
    4. How effective are your current partners and suppliers?
    5. What types of partners and suppliers do you need?
  • Key Resources: Resources mean any relevant intellectual property (IP), technical expertise, human resources, financial and physical assets, key contracts and relationships. In other words, resources refer to anything within your control that can be leveraged to create and market your value proposition (e.g., a patent pertaining to your value proposition, key contacts within the industry).
    1. What resources are necessary to:
      1. Enable the customer to achieve their value proposition?
      2. Maintain channels and partnerships?
      3. Build relationships with customers?
      4. Build revenue?
  1. What resources exist today?
  2. How effective are they?
  3. What are the plans to close the gaps?
  • Key Activities: What are the key activities to enable customers to achieve their value proposition, and generate revenue for the startup. What key activities are necessary to:
    1. Enable the customer to achieve their value proposition?
    2. Maintain channels and partnerships?
    3. Build relationships with customers? Marketing? Sales, Customer service?
    4. Build revenue?
    5. R&D?
    6. Billing?
    7. What activities exist today?
    8. How effective are the current activities?
    9. What are the gaps and plans to close the gaps?
  • Cost structure: What is the cost of delivering the value proposition, including the resources needed and key activities involved.
    1. What are the largest costs?
    2. What are the fixed costs and variable costs?
    3. What activities are the costliest?
    4. What resources are the costliest?
    5. What is the burn rate? (i.e. excess of costs minus revenue)?
    6. What is the runway? (i.e. how many months before all the cash is gone)
  • What will you charge your customers and how will you charge your customers?
    1. What is the value the customers are willing to pay for?
    2. How much are they willing to pay?
    3. How much are they paying today?
    4. What is the pricing model? Subscription, one-time, freemium, advertising, etc.
    5. What are the revenue streams? These could include: subscription-based per person per month, free for a basic service, with multiple tiers of extra services with fees, etc.
    6. How are they paying today? Cheque, credit card, etc.
  • Who is the talent and how are they relevant to the startup’s success?
    1. Appropriate biographies of the management and advisors.

 #2 What are the plans?

  • Gantt chart on one page of the next 24 months.
  • Cash flow forecast. There may be multiple cash flow forecasts illustrating multiple scenarios.

#3 Investor specific

  • Oral presentation deck which supports the oral presenter and is not intended to be read on its own.
  • Standalone presentation deck is intended to be read on its own and therefore has much more information than the oral presentation deck.
  • Cap table lists out each type of equity ownership capital, the individual investors, and the share values. A more complex table may also include details on potential new funding sources, mergers and acquisitions, public offerings, or other hypothetical future transactions.

#4 What is being asked of the investor?

  • Type of capital and amount?
  • Being lead investor?
  • Serving on board or advisory board?
  • Access to investor’s network of other investors, customers, employees, etc.?

#5 Legal documents

e.g. Charter documents, corporate organization, etc.2

#6 Historical results

Company history, past milestones, historical growth, etc.

 Your Next steps

  • If you are a startup, immediately begin to organize your data room to be able to address potential investor due diligence. The bulk of the information in your data room will also help your startup succeed.
  • If you are an investor, create your list of documented due diligence questions.

Footnotes

1 This article contains definitions https://koorandassociates.org/selling-a-company-or-raising-capital/startup-terminology-and-metrics/

2 This is a sample legal due diligence checklist  http://www.1000ventures.com/venture_financing/due_diligence_checklist_byvpa.html