William Poon: Cornell Tech FM 

Original Article BRV Due Diligence Framework Pt. 1

Once the fund managers agree as a group that we are interested in a company and want to learn more, one manager will gather a team consisting of other fund managers and associates. This team will then conduct due diligence to decide whether this startup would make a good investment. I’ll highlight the general topics and some questions that we look into. This list was refined by Rick Wang and other fund managers from the class of 2020.

High Level Diligence Framework

When conducting diligence, the best place to start are the top reasons that startups fail. These reasons can be categorized as follows:

No market need

  • Question: “Can money be made?”

Not the right team

  • Question: “Can the team deliver?”

Outcompeted

  • Question: Can they win?”

Detailed Diligence Framework

Product-Market Fit

This general topic dives into whether the founders have developed a product or service that the market actually demands and will pay enough for to allow the company to generate a profit.

Value Proposition:

Value proposition answers the main question of what value the company is providing to the user or customer. Sometimes the user and customer are one and the same and at times, they are different. This depends on the company’s business model.

Problem

  • Have the founders actually spoken to customers to identify an unmet need in the market?
  • Do the founders have a unique understanding of this problem?

Solution

  • What exactly is the solution that they’re suggesting? Does it solve the problem?
  • Are they addressing needs or wants?
  • Is the solution differentiated? Is it unique or are there similar solutions from competitors?
  • Is there a sustainable competitive advantage?

Product

  • Does the team have a unique, proprietary product? Does it work?
  • Is there technical risk remaining? Is there unique IP?

Market Size

Is the market large enough that the startup’s acquired market share would generate an adequate return on investment? If the market is small, then the startup must clearly be the solution and must establish a monopoly to make a sizable return. This is very hard to accomplish. Therefore, most investors will look for a startup that addresses a large market (total addressable market “TAM”). A conservative estimate assumes whether the startup’s 5–10% market penetration would create a large return. Alternatively, the startup could approach a smaller market first with the future plans to expand through additional products or other methods of expansion.

Total Addressable Market (TAM)

  • The most important thing to understand for an early-stage company is the total addressable market; how much money could the startup make in a year if it had a total monopoly. This communicates to the investors how large the playing field is and also allows the founders to show what the larger vision is. Ultimately, a company must also understand its Serviceable Available Market (SAM), how much of the market the startup is currently operating in, and Serviceable Obtainable Market (SOM), how much of the market they can tackle right now, though these metrics are harder to estimate and less relevant at the outset, when the product(s) and target customers are still being defined. Founders can also communicate the TAM with the number of potential users or customers in the market, how much in revenue could be acquired from each customer, or what areas they are looking to enter into. The founder should not simply cite statistics from an industry report, but rather use the opportunity to support their narrative of the company’s trajectory.
  • TAMs that VC funds look for will vary but most will want to see that the startup is tackling a TAM that is at least $1B. The reason is to know that the company is setting its sight on growth.

Market Trends

  • Investors will want to know what trends are appearing in the market that would help drive growth for this startup and their solution. Trends could be recent development in technology or growing customer needs and problems. Sometimes we look into how the TAM has grown over the past 5–10 years to get a sense of the market trends.

Industry

  • For a fund like Big Red Ventures that looks at startups from all industries, the fund managers may not be familiar with the startup’s niche industry and could require an overview of the industry.
  • Databases can include Capital IQ, Mintel, CB Insights, Crunchbase, and various industry reports.

Business Model

The Business Model is how the startup plans to make money. It should clearly communicate whether they’re selling products, services individually, or a platform, using a subscription model such as Saas for software startups. These different business models each present their own challenges. Communicating a strong business model helps investors analyze the risk factors or obstacles for future growth.

Focused on growth or profitability

  • Is the business model currently focused on rapid growth or profitability? Most investment opportunities for VCs will be focused on growth since that will bring a higher return. Companies that are focused on profitability will most likely be small businesses or perhaps more mature in the business lifecycle.

Barriers to scalability

  • By understanding the business model, the investor can pinpoint what would prevent the startup from being successful. If it’s a platform, for example, some barriers could include adequate demand on both sides of supply and demand or how to strike the right balance between them. For a subscription model, questions such as the right price or how often the customer should be charged will matter. Freemium models will bring questions of what features should be offered to invite a large population of users and what features should be offered for an additional fee and for how much.

Financial Model

  • The financial model helps give the investment team insight into the assumptions that the team is making for their startup = from how much of the market they believe they’ll be able to acquire, how many employees they plan on having and how much they’ll be paying them, to if they remembered that a software startup has incorporated infrastructure costs like hosting.
  • The team should know how much they are budgeting for reinvestment, especially in the growth stage because if it isn’t included in the model the projected growth rate can be off.
  • At the early stage, the financial model will not be validated and the forecast could be very ambitious. However, we have found that a financial model provides valuable insight into their startup and thinking.

Continued in Part 2.

Contribution from Thatcher Bell, Jennifer Chu, and Nicole Beck.