The due diligence funnel

Published On May 16, 2022

Note: Great news! We’ve added a fifth Due Diligence judge, and a new step in our funnel, for the 100K Best of the Fest prize this year. We’ve updated this post with more details.

Startup pitch contests seldom peek beneath the surface of a founder’s story. In the short amount of time available to judges, a startup has only time to frame the basic business model, drop a few comparisons, and hope to pique interest. That’s why, despite the showmanship, reality TV shows like Shark Tank and Dragon’s Den don’t actually reach agreement on stage: Participants are warned beforehand that nothing said during the show is legally binding. If they want to secure funding, they have to survive a far more detailed inspection.

When a company closes investment, they go through a due diligence process. From the investor’s point of view, their job is to steer dealflow towards a funnel that identifies the startups most likely to deliver a significant return on their investment. In 2022, Startupfest building this kind of due diligence thinking into our Best Of The Fest Investment prize—and unlike reality shows, one company will walk away from the event with actual financing. Here’s how it’ll work.

 

The Due Diligence Funnel

 


The five dimensions

For a startup to succeed, it has to execute well in five dimensions, and that means beyond the initial framing of what the company does, the winner must deliver superb answers to five questions from the judges:

 

Product and technology: What do you make?

A startup is searching for a sustainable, repeatable business model. That means discovering an unmet need within a market, then creating the product that satisfies that need. While not all startups are technology companies, most are, because the primary goal of a startup is rapid scale—something that digital systems do far better than physical ones.

The first question investors need answered, then, is what does the company sell, and how is it built? What proves that the product will meet market needs predictably and reliably while delighting customers? What are the inputs to the product, the technologies on which it depends? Is the technology realistic, is the roadmap realistic, and are the systems scalable?

 

Sales and marketing: How, and to whom, do you market?

If a business doesn’t deliver a return on investment, it’s not a business—it’s a hobby. Whether the company makes money from transactions, advertising, subscriptions, or another form of revenue, it needs a way to reach prospects and convert them to customers. This is sometimes referred to as front-office activities.

So the second question is answered by the sales and go-to-market strategy: How does the company sell, and to whom? This is about capturing attention, charging the right price, and making sure the business model is viable. It’s also about demonstrating an understanding of the target customer, their needs, pains, and existing solutions.

 

Finance and funding: What fuels the business?

Before revenues kick in, a startup runs on funding. Whether that’s a simple loan, revenue-based lending, convertible debt, traditional equity—or just your hard-won savings—the fuel for growth comes from outside backers. Even after you’ve hit break-even, one of the things that distinguishes startups is that they reinvest earnings into R&D as they build out differentiated technology, chase market dominance, and compete for the best talent.

The third question to tackle is how is the startup funded—and how will that shape its growth? Are employees properly motivated? Does the firm’s returns exceed the interest on its loans, and how long will it take to get there? When do convertible notes become equity, and what guarantees or expectations do investors have? Will the company act on its first chance at liquidity, or hold out for a larger public offering? And how does its cashflow constrain the startup’s ability to pour earnings back into research and development?

 

Legal and operational systems: How are you structured?

A company is a set of people guided by processes. Much of what makes a company exist is information: Legal contracts, intellectual property, data, accounting systems, and stock agreements. While this might seem mundane, a significant portion of due diligence, financing, mergers, and acquisitions is devoted to the “data room”—a collection of documents that describes the state of the organization.

The fourth question, then, is whether the structure of the organization is workable. Is there sufficient equity to motivate the founders and attract talent? Does the company have accounting processes in place? Is there legal entanglement from intellectual property or software licenses? What contracts, liabilities, and obligations does the organization have today, and what will it need in the future?

 

Team, culture, and leadership: Why this team?

If you have a good startup idea, you’re seldom alone. There are other companies racing to be first, or best, to market. So the final question is: Why this team? All else being equal, what is it about this organization that can share a compelling vision, attract the best talent, and ride the inevitable rollercoaster of startup growth?

A seasoned team may have better contacts, and hit the ground running. On the other hand, a first-time founder may have a fresh approach or more modern knowledge that gives them the upper hand. Some founders may have full-stack skills, able to turn out features at breakneck pace, but be unable to work alongside other, less technical employees. Others may be visionaries unwilling to devote themselves to paperwork and process.

 


The order of the funnel

We’re going to run our Best of the Fest Investment prize in the order above, because it narrows the field in a logical way:

  • Most companies can explain their technology stack and go-to-market strategy without disclosing confidential information. Discussions about shares and team experience can be challenging and awkward, and should be undertaken once we know the company has identified a reachable target market with a product or service it needs.
  • The order moves from things outside our control to things within our control. While a company can design a sales strategy, there’s no guarantee customers will buy from it. Similarly, a product roadmap can be detailed and convincing, but product development is fraught with uncertainty. By contrast, fundraising strategies and legal/operational information is concrete and objective, and the founding team is who it is. There’s no uncertainty in the latter phases. As with startups, investors want to narrow the field by reviewing the riskiest things first, and only investing in a review of finance, legal, and the team when they know the fundamental ideas are solid.

No event can equal the detailed scrutiny of an actual due diligence process, which often takes weeks and involves dozens of experts. But with this five-stage funnel, the Best of the Fest Investment prize in 2022 moves far beyond the platitudes and veneer of traditional pitch contests. It’ll help the judges make a better decision—and by doing it in the open, show the hundreds of aspiring founders in the audience how they can best secure their own financing when the time is right.

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