Due diligence can differ between the pre-seed and seed stages of startups, although many aspects of the process remain similar. The extent and focus of due diligence often change based on the stage of the startup and the specific needs and expectations of investors or stakeholders. Here we highlighted some key differences in due diligence between the pre-seed and seed stages:
At the pre-seed stage, due diligence will be less extensive because there is no fully developed product, revenue, or a complete team. Investors focus on the founder(s), their skills, their history and track record and the concept’s potential, specifically its USP. They will conduct market research, assess the product’s position in the market (entry) segment.
Seed-stage startups typically have a working prototype and may have generated some initial traction or revenue. Due diligence becomes more in-depth, covering aspects like product-market fit, early financials, user metrics, and the scalability of the business model.
At this stage, investors place a heavy emphasis on the founder or founding team. They assess the team’s skills, commitment, and vision. The due diligence process may involve background checks, reference calls, and in-depth interviews with the founders.
Seed-stage investors continue to evaluate the founding team, but they also scrutinize the broader team that’s necessary for scaling the business. They look for gaps in expertise and evaluate whether the team can execute the business plan effectively.
At this stage, financials are less mature. Investors may focus on the founder’s ability to manage finances and the feasibility of the business model. Projections are often high-level and based on assumptions. The startup’s internal processes are reviewed (internal “hygiene”).
Seed investors expect more detailed financial information. They assess actual financial performance and the startup’s ability to generate revenue. Projections are based on more concrete data, and there is greater scrutiny of the startup’s burn rate and capital needs.
Market validation often involves assessing the size and potential of the target market and industry trends. Investors want to know if the startup’s concept addresses a real problem. Fundamental is always if the product is addressing a new market or if it is targeting to replace existing product(s).
At the seed stage, investors expect more substantial evidence of market validation. This could include user feedback, customer acquisition metrics, and early revenue generation. In general, they will look for potential customer reference all to understand how far the startup has progressed in its market and business development.
Intellectual property considerations are often less detailed at the pre-seed stage, but investors may want assurance that there are no significant legal barriers to developing the concept. Having a clear sight on (potential) patents and the overall patent playing field is essential.
Seed investors typically conduct a more thorough review of intellectual property, including patents, trademarks, and copyrights. They expect to see patent applications in progress. They will also conduct legal due diligence to ensure there are no legal issues or liabilities.
While these differences exist, it’s essential to note that due diligence is a tailored process. The extent and focus of due diligence can vary widely depending on the startup, its industry, and the expectations of the investors or stakeholders involved. It’s crucial for founders to be prepared and transparent throughout the due diligence process at any stage.
One of the challenges that comes with design services is the cyclical nature of the services business. When the economy tightens and corporates are watching their operational expenses, the first step will be to halt any external contracts/contractors which are not deemed absolutely essential.
Whereas the earlier (staircase) model is a good approach in scaling up revenue and creating new revenue streams, the foundation of the company is still based on the service model: headcount continues to be the main driver (typically up to 60-70% of revenue). In terms of (enterprise) valuation the additional revenue streams, however, will already make a significant difference.
Design services companies typically start small (some exceptions when it concerns management buy-outs) and natural growth is a slow process as it requires hiring and training of engineers based on/driven by the revenue stream of the company. Growth of business is tied to growing the team and it is not always easy to find the engineers.