This article is the fifth in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
How often have you heard about a new product and thought “what a great idea”, only to find out later that the product failed miserably? It happens all the time… and I mean ALL THE TIME! As consumers of technology, we are inundated with new products on a daily basis. Many of these products serve a useful purpose, but they don’t change our lives or our productivity in a meaningful way.
So before you accept an entrepreneur’s premise that her product will rule the world, step back and assess whether she’s really got a game-changer. Speaking with customers and prospects is a central part of any solid due diligence process. But how you do it matters a great deal. If you ask superficial questions, you will always hear positive answers. You have to get into the mindset of a future buyer to understand how useful this new product will be.
Q: Ham, I have heard you talk about “oxygen, aspirin and jewelry.” What does that mean and how do you go about the process of determining whether a product is “Aspirin” or “Oxygen”?
I start with the following question: Is the product a ‘Nice-to-Have’ or a ‘Need-to-Have’? Aspirin helps reduce pain but isn’t critical for survival, so it is a nice-to-have product. However, you can’t live without oxygen so it is a need-to-have item. Keep in mind that this is a continuum, and that the real difference between the two categories is just a market size question and a question about buying priorities - inevitably with any given product, the oxygen buyers are just a subset of the aspirin buyers - there are always more customers who look at it like aspirin than oxygen. For a start-up the questions are: (1) can you get to the oxygen folks early on to give the company a toehold and (2) are there ultimately enough reachable aspirin buyers to make for a big market and grow a big company?
With that in mind, my diligence process is simple. I reach out to current customers and prospects for the company’s product. During my customer checks, I focus some of my initial questions on understanding the customer’s key pain points and try to discern their buying priorities. I ask the following three questions:
What problem does the product solve for you?
On your list of the top problems in your organization, where does solving this problem fall on your priority list?
Is your company generally an early or late adopter of new solutions?
By asking these three questions, you learn a lot. First of all, you hear in the customer’s words what problems are solved by the product (see discussion of features vs benefits). Does that match what you are hearing from the entrepreneur in her pitch? If not, this is useful information you can pass back to the entrepreneur. If it does match, then you know the entrepreneur is doing a good job of listening to the customer.
With the answer to the second question, you are gaining critical insight helping you gauge where the product falls on the aspirin/oxygen spectrum. If the customer tells you that the product solves one of his top three problems, you are in Oxygen territory. Anything outside of the top 3 priorities and you are now in Aspirin territory. But don’t rely on just one or two customer reference checks. This is one area where you need to dig deep during your due diligence! By talking only to one or two early adopters it is very easy to fool yourself into thinking there is more demand for a product and a larger market than there really is.
Q: What can you tell us about the buying habits of early adopters versus the buying habits of mainstream customers?
In most cases, initial customers for a tech startup will inevitably end up fitting the classic “early adopter” profile. Early adopters in the consumer space are easy to recognize.
They are the ones willing to buy from a new company with no established track record.
They are the ones who are happy to show off the latest new electronic gadget.
They are the ones waiting in long lines whenever Apple releases a new iPhone.
And, they are the ones with a closet full of last year’s wonder products.
In the corporate world, early adopters tend to be either really hungry small players looking for absolutely any edge they can get to help them compete or leading technologists in large corporations. The big company technologists have a mandate from senior management to be on the lookout for new productivity enhancing products, and they have significant budgets to pay for pilots and test installations of all these new products. Since part of their job is to stay on top of new technology trends, it doesn’t matter to them whether a product is Aspirin or Oxygen. And, just like your friend with the closet full of electronic toys, it’s not unusual for the corporate early adopter to undertake many dead end beta evaluations - in effect, to have dozens of forgotten products in his proverbial closet.
It’s important to recognize this type of customer for the role they play in the ecosystem. They provide early feedback to the startup company on the quality and usefulness of a product. They sometimes act as references and write reviews or participate in press releases or whitepapers on products that influence “mainstream” customers. But, early adopters represent a VERY small percentage of the overall market, and their desires and needs are different than the majority. Though startup founders make this mistake every day, interest from early adopters should NEVER be confused with market traction or true customer validation.
Although early adopters are important, when doing diligence we must speak with the larger mainstream customer base to gauge the true customer need. A startup company will not grow beyond a few million dollars in revenue if it can’t Cross the Chasm and sell to mainstream customers. And mainstream customers are always going to have more oxygen products than aspirin products at the top of their buying priority list. To be successful, you are either going to have to come up with a product that is oxygen to a lot of customers, or be really good at marketing aspirin.
Q: How do you pull together a list of customers / prospects to call?
I start with the list of key customers and prospects that are provided by the company. This list is usually relatively short --- say 2 to 4 contacts. It represents the contacts that the company expects will provide glowing reports. And, most likely, it will be a bunch of early adopters who represent a small slice of the overall market.
Next, I work with our due diligence team to draw up a list of prospects we believe might be interested in the product. These prospects should come from the more mainstream segment of the target market. At Launchpad, we invest in businesses where we have expertise. Part of that expertise includes having influential contacts at key target customers. If you don’t have those types of contacts when you are performing your diligence, you are exposing yourself to market risk. One clever way to find mainstream customers to call is to ask the company-provided contacts who their competitors are.
If possible, try to connect the company to potential sales opportunities with these prospective customers. The feedback you will receive from these sales calls should prove instructive in assessing the “Need to Have” level of the company’s product. In many cases it is equally important to talk with the company’s partners or prospective partners for their perspective on the “need to have” requirement. Remember that these partners are some of the most likely acquirers of the company.
Q: Is it difficult to find customers and prospects to speak to?
In general, it’s not hard to find people who are willing to give you feedback on a new product or service. If the company doesn’t even have a prototype to demonstrate, their feedback is based on their perception of what they believe the product will do for them. Without something to actually interact with, their input to you will be of limited value.
Let’s look at a couple of examples. What if the company is building a new medical device that simplifies a complex surgical procedure. With just a set of CAD drawings, a surgeon can only imagine whether the device will help, and justifiably, she will be reluctant to give a positive recommendation, or if she does, it will be based on her conception of what the product *might* be able to do for her.
Now, imagine a new video game. It’s based on the latest in Virtual Reality technology. But, all the company can show you is some artist renderings of what the virtual world will look like. How are you going to find out if their target market of males between 16 and 24 will make this new game a big hit?
In both these examples, the stage of the company’s product limits the value of customer due diligence. You will have to rely on your own expertise and maybe a few of your most trusted industry contacts.
Q: How do you handle sensitivity around speaking to customers and not spooking them away from this early startup?
It’s not unusual for a CEO to be hyper-sensitive when investors call their customers. They worry that customers will freak out because the investor might raise red flags about the long term viability of the company. Personally, I believe that CEOs are justified in thinking this way. If investors aren’t sensitive to this situation, they can cause the company harm. So how do you go about asking questions in a way that puts everyone at ease and gets you the answers you need for your diligence report?
First of all, I set the stage by describing why I am calling. I tell the customer that I am a prospective investor and looking to help the company reach the next level of success. I frame my introduction in a way that should ease their concerns. Next, I start with questions about the customer’s business and what problems they are solving with this new product. In most cases, the customer is very willing to open up about their issues and challenges. And remember, the answers to these questions are critical in helping you understand buying priorities - whether the product is Aspirin or Oxygen.
Depending on how open the customer’s initial responses are, I might dig deep and ask tougher questions, or I might limit our conversation to the basics related to Aspirin vs. Oxygen. And, I always end the call by saying something positive about the start-up company and thanking the buyer representative for their time and help with my research. By keeping a positive tone throughout the call, we can usually limit any concerns that the customer might have about the startup company.
Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.