Investing in Startups: Four Levels of Fitness - TechInvest Magazine Online

The fitness concept in the sense of a startup’s suitability for financing is relatively new, while the term “investment readiness” is rather common. Cambridge Dictionary determines readiness as “the state of being ready,” and fitness as “the quality of being suitable for someone or something.” Like that, the fitness concept is more in line with the idea of a startup’s suitability for funding.

Outlining the Fitness Concept

The term “product-market fit” is widely known, but product-market fitness is only one of several funding fitness levels. According to CBInsight, 35% of startups failed, being unable to raise money. Three main reasons for this inability are the following:

• Concepts are non-competitive in the market – 20%.
• A product does not fit the market – 35%.
• Business models do not fit – 19% [1].

Entrepreneurs can improve their chances of developing their businesses efficiently by selecting the right type of investor. In this way, we can recognise one more level of fitness: investor-founder fit. Today, Mergers and Acquisitions (M&A) become a private equity market pipeline, together with Corporate Venture Capitalists (CVCs) and Syndicated Investors. [2] It is important for startups to consider the types of investors they want to attract. Each type of investor has its own specific vector of investment rationale, or main direction of activity that influences investment decisions.

A number of surveys indicate that investors’ decision-making is heavily influenced by perceived fit. For founders, understanding how investors perceive a startup’s fitness is a prerequisite for successful funding. The perceived fit not only answers the question “to fit or not to fit?” but also comprises the whole concept of fitness. The cradle of this concept is a dynamic circle of the startups’ sourcing and screening depicted in Fig. 1.

There are two challenges faced by startups at the same time. First, they have to develop themselves to become profitable enterprises. Second, to win the funding race founders have to demonstrate to investors how well they are fit for funding. It’s a pity that most founders understand the second perspective only. Yet, not many investors agree that the first challenge is their responsibility. To that end, intermediaries/facilitators may come to help founders while serving the interests of investors.

Levels of Fitness

The definition and prioritisation of fitness perspectives require a structured approach. The latter is depicted in Fig. 2, as the startup fitness pyramid that structures two fitness challenges. Four levels of startup fitness are presented on the right arrows: proof of concept (POC), minimal viable products (MVPs), business experiments with MVPs, and exit scenarios.

On the Problem-Solution level, founders have to explain what the customer’s serious problem is and how plausible the solution is. Startups can use the Six-Step method to identify the customer problem they will solve:

Step 1. Determine a problem:

• Currently used available alternatives.
• Customer awareness.
• Address the problem with a focus on the most important facets.

Step 2. Determine the product’s novelty:

• Incremental – The degree of innovation is low. Minor changes are made to an existing product.
• Medium-Innovated – The medium degree of innovation. Based on the R&D enterprise’s activities.
• Purpose-induced – The medium degree of innovation. Innovations of this type are driven by customer needs and demands.
• Breakthrough – A very high degree of innovation. Applying new technology to meet unknown needs with great benefit to the customer.

Step 3. Specify the product’s features:

• Usability – It is easy for the customer to understand how to use a product.
• Capability – The product’s functions are determined.
• Utility – Customers perceive the usefulness of the product.

Step 4. Estimate the status of digital services:

• Digital services are integrated with a physical product to add value to the latter.
• Physical products are not completely dependent on complimentary digital services.
• Independent digital services.

Step 5. Define customer benefits:

• Functional benefits – Technical or physical advantages of products or services.
• Symbolic benefits – Advantages of products or services related to self-esteem fulfilment, social approval, or personal expression.
• Experiential benefits – Advantages of products or services related to satisfaction, convenience, and any other pleasure experiences for the customer.
• Cost benefits – The benefits of purchasing products or services are realised through minimising the price.

Step 6. Formulate a solution.

The Product-Market level is well described in business literature.

Investors do not know exactly how early-stage and typically pre-revenue startups are fit for funding. Until recently it was assumed that a business plan plays a key role, in outlining business opportunities, problems and solutions, target markets, teams, and financials. It was also assumed that business models were somehow validated in the market. With a strong reliance on historical data patterns, this approach works for revenue-generating enterprises but turned out to be ineffective for pre-revenue startups. In the latter case, a validated experimental approach promises to find the optimal balance between risk and profit. Business models form a core of this approach, while startup founders are key performers. [3]

Since the business model is something inherent to startup success, it shows the best how a startup is fit for funding. Business modelling has four important features correlated with validation:

• It gathers all essential elements in one framework, creating a tool to operate with these elements.
• It allows for discovering interrelationships among elements and distinguishing patterns that can be useful for business profitability and scalability.
• It captures value, leverages profit, and even makes any technological innovation viable.
• It is a self-learning process both in terms of mastering new modelling approaches by humans and in terms of Artificial Intelligence/Machine Learning (AI/ML) applications. [4]

Special attention to Investor-Founder Fit

An exit event is a crown of investor-founder cooperation. Planning an exit strategy is important for both entrepreneurs and investors. To find a balance between startup preferences and acquirer/investor criteria five groups of factors should be taken into account:

1. Main concern about a prospective startup’s funding/acquisition. 2. Main goal to reach after the startup’s funding/acquisition.
3. The main feature of the startup’s investor/acquirer.
4. The essence of a proposal to the startup’s investor/acquirer.
5. Key strategical considerations and a timeframe.

An algorithm can use information related to the five factors to form one of three scenarios as shown in Fig. 3:
Scenario 1: Syndicated investors intend to increase the startup’s value to sell it later at a profit.
Scenario 2: M&A acquirers want to improve their own companies’ financial performance at a reasonable level of risk.
Scenario 3: CVC investors take equity stakes in startups to advance their products/services or develop complementary products.

Investor’s vectors of investment rationale include:

• Syndicated investors are looking for exit potential. Generally, their screening criteria are based on the strength of the management and the prospects of profitability of the company.
• The CVCs aim to facilitate team integration and innovation through screening directions for team integration and innovation.
• It is the goal of M&A acquirers to acquire businesses. As a result, they focus primarily on team competition and marketing capabilities, as well as scalability.
  

The PROFIT Startup Dossier is a tool to provide Investor-Founder Fit. Using the Dossier, startup founders can customise information for the screening process, taking into consideration M&A acquirers’, CVCs’, or Syndicated investors’ vectors of investment rationale. [5]

References

1. The Top 12 Reasons Startups Fail; https://www.cbinsights.com/research/startup-failure-reasons-top/

2. 2023 M&A Trends Survey: Navigating Uncertainty; https://www2.deloitte.com/us/en/pages/mergers-and-acquisitions/articles/m-a-trends-report.html

3. Discovery and Validation of Business Models: How B2B Startups can use Business Experiments; https://www.proquest.com/openview/c10b094f6ac70e3c4c369325d7460f8b/1.pdf?pq- origsite=gscholar&cbl=2034500

4. Robo-Fitness Validator “Get Fit for Funding.” White Paper; https://profit.enterprises/investor-gate/

5. A Data-driven Startup Dossier for Sourcing and Screening by VCs; https://techinvest.online/a-data-driven-startup-dossier-for-sourcing-and-screening-by-vcs/

About PROFIT.enterprises:

PROFIT.enterprises is a technology platform that is focused on initial sourcing and screening for investments in early-stage startups. The platform kicks startups to get fit for funding and shows investors attractive business opportunities via the discovery and appropriation of intangible assets. As a data intelligence partner, PROFIT.enterprises provides investors with trustworthy information about startups’ prospective profitability and risks, making the deal flow efficient, quick, and convenient.