Mosaic Venture Lab
Mitigating Risks In Early-Stage Investment Endeavors
Johnny Yu
In my tenure within private equity fund services, I have encountered numerous inquiries from fellow investors grappling with the intricacies of assessing early-stage projects. Many express concerns regarding their limited grasp of technology, the jargon-laden language used in startup pitches, and a fear of being perceived as uninformed. Additionally, finance experts often question their suitability for evaluating ventures lacking tangible financial metrics, while others struggle to comprehend the valuation reports based on patents. These challenges can surface at any stage of the evaluation process, particularly when dealing with nascent opportunities.
To achieve a mutually beneficial outcome and minimize risks, we must adopt prudent strategies in this endeavor. Here are some of my personal insights and an invitation to consider diverse perspectives.
Conducting In-Depth Due Diligence:
In the domain of due diligence, investors often adopt two primary approaches. The first entails engaging external due diligence agencies, predominantly favored by large investment institutions and private equity funds. The second internal approach entails investment managers defining the scope of due diligence within the organization, seeking pertinent information from the startup, and conducting interviews with key executives, supply chain partners, and potential collaborators. Since professional due diligence agencies might prove prohibitively expensive for smaller funds and are not typically deployed for early-stage projects, we shall focus on the latter approach. Key considerations include:
Assessing Team Resilience under Pressure:
Startups teams exhibit diverse characteristics during the early stages of entrepreneurship. While proficient in research and development collaboration, some teams falter during business development and fundraising discussions, leading to personal conflicts rather than constructive discourse. Investors often assume the role of mediators, adding uncertainty. To mitigate risks, I would recommend familiarizing oneself with team personalities before the fundraising phase and observing their performance under pressure to determine the feasibility of further fundraising discussions.
Evaluating Probability of Patent Commercialization Success:
When evaluating patents secured by startups, two essential factors merit consideration:
a) Conducting an FTO (Freedom To Operate) Study: It is prudent to await an opinion letter from a patent law firm regarding FTO, outlining the rights of manufacturing, usage, sales, and offering without infringing upon others' patent rights, unless one possesses legal expertise and certainty.
b) Assessing Time and Resources for Commercialization: Startups must furnish investors with data on the time and resources required from patent application to successful commercialization. Investors must discern the most efficient means to meet these needs and identify the optimal timing for acquiring external resources to support the startup's progress. The product verification process (from prototyping to UX) necessitates collaboration with partners (as detailed in the fourth point). Startups' limited resources might hinder them from obtaining valuable market insights (customer insights), rendering interactions with end-users less informative (needs, desires, concerns). Valuable information is often in the hands of collaborating manufacturers, profoundly influencing product design and technological evolution. Consequently, I would advise investors to directly engage potential partners to ascertain authentic market needs and validate resource requirements.
Evaluating Probability of Certification Approval:
Certification requirements pertain to specific products, such as automotiverelated components, medical products, etc. While regulations are not immutable, startups must demonstrate the inapplicability of extant regulations to their novel products.
This entails substantial resource investment and entails the risk of low approval probability. Certification based on analogous products generally necessitates fewer resources, given the presence of comparable market products. Nonetheless, such an approach might necessitate compromising market positioning initially, with enhanced data verification confirming product value leading to significantly higher approval probabilities.
Addressing ProductMarket Fit:
Market pain points and collaborator pain points are distinguishable concepts. Addressing market pain points might differ from resolving collaborator pain points. The former could involve designing products that save users substantial time while maintaining efficacy but could face challenges in scaling production, resulting in limited affordability for users. Conversely, a biotech startup seeking to enhance a specific sensory ability might encounter physician apathy in favor of more critical life functions. Evaluating product-market fit and strategic execution necessitates addressing these issues. If productmarket fit falls short, adjusting product development or seeking collaborative assistance for joint product development is recommended. Investors might serve as consultants, guiding startups in aligning their offerings with market demands.
Leading the Investment Endeavor:
For minority investments, absolute respect from startups is challenging to attain, often involving concessions on rights. Small funds are better served by co-evaluating deals with other investors, forming a ‘significant minority’ consortium and spearheading investment efforts. This proactive approach enables in-depth comprehension of industry trends and the startup's research and development endeavors.
Investors confronting exit pressures should explore alternative mechanisms, such as reselling equity to subsequent investors or restructuring their own funds
Engaging in Board Participation:
At the investment decision-making stage, a critical question frequently arises: should an investor secure a board seat? In the context of mid and late-stage deals, the conventional thinking pattern is to avoid directorial involvement for a smooth exit postIPO. However, in early-stage deals, active investor participation is crucial to gaining insights into the startup's operations, product development, and adeptness in responding to market trends.
Strategic Exit Planning:
Early-stage investments demand substantial time and effort, with startup management teams facing fundraising challenges. However, fundraising endeavors cannot adhere to rigid schedules. Consequently, product development timelines frequently deviate from expectations, delaying fundraising schedules and impacting exit timing. Investors who remain fixated on the initially projected exit timing in the investment evaluation report risk stagnation. I have encountered numerous startup CEOs who have suffered blame and slander from investors, unable to voice grievances, subsequently leading to external potential investors withdrawing support and profoundly affecting company development. Investors confronting exit pressures should explore alternative mechanisms, such as reselling equity to subsequent investors or restructuring their own funds.
Investors inherently harbor expectations for startups, but excessive pressure might prove detrimental. While constructive pressure can prove beneficial, an overwhelming burden risks becoming the final straw. The above insights presented herein pertain to risk planning for early-stage investments, encouraging open discourse and diverse perspectives.
