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I think it's time to replace the "think big" mantra with "think niche." As you point out, there is no reason why a niche, either feature or market, can not later be expanded. In fact, targeting a niche first may help because it generates buzz and initially targets more involved customers who will provide feedback and guidance
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Definitely be straight up. Lean on the harsh side. The way to mitigate is to be constructively critical. "We're going to say no because we feel your team lacks....." or "Your team came off as too arrogant" The worst thing would be a white lie or something vague. There is nothing I can learn from that.
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