Spotting Investor Red Flags: Evaluating Early-Stage Startups

精闢見解 | 10 十一月 2023

Red Flags

During the process of negotiating a potential investment in a business venture, investors will undertake a “due diligence” review of the target business to identify commercial and legal risks. Serious issues identified in this process are referred to as “red flags”.

When looking at investment in startups, there is a lot less focus on the legal details typical of a standard due diligence exercise. Venture capital investment is, by nature, a high risk – high reward affair, and early-stage startups can understandably be a bit unsophisticated in the management of their legal affairs. However, what successful VC investors are often looking for in startups are certain intangible qualities – a convincing business plan, potential for growth and a demonstration of the ability and drive required to overcome challenges – which make them worth taking a bet on.

In today’s column we will zoom out and focus on some of the more fundamental red flag issues often found in early-stage startups - which can easily sink investors’ interest in the project.

Spotting Investor Red Flags: Evaluating Early-Stage Startups

Growth Mindset

Venture capital investors are typically only interested in investing in projects with a high potential for growth. The goal of most VC investors is to see the target business grow rapidly, capture market share, and exponentially increase in valuation, leading to an eventual exit at a very high profit margin. The reason for this is that the vast majority of startups will fail, so the few success cases need to really make it big in order for a VC’s investment strategy to pay off.

This aspect is one of the key differences between a “startup” and a traditional “SME”. A normal business typically needs to be sustainable, and its main goal is to consistently generate profits for its shareholders. However, a startup will be willing to burn through (lots) of investor money in order to gain market share and increase its valuation. These businesses are often not profitable for many years as they grow, as stakeholders are not interested in generating profit in the short term, but rather achieving a market valuation which will allow for a windfall exit (such as through a sale or IPO).

As such, growth may be the single most important metric to potential investors. While having a solid business model capable of generating revenue is important for its long-term viability, a startup will not be attractive to investors at an early stage if its business model is not scalable.

Understanding this, founders who are looking to secure investors interest may need to review their business plan from the perspective of focusing on growth and scalability rather than conventional return on investment metrics.

Founding Team

The founding team is probably the single most important component of an early-stage startup. A startup’s identity is often closely tied to its founders, and more so than in any other type of business, potential investors will be keenly interested in the composition and dynamics of the founding team.

Unnecessary complex or inefficient management structures are bad signs for the viability of a startup projects. Investors will want to know what each member of the founding team brings to the table. What are the unique skills or experience that will contribute to the success of the business? Are co-founders just friends or family who want to “get into tech”? Investors want to see their money go into growing the business, not wasted on management dead weight.

Investors will also pay attention to how well the founding team works together. If there are signs of discord between founders, or if there is no clear leadership structure etc., this would represent a clear risk that the management of the business may not be able to work together effectively to achieve its goals.

Founders should have their house in order before talking to investors. A clearly defined identity and roles for the founding team and a common vision for the project will impress investors. Having a founder’s agreement in place shows that the founders take their legal relationships seriously. Also, maybe re-consider whether hiring both your cousins as “vision-leaders” was really the right management decision.

Unethical Practices

This one seems obvious, but many startups are disruptive by nature, and will want to test existing regulatory and legal boundaries as they attempt to create a novel offering in the market. These startups will often operate in legal grey areas as their product/service is maturing and being tested on the market. Despite these compliance challenges, what’s important is that the startup (and its founders) is reputed to act with integrity towards partners, customers, and investors. Fraudulent, illegal, or unethical behavior will harm the business in the long run.

Rather than try to hide them, founders need to be up-front in disclosing legal hurdles to their investors and work long-term solutions into the business model. While operating with some degree of legal uncertainty may be necessary in the short term, the business model presented to investors should always aim to achieve compliance with applicable legal and regulatory requirements.

At the end of the day, more than any single legal problem, a feeling that founders are behaving in an shady manner or have skeletons hiding in the closet will make investors think twice before committing to a project.

Finally, besides avoiding some of the most common investor red flags, founders should always place the focus squarely on the strength of their startup project. Hurdles to success are many – strong market incumbents, competitive threats, overly ambitious goals, talent retention challenges, regulatory gatekeeping, resource limitations etc., - but as a new and upcoming challenger, a startup will have its own special set of advantages – fresh and dynamic ideas, personalized approach, larger risk appetite for risk. – These will give the startup a chance of standing out in a competitive market environment, and will be what ultimately convinces investors to take that bet.