Finding the right investment opportunities means also passing the wrong ones. In this article, I go through the most common red flags that are instant signals for me to let the case go. This is not an exhaustive list, but more of an overview of issues that can kill an otherwise very appealing opportunity.
A Solution Looking for a Problem
When screening startups I tend to prefer companies with proven traction. And even companies without traction there should be a clear problem to solve and somebody who is willing to pay for the solution – i.e. market. When the team starts to look for a problem that their solution can solve changes are that there is no significant market demand for the solution.
Scalability is typically the issue that makes me pass an otherwise interesting opportunity. I need to make my returns and it means that the business needs to grow large enough and fast enough.
Especially with tech companies, the founders tend to think scalability as a technical issue, but there is more to it. Every element of the business needs to be scalable: Product, tech, sales model, distribution, HR and so on. (It does not matter how many users the system can handle at the same time if the bottleneck is in onboarding or product demonstrations.)
In these cases, the founders should note that their business might be good business as such for the founders, but due to the lack of scalability, it will not be good for the investors. The question to be answered at this point is whether the founders wish to pivot the business model on a more scalable one or continue building the business without investor funding. It should be kept in mind that both are feasible options.
I need to be able to work with the team; not only when things are going great but especially when things are going bad. Thus, there needs to be open communication and culture of trust between the team members as well as the investors. If for one reason or another I do not feel that I can trust the team, I will pass the investment opportunity. Also, a non-coachability is an issue since I cannot add any value to the startup.
I recall a case when discussing valuation one founder started literally shouting at me claiming that I do not value all the hard work they have put in creating the product. After this 10 minute feedback, I thanked the founder and said that there is no point in continuing our discussions. If I cannot have an open discussion about an as simple thing as a valuation of a company, how on earth I could have any feasible discussions with the founder about anything resembling something challenging?
Investing in a Hole
The financials of the company need to make sense. If the investment would mainly go to cover existing liabilities, the investment is not creating the growth I am investing for; thus, there would be no investment case for me.
The burn rate and size of the funding round should also make sense. Personally, I prefer companies aiming for 18-24 months runway or 12 months for very early stage cases. If the runway is less than 12 months, the focus of the team is not in building a business but in raising the next round.
There are three elements through which an angel investor can create good returns: Making a great exit, optimizing the holding time of the investment and getting in with a reasonable valuation. Thus, the valuation of the company by the time of the investment round is crucial for the investor.
While there is always the possibility to negotiate, the valuation of the company has to be in the ballpark for what the angel investor is prepared to pay considering the stage, traction, and quality of the startup. (Yes, the valuation of a startup is based on these factors. It is not based on the alternative cost of the hours the team has put into the startup or how big the IPO valuation of the unicorn X was.) If the valuation is through the roof, there is no point in wasting time meeting the team.
Diluted Cap Table
The founders need to have enough skin in the game; not only after this investment round but also taking into account the future ones. If the founders became over-diluted they are no longer founders but the employees of the investors instead. While I have been running businesses in the past, I invest to be an investor, not an entrepreneur. Thus, I can only invest in case there is somebody who has the ownership of the business – going through the walls when it is required.
It is only natural that a startup cuts some corners when it comes to administration and legal side of the business – after all, a company with 100% legal compliance can rarely be characterized as a startup. However, there are some legal issues that may constitute a deal breaker.
The most important legal issues are related to IPRs: If the competitive edge of the company relies on the IPRs the company should have ironclad protection over those IPRs. Options and other rights granted to the shares of the company can also raise issues: The cap table has to be clear and undisputed (pro-tip: always follow the fully diluted cap table). Disputes with previous shareholders’ – even if they are no longer holding the shares – should be cleared.
Legal disputes are risky for the investor even when the startup ends up being on a winning side of the dispute: Startup has limited resources, so fighting a legal battle is a no-go – there is little difference between losing a legal battle and going bankrupt and going bankrupt before winning a legal battle.
Bonus Flag: Out of Investment Scope
This one is something that the founders have zero control over. I have a defined investment strategy and it includes defined investment scope. I do not invest in companies outside this scope. Period. No matter if it looks like the greatest unicorn in B2C, I do not invest in B2C as I have neither sufficient understanding nor competitive advantage in assessing B2C businesses.
(Sometimes I feel bad for founders who instead of accepting this use a lot of time for trying to convince me to invest. For example, one founder took the time to write a pages long email why in their case I should make an exception to my investment strategy; that time would have been much more wisely spent on contacting some more potential investors.)