Lesson #233: Key Red Flags for Startup Investors

In Red Rocket’s Definitive Checklist for Startup Success, we detailed the many things that startup investors are looking for before making an investment.  But, I didn’t really talk about the potential red flags investors are hoping NOT to see.  To that regard, I recently a read a good book called The Art of Startup Fundraising written by Alejandro Cremades, a serial entrepreneur and co-founder of Onevest, a venture investing community platform.  One of the chapters in Alejandro’s book specifically talks about these red flags for investors, and Alejandro was kind enough to let me share that list with you.

Too Many Members of the Founding Team

Giving equity is a great way to motivate and enroll the help of more individuals when your startup is lean on cash. This can be applied to cofounders, key team members, friends and family investors in the seed stage, and even advisors and professionals such as lawyers. However, too much equity in the hands of too many (especially inexperienced) early shareholders can be problematic. Even too many team members at the beginning can be problematic from an investor's point of view. So, keep your fundraising goals in mind when hiring and considering bringing on cofounders.

Overhead Is Too High

If overhead is already too high, or the profit margins are going to be too small, investors should rightly be concerned. One of Sam Walton's core principles when building the Walmart empire was to always control costs better than the competition. That's where he found his advantage, and sustainability. Not everyone wants to run a discount business, but there is no lack of scale or revenue at Walmart.

Buzzwords

Peter Thiel at Clarium Capital says that the use of buzzwords is one of his pet peeves and biggest turnoffs. Forget the jargon when speaking with investors. Deliver substance.

Founders Have Other Jobs

Is this just a hobby for the founder? A part-time gig? Or are founders really serious and dedicated to making this work? Are founders available enough, and at the right times, to make the venture work?

Founders Have No Other Source of Income

Don't expect investors to be throwing millions on the table for you to go off and buy a bigger house, get a new car, party half the week away, and generally upgrade your lifestyle. This is money to use to carefully and prudently grow the business. Investors may be split on whether it is better for startup founders to have another job or not, but those without another source of income or some financial reserves could be prone to making rash mistakes. Whatever your situation is, make sure that you can eloquently convey the pros and cons.

Poor Credit Ratings

You may have been beat into foreclosure and default on almost everything back around 2008, but what does your track record look like before and after that blip? If there are small charge-offs you can pay off, does it make sense to clear that up? Are you up to date on your taxes? Failing to pay taxes as a business and business owner can be catastrophic for everyone involved. If you are at risk of being hit with a federal tax lien, consider at least working out a payment agreement with the IRS.

Weak Marketing Plans

Scaling and generating real revenues is going to require a realistic and aggressive plan. If this isn't your area of expertise, look for guidance.

Relying Only on Paid Advertising

Building on the previous point; startups can't rely only on paid advertising. Especially if they have only identified one or two channels to use. There may be times when funds are tight, and you need to be able to generate sales regardless of fundraising success, and profits and profit margins will be a lot better if there are other sales channels working.

Blind Optimism

You have to be an optimist to launch a startup, but unrealistic, blind optimism isn't going to sell investors, and it isn't going to make for a sustainable startup. Be positive, but acknowledge the real challenges that exist too.

Claims of Having No Competition

Claiming you have no competition is a sign of being overly optimistic. There will be the potential for some form of competition. Recognize it, and admit it, and you'll gain credibility and investors will be confident that you are on top of it.

No Technical Founders

If you aren't technical, and you have no technical founders, that means there will likely be significant cost in paying for technical development and maintenance. That is a hard cost that the venture may not survive without. Contrast that setup with having at least two or three cofounders who cover all of the main functions and skill sets.

Asking for Too Much or Too Little Capital

This can be a red flag that founders may not really know that they are up against. Don't be too shy. Don't forget that you can raise additional capital in further rounds.

Poor Use of Previous Funds

Startups that have burned through previous rounds of funding without generating results can be a scary proposition. Note that this doesn't necessarily have to mean break even or, in some cases, revenues. Some of the biggest stories of recent years appear to have changed these rules. However, you've got to have something to show for it.

Early Investors Not Participating in Additional Funding Rounds

If previous investors are not getting in on a round, that can definitely be a bad sign. If there is a good reason for that, make sure to address it proactively, rather than allowing it to work against you.

Entrepreneurs Have No Financial Skin in the Game

When launching a startup, entrepreneurs know they are going to be putting in a lot of time and energy. But many have no financial skin in the game. It's not really about the amount, it is about equal risk sharing. You are probably looking for investors who will not just bring money, but will also put in some work. You want them to bring some effort, their contacts, their expertise, and a lot of money to the deal. From the other side of the table, it makes investors feel a lot better if founders are putting some money in, too.

Lack of Momentum

Even if you haven't raised any funds before, it is critical to track and show progress. It doesn't have to be huge. It can be revenue, users, market share, or another metric you are focusing on. But make sure you are tracking and reporting traction and momentum.

Moving the Ball Forward . . .

Being alert to these red flags, and tackling them in advance is smart when it comes to clearing the path to getting funded fast. To save precious time, be prepared, streamline the process, clear any potential hurdles, and find the most efficient method of raising capital. Ultimately none of the red flags above are a show stopper by themselves. As a founder, what you need to do is keep the red flags to a minimum and have plans in place to correct them.

Thanks again Alejandro for sharing these excellent points with the Red Rocket readers.  You can learn more about Alejandro on his LinkedIn profile, and you can follow him on Twitter at: @acremades.

For future posts, please follow me on Twitter at: @georgedeeb.