Early Investing

Startup Investors: Watch Out for These Five Red Flags

Startup Investors: Watch Out for These Five Red Flags
By Adam Sharp
Date February 7, 2020

Today we’re going to talk about red flags in startup investing. These are signals that tell me it’s probably best to pass on a deal.

Red Flag No. 1 – Too Much Focus on the Industry

One of the most common negative signals I see is when a founder spends too much time telling me how amazing their industry is… how fast their industry is growing and how it’s going to change the world. But when it comes to the company’s revenue and traction, they skip over the details. It’s a bad sign.

So pay attention to what the founder is telling you. If the founder spends most of their time telling you about how fast the industry is growing but glosses over how fast their company is growing, you can usually pass on the deal (this is common in the cannabis space).

Never invest in a startup just because it’s in a great industry. The company should have impressive traction too. Real progress in the business. Revenue. Twenty percent month-over-month growth is the kind of metric I like to see at the early stages. Deals with this type of growth are not uncommon on AngelList or Jason’s Syndicate.

Red Flag No. 2 – Deceptive Charts

Another common red flag I see in startup pitch decks is the use of deceptive charts. For example, some will show you charts of their cumulative (total) revenue. As long as the company is treading water, a cumulative chart will make it look like the business is growing (even if it’s not).

This is just one example of a deceptive chart. You also need to watch out for ones where the x-axis and y-axis aren’t clearly defined. If the startup is showing you a revenue growth chart but it doesn’t include the real numbers, that can often be a bad sign.

Charts should be clearly explained and defined. If they’re not, the goal may be to deceive you.

Red Flag No. 3 – Only a Few Big-Name Customers

Sometimes startups highlight the fact that they have a few big-name clients. If a startup does business with companies that are household names, this can be a good sign. But you need context. The big-name clients need to be part of a larger growth picture.

For example, startups will often state that they sell to a big corporation like Disney, but not provide details on that deal or on the broader revenue picture at the company.

Just because it managed to get a deal with a big name doesn’t mean much on its own. Maybe the founders have a friend at this big corporation who got them in the door. In the vast majority of cases, these startup deals with big companies don’t amount to much.

So my advice is to never base your decision to invest on the fact that the startup has deals with a big name. If the startup has good overall growth numbers, it’s usually willing to share them. And if it’s not sharing specific revenue numbers, it better have a good reason (but usually doesn’t).

Red Flag No. 4 – Lack of Experience in the Industry

You’d be surprised how common it is to see startup teams with no previous experience in their industry. This usually pops up in hot investment areas like cannabis, drones and artificial intelligence.

It sounds obvious, but ideally you want to invest in founders who are experts in their industry. Generally speaking, the longer they’ve been working in that industry, the better.

The easiest way to judge their expertise is by looking at their traction. Again, it usually comes down to the fundamental metric: revenue. If they know the industry, they’ll be thriving (or at least showing the potential to).

Most great founders have a good “origin story” about why they started the business. If it’s something personal that’s driving them, that’s usually a good sign. Sometimes great founders build a product for themselves, and other people just happen to like it too.

Red Flag No. 5 – Team of Unknowns

You also want to look for a team that has worked together in the past. If the core founding team has successfully worked together before, that’s usually a great sign. If the team hasn’t ever worked together, it could be a red flag. Founder disputes often destroy startups.

Don’t Learn the Hard Way

Hopefully you won’t see too many of these red flags while you search for investments. The sites we’ve recommended so far – MicroVentures, AngelList and Jason’s Syndicate – generally do a good job weeding these types of deals out before you’d ever see them. But even on high-quality sites like these, mediocre deals do get through sometimes. I learned some of these lessons the hard way, after all.

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