As an angel investor, it's important to carefully evaluate any potential investment opportunities before committing your hard-earned money. Unfortunately, not all investment opportunities are created equal. You’ve probably heard of the rise and fall of Theranos, resulting in its founder being jailed for fraud. Similarly, the Slush and Immigram scandal reminded us how often there’s more at stake than money – bad investments can also damage your reputation.
Theranos, a company founded by Elizabeth Holmes, promised to revolutionize the medical testing industry by developing a device that could quickly and cheaply run a wide range of lab tests using just a small amount of blood. However, it was later revealed that the company's technology was not as advanced as claimed and that many of the tests were actually being conducted on traditional lab equipment.
In hindsight, there were many red flags for the investors, including the lack of transparency, the departure of several key employees, the company’s challenges with getting FDA approval, legal and regulatory troubles, and more. The investors missed the signs due to the charismatic leadership of Elizabeth Holmes and ended up losing a lot of money.
Russian startup Immigram aimed to help Russian citizens emigrate easier. When it won the Slush pitching competition and the top prize of one million euros, public outrage ensued. The awarding was deemed tone-deaf and inappropriate in light of Russian aggression on Ukraine. Eventually, Immigram opted out of the competition and Slush revoked the prize but the damage had already been done. This case serves as a reminder for investors to be mindful of the political and geopolitical risks associated with investing in certain countries or industries. Also, to consider the potential reputational and legal risks.
Fortunately, red flags can help detect potentially risky investments. Based on Dealum founders’ experience, here are the top 8:
- Unrealistic plans or financial projections: be wary of companies that present overly optimistic financial projections that seem too good to be true. When a startup's projected growth or revenue numbers are vastly different from industry averages or are not backed up by a solid plan, it can be a red flag. For example, a startup claiming they will achieve 100x growth in their first year without a clear strategy on how to achieve it.
- Burned-out leader: burnout is relatively common among startup leaders. The startup environment is known to be particularly challenging and demanding, which can take a toll on the founder(s). The stress of building a business from scratch, raising capital, hiring a team, and achieving profitability can be overwhelming, and also make founders work exceptionally long hours. All of these factors can contribute to burnout, which can negatively impact the founder's ability to lead the company and make sound decisions. Beware when the founder or CEO has been through multiple failed startups or appears to have lost their drive and passion for the current venture.
- Messy cap table: a startup's capitalization table (cap table) is overly complex or shows a lack of organization. For example, a cap table with multiple rounds of financing and a large number of shareholders. Poorly organized cap table makes it hard for investors to accurately value their investment, can lead to dilution of ownership in later investment rounds, and subsequently bring up different legal issues or disputes. Eventually, it can also become a problem when raising additional funds or making an exit. Read more about what a healthy cap table looks like.
- Very limited market: if the total addressable market (TAM) is very small, it puts an obvious cap on the possible revenue. For example, a niche market with only 100 potential customers can’t support significant growth. Even though a limited market doesn’t necessarily mean a startup will fail, it means limited scalability. Targeting a limited market requires very thorough market research on the founders’ side or a well thought-out business plan where to go from there. Gathering data on the size, growth, and demographics of the target market is crucial to determining if the idea is worth pursuing.
- Founders mismatch: the founding team can have a mismatch in many ways, e.g. in their skills and experience, goals, communication, or commitment. Incompatible goals, skills or personalities can cause conflict and keep the startup from succeeding. The more unified and aligned the founders are, the better they’re able to work as a team towards one goal. And that doesn’t mean they have to be similar – rather they have to complement each other. In case of skills, it’s not ideal to have a team of only developers; when the founders include a developer, a salesperson and a scientist, they still need complementary expertise in marketing, management, and finance.
- Lack of entrepreneurial skills: when the founders lack entrepreneurial skills, e.g. a scientist CEO without any business experience, it can become a problem for the startup in several ways. They can have difficulty in understanding the market, making adequate plans or decisions, and hiring a balanced efficient team. Subsequently it can cause difficulty raising funds and keep the company from realizing its full potential. Even though the lack of entrepreneurial skills isn’t necessarily a death sentence for the company, it’s crucial that the founder is aware of their shortcomings and work actively to bring the necessary skills on board – either in the form of education, other co-founders or hired specialists.
- Uncoachable team: being coachable is one of the key qualities to succeed in life. When the team is unwilling to take feedback or make changes, it means they lack the growth mindset necessary to, you know, run a growth company. Pay attention to whether the team is open to constructive criticism and willing to learn or gets defensive. Are they willing to try new approaches? To change their perspective? Or do they cling to their ideas even when old ways clearly don’t work anymore?
- No unique value prop in a crowded market: in a saturated market, a startup needs a unique selling point to position itself, differentiate from competitors, target and attract customers, and make overall smarter decisions, e.g. about product development or marketing. A startup in a highly competitive market with a generic product or service is not likely to stand out or succeed.
As you can see, many of these red flags are intertwined and can go hand in hand. For example, if the founders lack business skills and are also uncoachable, it also probably leads to unrealistic plans or problems with targeting the right market with a suitable value proposition. On the other hand, when the founding team is inexperienced but highly coachable, there might be no problem at all. Just keep in mind, which signs to look out for and pay close attention to when any of them comes up.
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