Red Flags for Start-Up Investors

Investing in start-ups has now become more common than it was earlier. Earlier, companies could only obtain sizeable funds if they accessed the public markets. However, all this has changed over the years.

Companies can now access the sizeable amount of funds by tapping private individuals as well as institutional investors. Since the number of transactions has increased, so have the number of failures. Investors now have more experience. As a result, they can now draw upon that experience to pinpoint the characteristics of a start-up that is more likely to fail.

In this article, we will list down all the red flags which are used by investors to identify bad investments.

  • Too Many Co-Founders: When investors screen start-ups, they are looking at firms where there are two or three co-founders who have complementary skills. If a start-up has too many equity shareholders on the founding team, it can be a major red flag for the investors.

    It is common for start-ups to recruit early co-founders and employees by offering them an equity component. However, if a company is just handing out equity freely to many individuals, it is a signal to the investors that the company does not believe that its equity is worth much!

    The first problem with too many co-founders is that there is less equity left to utilize during later rounds of fund-raising.

    The second problem is that when there are too many co-founders present, reaching a consensus can be quite difficult. This is because a higher level of difference of opinion and internal politics is possible with more founders. This can delay the growth and development of the firm. Hence, it is rightly considered to be a red flag.

  • Cash Flow Position of the Founders: If the co-founders have other sources of income, then they will be able to devote their initial years to the company without an expectation of immediate returns. However, if the co-founders are not financially independent, they will try to take out cash from the firm.

    It is obvious that investors have to run their families and hence would want the start-up firm to pay them hefty salaries. The problem is that start-ups tend to run into cash flow problems more often than not. Therefore, if the founders also need to keep withdrawing funds from the cash flow, then the start-up may be headed for trouble.

  • Skill Distribution Amongst Partners: Investors generally want the start-up company co-founders to have all the skills required to run the business. If a start-up firm does not have any technical co-founders, it can be a huge setback to the firm. This is because, in the absence of technical skills within the core team, the firm has to rely on the opinion of an outsider. This can be both expensive as well as inconvenient. This is why investors view the absence of technical co-founders as being a red flag.

  • No Skin in the Game: In many cases, start-up co-founders tend to have their day jobs. They often pursue the start-up opportunity as a side gig. Also, such kinds of investors have very little money invested in the start-up. Hence, investors believe that such start-ups are not tied to the success or failure of the company. Since they have other jobs, the start-up will not be receiving their full focus.

    Investors are divided over whether or not founders should have other jobs. Some see it as a definite red flag whereas others have an open mind. However, if co-founders are working other jobs, the company can expect to be on the receiving end of more scrutiny.

  • Leveraged Cost Structure: Investors like to invest in start-up companies that are asset-light and have a flexible cost structure. The problem with overheads is that it adds a lot of leverage to the organization. This means that overheads are mostly fixed. Hence, even if a company does not sell any products, it will still have to incur these overheads.

    Companies with higher overheads have a huge chance of going under in the event of a recession. It is for this reason that if a company has a cost structure with a lot of overheads, investors tend to steer clear of such companies.

  • Unrealistic Assumptions: Many start-up founders often tend to make unrealistic claims in front of investors.

    For instance, it is common for many start-ups to believe that they are truly unique and hence do not have any competition. However, this is often not the case. More often than not, the founders have simply failed to identify their competition. Their inability to do so is a testament to the fact that they are not humble and diligent. Hence, such claims can be a turn-off for investors who view it as a red flag and avoid making investments.

  • Earlier Investors Not Participating: From a new investor’s point of view, the absence of a previous investor in a new funding round can be the biggest red flag. This is because seed investors want to identify firms with great potential. This is the reason that they take additional risks and enter the business at a very early stage. Now, if they have already taken the risk and are backing out, it means that they do not think that the business is worth their time. Since they already have insider information about the operations of the firm, potential investors tend to view this negatively. Hence, the absence of existing investors from the funding round ends up discouraging other potential investors as well.

The bottom line is that there are many red flags that can help investors identify problematic start-up firms. Co-founders must think from the point of view of an investor and must avoid such red flags.

❮❮   Previous Next   ❯❯

Authorship/Referencing - About the Author(s)

The article is Written and Reviewed by Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to and the content page url.

Startup Finance