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Navigating Red Flags: Essential Insights for Startups
How to Navigate Due Diligence, and Manage Investor Relations for Early-Stage Ventures
I previously highlighted the Red Flags and points of concern when conversing with startups, and explained how I quickly assembled my 'No' list based on these discussions. Subsequently, I took into account the views of numerous investor friends and mentors, leading to a more comprehensive article. I succeeded in compiling the points that entrepreneurs need to pay attention to during investor meetings, along with the red flags.
This has turned into a long list where we've categorized red flags and points that entrepreneurs need to pay attention to during investment processes. Investors pay close attention to these issues when discussing with entrepreneurs. Not all of these may be deal-breakers individually, but when many items on this list come together, it results in an investment that investors will pass on. I would like entrepreneurs to keep this in mind while reading this list.
I am sharing this entire list in one go. My thanks go out to all my friends who assisted me in putting this list together.
Despite this extensive list, if you're still eager to present your startup to us, here is our concise form for you to complete.
PART 1 ONLINE PRESENCE
Meeting Etiquette and Efficiency
Meetings: Instead of requesting a meeting, ask direct questions. If your queries can be answered via email, refrain from asking for a meeting, as it would waste the time of both parties involved.
Agenda-less Meetings: Meetings that lack a clear agenda, such as a casual invitation to meet over coffee or a request for information on the startup ecosystem, or the search for a developer or project manager, or a proposal to partner with the company, or a hunt for VCs and partners in the region, are unproductive and lead nowhere. I have had similar agenda-less meetings in the past, but they proved to be inefficient, and therefore, I no longer engage in such meetings.Think of the audience. Having an agenda and sharing before the meeting both allows your audience to be prepared and also communicates to them that you will be prepared.
Ghosting Behavior in Entrepreneurship: Entrepreneurs sometimes exhibit ghosting behavior after initial meetings, or they fail to respond to emails within a reasonable timeframe. After several months, they may suddenly reappear, sometimes with excuses but often without, and try to pick up where they left off. This behavior can be surprising and unsettling.You are always performing and being evaluated. When you ghost, you lose credibility and take stock out of the relationship bank account.
Resistance to constructive feedback: Founders who are defensive, dismissive, or unwilling to consider alternative perspectives may hinder the startup's ability to adapt and grow. Poor communication skills and difficulties in building effective relationships with investors, employees, and partners may arise from this resistance. We don’t expect you to do everything we tell you, but engage in critical thinking and ponder through our comments before jumping into answers, this is not a test. Recommendations are made for a reason. Usually, there is a lot of wisdom and experience behind investor suggestions. Think of it like the tip of an iceberg. Until you understand what is below the surface you are in dangerous waters. Seek to understand what they see that you don't before replying.
Taking negative investment decisions personally: Founders who react emotionally to declined investment proposals may struggle to maintain a professional relationship with investors and could face difficulties when dealing with setbacks. It may be a no with this idea/model/traction, but it may be a yes with your next venture. Why succumb to your wounded ego and lose the relationship?
Social Media, LinkedIn, and Due Diligence
The social profile is the first thing I check during the due diligence process: The open online social profiles are the first things I check during the due diligence process, and it carries significance. If a founder is overly committed to sharing feedback and commenting on everything, it may not be a good sign of time allocation. I am not suggesting that individuals should avoid social media, but if they spend an excessive amount of time discussing and sharing, it may be a red flag worth considering. Especially if you are not actively linking your product/service to these comments to connect with relevant decision makers, it’s a question mark.
LinkedIn pages of the founders and the company is critical: I check all founder LinkedIn pages and the company’s linkedin page. If they do not add their startups to their profiles, this is an important WTH (What the heck) moment for me, unless the startup is in stealth mode for a valid reason. If their profile is still from an early company they worked for, they may not be ready to disclose their startup to everyone or may be ashamed. Sometimes startups do not want to share because of the product they develop, which is understandable. But if you change your job and start a venture, please add it to your LinkedIn.
Misrepresenting Education on LinkedIn: If you take an executive education program at an Ivy League university, do not add it as if you have graduated from these schools. On LinkedIn, it may look like you graduated from Harvard or LSE, but you only had a two-week online course. It is not a good sign. There is a certificates section on linkedin, use it. We don’t care too much about where you graduate from, good founders are everywhere.
Utilize your startup's email address as it holds great marketing potential. When I receive emails from a startup, I prefer it to come from their branded email address rather than a generic address such as Iamtoocheaptopayforagoogleaccount@gmail.com. The latter is not as professional and can also be seen as inappropriate, if you have a funny looking personal email address from collage like email@example.com.
PART 2 FOUNDER COMPOSITION
Family Relationships Among Co-founders: Co-founders who are related by family - or partners/significant others - can be tricky. Co-founders who are related by romantic or family relationships can be tricky to judge. I do not necessarily consider this a red flag but a yellow sign. The team can entirely be made up of family members, or the co-founders can be a couples/significant others. However, this information should be shared during calls or meetings, as it can be difficult to extract at times and it leaves a bad taste when discovered later
Team Composition and Presentation: Early-stage startups often include all team members on a team slide, including advisors, VCs, relatives, entertainers, and interns. However, having a crowded team slide is unnecessary. As an investor, I focus on whether the product, market, and founder capabilities are well-matched rather than the team size, whether it's two or twenty. It's not expected to have a large and excellent team in the pre-seed or seed stage. Quality is more important than quantity.
Conflicting Visions among co-founders: Detecting disagreements or potential conflicts among co-founders, especially concerning the startup's future direction, may signal future issues or even a potential breakup.
Complicated cap table: A complex capitalization table with various share classes, differing liquidation preferences, and unclear ownership structures can make future fundraising and exits more challenging. Any non-active x-founding team member is especially a huge concern.
Overemphasis on "serial" entrepreneurs and complex structures: Startups that prioritize "serial" entrepreneurs or "advisor" figures, or involve intricate structures like tech leads and phantom shares, might focus more on superficial aspects rather than the actual business.
PART 3 METRICS, PRESENTATIONS, & BUSINESS SUCCESS
Vanity metrics refer to social media followers, traction, or other statistics that do not directly impact a business's core operations. While it's good to monitor progress, I prefer to focus on the results rather than the entire pipeline. Specifically, I'm interested in metrics that reflect the number of customers, revenue generated, and active users, which provide a more accurate representation of a business's success.
Competitive Comparison Slides: The slide that compares the competition and rivals should not be simplified into check-boxes. Lack of Understanding or worse bad mouthing Competition. A terrible way to present competition is to say we don’t have competitors. Our good friend Ozan has made a video to show founders what a terrible idea that is. (watch the video from here). This is a common mistake that I hate. The other mistake is to show a slide that compares the competition and rivals should not be simplified into check-boxes. A more effective way to present competitive comparisons is by using a table or better using Steve Blanks Petal Model. Startups should showcase their unique strengths and advantages without relying on check-boxes. It is crucial to transparently share accurate positioning in relation to all other rivals.
Revenue Expectations and Presentations. Presenting five-year revenue expectations during pre-seed or seed stage presentations is often meaningless and unhelpful: Presenting five-year revenue expectations during pre-seed or seed stage presentations is often meaningless and unhelpful for all parties involved. J curve revenue graphs or linearly increasing bar graphs are unnecessary and add little value. I especially cringe when founders tell me a financial advisor, or worse an accountant has made their financial models, or they send me the link to an unverified online model to validate your hypothesis.
Lack of focus: Founders who emphasize multiple potential ventures and opportunities without demonstrating mastery in any single area.
Over-reliance on a single customer or supplier: Startups that depend heavily on one customer or supplier for a large portion of revenue or resources may be exposed to significant risks.
Prioritizing profitability and lean operations: always favor startups that focus on acquiring clients and generating revenue early, rather than investing heavily in unvalidated products or building large corporate structures.
Excessive spending on luxury items: Founders who possess the latest and most expensive electronic devices may be perceived as prioritizing personal luxuries over the financial well-being of their startup. Owning MacBook is fine, but fundraising to buy MacBooks for all your staff may not be a good sign, unless your competitive advantage and core is design.
PART 4 LEGAL
Legal Agreements and Due Diligence
SAFE Agreements and Modifications: If you send a SAFE, please refrain from updating or changing it. Often, I have to compare the original YC documents with the shared SAFE, and law offices may add or modify this document. I have come across many agreements named SAFE that look similar but are not the original YC SAFE. It appears that law offices use YC's reputation to prepare a new convertible note.
NDAs, Data Rooms, and Due Diligence: If a company insists on an NDA before sharing their data room or avoids discussing important KPIs during or after a meeting, especially during the due diligence process, it can be a cause for concern. Personally, I do not sign NDAs or agreements in order to evaluate a company's Data Room. If a company appears hesitant to share their data room or does not allow multiple customer feedback calls, this can also raise concerns.
Founder Behavior and Investor Relations
Founder Focus and Event-driven Behavior: Keep an eye on the founders to determine if they are focused on one event after another. If there is an indication that they are event-driven and prioritize discussing their plans before achieving anything significant, it is best to avoid investing with them. Some founders attend every organizational or meeting event and consider it a success, while I believe that events provide additional value, there is an optimal level of participation.
Investor Relations and FOMO: Generating a false sense of urgency for investors, for example: "Our priced round will conclude by the end of May or beginning of June, and it will be a $10 million round with a $50 million valuation. We are presently selecting our lead investor for this round, while simultaneously conducting a bridge round at an earlier valuation. Additionally, our A round is scheduled to occur in six months. This presents an excellent opportunity for investment.
Relying too heavily on the leading VC of a funding round can lead to imbalances in privileges, discounts, and even side letters. In early-stage rounds, it's reasonable to expect that all investors would receive similar terms and conditions.
Inconsistent or vague answers: When asking questions and receiving indirect or ambiguous responses, it may indicate a lack of clarity or understanding from the founder.
Limited or superficial industry knowledge: Encountering founders who appear to have a strong vision, but struggle to answer specific and detailed questions, revealing a shallow understanding of their industry.
Absence of a technical co-founder: A startup without a technical founding member may face challenges in developing and scaling their product. Additionally, founders who talk excessively without engaging in meaningful interaction can be problematic.
Unrealistic financial projections and inadequate go-to-market strategy: Startups with overly optimistic financial forecasts or insufficient plans for entering the market may struggle to achieve their goals.
"Not actively raising funds" startups: Companies that claim they are not currently seeking investments may have hidden motives or could be trying to create a false sense of urgency among potential investors.
Uncooperative Founder: Founder refuses to fill out an application form and share their pitch deck, displaying a lack of transparency and unwillingness to cooperate with potential investors.
PART 5 BONUS
Demo Day Video Preparation: When recording a demo day video, startups should take the time to prepare it carefully. They should ensure that the lighting, sound, and background are of good quality to demonstrate their concern for their audience. While a Hollywood-level production is not expected, it is important that the lighting, audio, and other elements are appropriate and speak slowly and clearly. Have simple visuals that support your main points.
Spin-off Companies and Funding Challenges: Startups that spin off from an existing entity can pose a challenge when seeking funding for a new product Startups that spin off from an existing entity can pose a challenge when seeking funding for a new product. It may not be clear whether the old company will be shut down or who will take charge of the new venture. Splitting responsibilities among several co-founders can further complicate matters, especially when the new startup's share structure includes passive co-founders. Additionally, closing the old venture may prove difficult if it generates revenue, adding to the complexity of the situation.
Despite this extensive list, if you're still eager to present your startup to us, here is our concise form for you to complete.