Red Flags
How to spot warning signs before investing in Early Stage Tech Startups ? 9 Lessons Learned from a thousand calls with founders
Summary
Concerns with equity distribution: Passive co-founder shares, high equity ownership by non-operating advisors, and "founder behind the curtain" situations are red flags due to issues with commitment, focus, and decision-making power.
Co-founder dynamics: Multiple commitments, Co-CEOs in early-stage startups, and aggressive tone of communication are warning signs of potential distractions, power struggles, and poor communication.
Organizational and communication issues: Delayed responses in investment matters, disorganization in sharing company information, and reliance on third-party financial intermediaries or personal assistants are indicators of poor time management, ineffective organization, and a lack of direct contact with founders.
Maybe I am quite selective, or as my wife calls me, obsessive, about certain topics where I exercise great care and discipline. Like Sinatra's song, this is "My Way." In the past twelve months, I've had roughly a thousand calls with founders and identified my most significant red flags.
Initially, I planned to create a checklist for my notes, but I eventually compiled them in my Notion notes, and after an hour-long effort, it turned into a post for Substack. Here are my definitive NOs for startups.
Passive co-founders shares: One of my red flags is the presence of passive co-founders in the cap table. If a co-founder is not actively involved or taking responsibility but holds a significant portion of equity shares, this raises concerns for me. I prefer to see all co-founders fully committed and focused on a single objective within the startup. If some co-founders have multiple commitments yet are still working on the startup, it prompts me to carefully evaluate my investment decision. Ideally, I seek a clean cap table with fairly distributed shares among co-founders who demonstrate full-time commitment to the venture.
Similar red flag: High equity ownership by non-operating advisors or consultants, which may dilute the equity pool for active team members and investors.
Multiple commitments of the co-founders: One more issue is when one of the co-founders has another job, company, or commitment and starts a new venture with another co-founder, expecting to either leave the other company within a year or sometimes not planning to leave at all. This creates a complex and potentially conflicting structure. While the founders may justify this arrangement by claiming that the co-founder with multiple commitments brings network, new potential customers, or financial resources from the other entity, I prefer not to invest in such situations due to the potential distractions and divided focus of the involved co-founder.
Founder behind the curtain: One added red flag is a situation where one founder holds the majority of the company's shares and adds one or more co-founders with minority stakes, who then assume the role of CEO. In such cases, the minority shareholder CEOs are the ones handling calls and fundraising efforts, but when you delve deeper, you realize that the majority shareholder, often referred to as the Chairman, is the one making decisions. The co-founder CEO with minority shares may not have the necessary decision-making power, and you may not have the opportunity to communicate directly with the majority shareholder.
Brief explanation: The 1st, 2nd, and 3rd points are quite similar, but each presents different issues in their respective situations. Passive founders, as described earlier, are not active in the venture but appear on the cap table. The multiple-commitment founders struggle to balance different jobs or responsibilities. The "founder behind the curtain" is often involved in financing and decision-making, monitoring and organizing from behind the scenes but not wanting to take on executive roles. Sometimes, these individuals are wealthy and refer to themselves as investors in their own majority-holding companies.
Co-CEOs in early-stage startups: Another concern arises when co-founders exhibit power struggles in the early days of a startup, designating themselves as Co-CEOs or one as Chairman and the other as CEO. This arrangement is quite unusual, especially at the beginning of a venture, and serves as a strong signal for potential power games that could lead to early divisions or breakups. Startups should not mimic the structures of large holdings or corporations; their focus should be on testing their hypotheses and driving growth.
Aggressive tone of communication: Communication determines the outcomes of life and death situations especially in early stages of a startup. In today's world, where we mostly rely on online calls, emails, and text messages, every word and response matters. Both the timing and content of the communication are important. If I sense tension in the founders' tone of speaking, frequent arguments, or defensiveness, it indicates a potential energy drain even at the start of our journey together. While I don't expect founders to agree with everything I say, I do value wise communication skills. I tend to avoid investing in teams with aggressive or passive-aggressive tendencies.
Delayed Communication from Founders in Investment Matters: Once a fund raising round is open, it should become the priority of the founder, significant delays in investment-related communications is simple unacceptable and adds more time to the process. A further red flag for me is founders who respond irregularly or with significant delays in investment-related communications, which should be a priority. By "late," I mean a latency of three or more days. I expect replies within one to two days at most. Sometimes, founders respond a week later, excusing themselves due to other priorities or tasks they had to focus on. This behavior indicates that the founder may struggle with effective time management or organizational skills.
Disorganization in Sharing Company Information and Data Room Management: This important consideration is related to the organization and presentation of information by the startup. If founders share a data room with messy files, no folders, or inappropriate file names (e.g., "copy" or files with tags like "(1)" or "(2)"), it can be concerning. For early-stage startups, I don't expect a full due diligence process, as they have limited resources, and I want them to focus on their core tasks. However, I do expect them to share a minimal set of files in an organized manner. If they are unable to manage this simple task, it could be a sign that they may struggle with more complex challenges the company may face in the future.
Third-party financial intermediaries: A red flag for me occurs when early-stage startups use third-party financial intermediaries to raise funding rounds. It's concerning when these financial companies handle most of the communication, leaving limited opportunities for direct interaction with the founders or CEO. I prefer to connect exclusively with founders, especially in early-stage startups, to discuss the venture in more depth. Sometimes these intermediary companies join calls and push for follow-up calls to impress their clients, as they stand to earn commissions or fees from successful transactions.
Personal assistants: In everyday matters PA's or CEO Interns save time. But when fund raising starts, that communication should be managed by the founders without intermediaries. Foudners should allocate time on their calendar for Fund Raising calls or time to spend on topics around fund raising. Yes it's difficult to organize sales calls, team standups or other "real" duties but if the founders wants to close a round quickly, they have to create time for it.
Last red flag occurs when founders of early-stage startups use personal assistants to manage their agendas and have them reply to emails to schedule calls. In my opinion, this approach in the early stages of a startup indicates a misuse of resources and suggests that the founder may not be effectively organizing their time. I even dislike this approach when close friends do it; when I ask them to meet online or offline, they suddenly CC someone else and write, "Please find us a proper time to meet." I can't imagine how these individuals manage their company's resources when they struggle to manage their own time.
Note on this: I'm aware that hiring a personal assistant can be as affordable as $150 a month, but I still don't consider this approach suitable for organizing one's own agenda in early-stage startups. While it might be a great solution for a public company CEO, it's not ideal for a startup.
Some friends of mine have differing opinions about using personal assistants, and I've heard various viewpoints on the matter. Despite this, I maintain that personal assistants aren't vital or necessary during a startup's early stages. If founders delegate all their communication to assistants, they could be seen as unapproachable and lose direct contact with their team and customers, which is essential in a venture's early phase. Moreover, this strategy might harm the startup's culture. Founders risk becoming detached from everyday tasks, which could make informed decision-making challenging. Depending on an assistant's communication abilities might not be the smartest move.
I'd like to add that I don't pass on investment opportunities based solely on one of these reasons; sometimes, I even invest in startups with a messy data room. I expect that founders will become more orderly over time and see these minor issues as a result of their inexperience. This list serves as a simple filtering algorithm for me. In early-stage decisions, making choices can be challenging, but if there are obvious NOs, it's easier to pass on the opportunity. This list acts as a preliminary framework for selection.
If you have any red flags of your own, please feel free to share them with me. I'd be excited to include them in a follow-up post.