Investing in startups is the new black – everyone wants to do it. And with the JOBS Act Title III going into power this May, everyone will be able to invest in private companies. In connection with that, a lot of people are wondering how to do it – how to evaluate a potential investment opportunity, especially on the early stage of the company. Here are some of the red flags that startup investors can spot in a startup that is likely to fail:
- A small or unscalable idea
Investors tend to have more interest and trust to ideas that appeal to a big number of potential customers. They would most likely support a startup whose product appeals to everyone and anyone, than a small niche business that only appeals to a very narrow market.
- No focus
At the same time, investors believe that you can’t be a jack-of-all-trades – you’ll end up being a master-of-none. It is hard enough to launch one business, that is why entrepreneurs should have a focus – they need to have a plan of what are the steps they need to take in order to scale their idea.
- Wrong market positioning
It is important that entrepreneurs did their homework and went out to talk to their potential customers before launching the product. They might be working on a good idea, but they need to take the time to properly research the market – who actually needs the product, what features, how will they sell it, who else is doing the same or similar thing and how are they different.
- Very high burn rates
With the shift in the market, investors are focusing more on the profitability over hyper-growth. Having high expenses while seeing slow revenue growth is not a good sign.
- Lack of commitment
Especially at the earliest stages, some founders are not fully dedicated to the company – they might be holding another job and handling the new venture on the side. Institutional investors usually focus only on full-time teams. The careful approach towards not fully committed founders is based on the fear that founders have not taken the time to define a clear path to profitability, with an execution plan in place. They also might be moving slow and could be still in the process of making the decision to work on the idea.
- No go-to-market strategy
One of the best competitive advantages is distribution. Make sure that there is a strategy in place with content marketing, business development deals, and strategic partnerships to propel the growth of the company. Entrepreneurs are typically so focused on building their product, that they don’t think far enough ahead to their go-to-market strategy, and how that will help them to achieve a proof-of-concept to attract growth capital.
- Too many founders
Just one founder is usually not ideal because it may imply an inability to attract talent to the team. But if a founder is very skilled at storytelling, which helps to bring in both capital and other team members, one is not a bad number. At the same time, more than four founders typically ads risk – it is much harder to come to a fast decision and handle execution. Harvard’s Noam Wasserman found in his research that 60% of failures in startups are due to “people problems.” Two or three people on the founding team is a great number.
- Founders disconnected from reality
It is great to have a big dream and try to make it a reality – that is how revolutionary products and services appear. But there is a difference between an entrepreneur and a dreamer. As an investor, you want to bet on the founders who their numbers, their 18-to-24 month execution plan, and how they intend to spend the capital raised from outside investors.
- Wrong or incomplete leadership
Especially on early stages, investors are backing the team, not the company. Being an entrepreneur takes a lot than just a set of mind. It is hours of hard work, sacrifices and hard decisions. You also want to back a complete team – with all key people in place and working as a well-oiled machine.
- No mentors or advisors
Many people talk about entrepreneurs as “lone wolves” – but they are not as long as they have a team of mentors/advisors guiding them. There are a lot of established startup ecosystems which can be used to find mentors who are experts in the needed field. Founders need guidance, a look from the side and a fresh perspective – sort of a reality check from people who know the team and the business well enough.
- No support from early investors
If the startup has already raised some capital from other investors before, look at how many of them are not reinvesting. Sometimes it is as simple as an investor running out of the power to invest, which is fine – but if not, you need to understand the reasons why: Have they lost faith on the future of the company? Do they have trust issues with the founder?
- No momentum
If a company is not growing at a decent pace, month over month, you should understand the reasons why. Sometimes just simple tweaks to the business need to be done, but it might be something more critical, such as there is no product market fit.
- No revenue model
Startups may not have a revenue model day one – and that is fine, but they need to have a clearly communicated revenue plan for down the road. And this revenue plan needs to be material enough and be based on credible assumptions.
- Less capital than needed
Raising enough money is important. That means raising enough to build the product and to achieve the next business step. Usually, investors want to see that amount is large enough to at least carry the startup for the next 12 to 18 months.
- Return On Investment
The company needs a clear roadmap to at least a 10-time return on your invested capital. In the end of the day, you are investing to make money.