After watching countless presentations and participating in pitch decks over many years, even the most seasoned investors and venture capitalists can miss red flags that are subtle and not immediately apparent.
So that you minimize the likelihood of learning the hard way, the following are the top subtle red flags that investors should watch out for when evaluating a potential investment. By staying alert and knowing what to look for, you can make informed decisions and steer clear of opportunities that are deemed not worth the risk.
An unbalanced team
A key factor when considering an investment is whether the business experience and technical knowledge of the founding team are in balance.
There are presentations of many companies with deeply credentialed and innovative technical founders with absolutely no business experience on the team. Conversely, there are also companies full of excellent business professionals who are deficient in their technical prowess. A founding team should always have technical background relevant and equipped to be viable.
Without a fine-tuned balance of business acumen and technical ingenuity, a startup You may struggle to develop your innovative product, bring it to market, scale the business, and attract customers and investors.
High staff turnover
Frequent and high turnover is usually a red flag for investors, as it often indicates instability and internal conflicts within the founding team. Turnover disrupts the company's operation, culture, and growth trajectory. It's a red flag that drama is consuming the company while its mission is largely sidelined. A revolving door showing that the company cannot retain the best talent will have an impact negative on its financial prospects, both in the short and long term.
Instability on a founding team can manifest in abrasive, ego-driven management, favoritism and unfair compensation, issues, and inequity that will drive people away.
Changes in leadership are normal and healthy as a company grows. But when these changes happen too frequently, investors should pay close attention, as it often suggests deeper problems in the business.
A business with no exit plan
A company founder is motivated to create a sustainable and profitable business that allows them and their employees to enjoy a particular lifestyle. They have no intention of growing rapidly or going public. However, they may seek investment to expand their product or geography.
Here's what you need to know about the model for members in the new business. It is based on the experience and personal relationships of the owner. Without a succession plan, the business is vulnerable if the owner leaves or is no longer able to run the business.
Even if you are an investor, you may find yourself with secrets about "opening the curtain" and getting closer to the details of the business. Because the business is solely dependent on the owner, your exit options are limited. The owner may not be interested in selling the business, and valuations are lower if the owner decides to sell.
Some companies that fit this profile. Investors who thought they were financing a good deal that would pay off and are still looking for a return on their investment or an exit bonus 20+ years later.
The founder is a charismatic liar
When finding a company you'd like to invest in, it's critical to examine the character and integrity of each person on the leadership team. Pay special attention to the founder.
While charisma in a founder is a valuable asset, that charisma can "bewitch." A charismatic and a non-charismatic founder should receive the same thorough investigation. We get the best lessons from hard knocks: a small investment spent in a particular startup. Unfortunately, other investors had larger funding stakes in this company. We all lost our capital.
The charismatic founder of an AI company captivated with its persuasiveness. He was initially sincere, so there were no red flags. But when he won an award for his innovative enterprise the recognition for him went to his head. He lied about the company numbers. Investors discovered the fake numbers when they sensed something was wrong and eventually had to find out.
They discovered two sets of books: one invented for investors; the other with the real numbers. This is a cautionary tale for new companies to have an independent administrator review the company's books regularly and share the results with all interested parties, including investors.
While a founder may claim to be transparent, you need to make sure they prove it. Warning signs that they may be trying to deceive:
- They show successes and say nothing about challenges.
- They make commitments but do not deliver according to the commitment.
- They don't respond in a timely manner when contacted or respond weeks later because they are avoiding you.
- They don't want to answer the hard questions and tell the truth. Don't be tempted to excuse him.
Other Warning Signs: Are Company Leaders Presenting a Wild Vision of Exponential Growth? Is the founder hiding critical information that needs to be known? If something seems too good to be true, it probably is. If you find any sign of dishonesty or inconsistency in the founder's statements and actions, you have to run.
A Romeo and Juliet team of leaders
While there have been effective teams where the founder is in a romantic or marital relationship with a staff member, there are great risks.
From the point of view of the employees, the pair is untouchable even if one of them performs poorly. Only partners can participate in informal discussions about the business.
If the relationship sours, it will have a negative impact on this business. Employees will feel compelled to take sides, which will be disastrous for the company. A startup that was raised at the time to finance had a partner from whom he was divorcing. As the divorce became more contentious, the business suffered and eventually went out of business.
If a team of spouses or family members run the business, you may be faced with a lack of diversity of thought and perspective. The traits that attracted you to each other may be traits that perpetuate the status quo, closing off the perspectives of others.
A power couple can hog power to the point that key team members are intimidated and hesitant to contribute fully. When creativity and innovation are stifled, the company will find it difficult to grow, pivot, or adapt to changing market conditions.
As an investor, you should thoroughly research and understand the companies in which you are considering investing. Two hats must be worn: one for surveillance; the other for trust. You have to remain vigilant and confident throughout your relationship with a company that you have helped finance.
You cannot think that once a company has been researched and funded you can walk away and trust the founder and his team to build the business honestly and ethically. A founder who lacks an ethical core will not hesitate to do everything possible to get money from him.
The brutal truth is that a founder can change after seeming honest at first – remember the previous AI company founder, who changed after winning a prestigious award.
While it may seem like the startup ecosystem is full of upstarts, the vast majority of founders are honest, even the charismatic ones. The advice is to keep your heart and head in balance. That way, you'll protect yourself from investments that go nowhere and eliminate the odd needle in the haystack of the scammer lurking on your list of potential founders.
