A Comprehensive Guide To Spotting Red Flags From Screening to Post-Investment

Early-stage investors face two options: invest in a company that might fail or miss out on a potentially lucrative opportunity. These two results define the skill and knowledge of all investors. But how do you understand if a deal is worth investing in? Through due diligence, of course.

Every company, even those that make it to the Fortune 100 list, has inherent flaws that could jeopardize its success. By uncovering these flaws early on by conducting due diligence, investors can assist companies in addressing and fixing them, transforming potential weaknesses into strengths, and making the company a more viable investment. The goal is to identify problems and implement solutions, ultimately enhancing the company's prospects.

Moreover, challenges may arise after the investment, too. Investors must then decide whether to continue supporting the company, possibly increasing their investment, or to cut their losses and move on. This decision requires carefully evaluating the company's progress and potential, ensuring that investors make informed choices that align with their long-term investment strategies.

In this blog, we tap into Mark Neuhausen 's experiences and notes regarding issues that may arise during different stages of investment and how to mitigate them.

Risk Is The Reality of Angel Investing

Angel investing is regarded as a way to support early-stage companies and reap significant financial rewards. However, the reality is that angel investing is a high-risk, high-reward endeavor that requires a deep understanding of the startup ecosystem and a willingness to take calculated risks. A study by Gust, a SaaS platform for funding and operating early-stage companies, reveals that angels only invest in about 1 in 40 startups they see. A different study by Professor Rob Wiltbank and Willamette University reveals that 50% of startups that raise money fail within 18 to 36 months, returning nothing to investors. Another 30% of companies may take three to five years to exit but will typically return less than a 1X return on investment.

So, what about the startups that do succeed? The data shows that only 20% of startups will provide the big returns angels seek. However, these successful startups typically take eight to 13 years to reach an exit, requiring angels to have a long-term perspective and a willingness to wait for returns.

Red Flags to Watch for During a Pitch

1.???? Is the founding team financially invested?

When evaluating a pitch, it is crucial to consider whether the founding team is financially invested in their venture. This aspect requires some nuance from the investors, particularly when assessing different types of entrepreneurs. For instance, a second-year college student who drops out to start a company is unlikely to have substantial personal financial resources. However, if they have managed to secure investment from friends and family, it indicates that those close to them believe in their potential and are willing to take risks. Such cases reassure investors, demonstrating trust and commitment from people who know the entrepreneur well.

On the other hand, seasoned professionals, such as former Microsoft or Apple executives who claim to have held senior positions, should ideally show significant personal financial commitment to their new ventures. When such individuals have only invested a modest amount, like $30,000, but seek larger sums from external investors, it raises questions about their confidence and dedication. Investors like to see that these entrepreneurs have substantial "skin in the game," as it reflects their belief in the success of their business. Asking entrepreneurs how much they have invested is a fair and important question during a pitch. The greater their financial commitment, the more encouraging it is for potential investors.

2.???? Are the interests of the founding members and angel investors aligned?

Another crucial aspect is whether the financial interests of the founding team and angel investors are aligned. Mark recounts a life sciences pharma company that once pitched at Keiretsu, where three founding team members made around a quarter of a million dollars in salary. Despite the potential for a big payoff, only the founder had a significant equity stake, while the other two co-founders had less than 2% equity in the company. This misalignment of interests can be problematic.

If the founders are making huge salaries, their primary interest might be keeping the company afloat and securing future funding rounds. However, if they hold substantial stock, they would focus on increasing the stock price. Since investors typically receive stock or convertible notes that convert to stock, the founders must be incentivized to increase the stock's value, ensuring that their interests and those of the investors are aligned.

3.???? Have the pre-revenue companies validated the problems they are solving?

Approximately 20% of the companies that come across an investor's desk are pre-revenue, and for these, demonstrating validation is crucial. Investors look for evidence that the company is addressing a significant problem validated by a substantial number of potential customers—ideally, a hundred or more, depending on the market size. Through open-ended questions, entrepreneurs should ascertain whether a significant majority, say 90%, identify the issue as a top-three problem.

Importantly, this initial phase should focus solely on understanding the problem, not pitching the solution. Entrepreneurs often fall into the trap of asking, "What do you think of my idea?" which typically garners positive responses but does not guarantee future sales. Instead, they should verify the problem's significance and return to the same group with their proposed solution to see if it resonates. If 90% of those who acknowledged the problem also believe the solution is effective, it indicates strong market validation.

4.???? How is the subscriber/user growth of the company?

Another critical factor to consider when evaluating a company, especially those with subscribers and users, is the growth and engagement of its user base. Investors are not attracted to simply the number of subscribers but rather the entrepreneur’s understanding of the audience’s behavior and feedback. Are the customers demonstrating that they can't live without it once they've started using it, or do they abandon it after a month or two, indicating that it's not essential to them? High user retention and positive feedback are strong indicators of a product's value and potential for long-term success.

Problems That Can Occur During Due Diligence

Due diligence (DD) is a critical phase in the investment process, yet it comes with challenges. Here’s what can go wrong while dissecting a business during the DD process:

1.???? Uncovering crucial facts about the company which was hidden during the initial interaction

One of the primary objectives of due diligence is to validate the claims made by the entrepreneurs. However, this process can sometimes reveal unsettling truths. Mark gives an example of a due diligence case where the initial concerns about a company escalated when it was discovered that one of the founders had been convicted of federal securities fraud and had served time in prison. The most troubling aspect was not the founder's past conviction or attempt to remain involved as a 1099 employee but rather the lack of transparency. The fact that this critical information was not disclosed upfront raised severe trust issues. Investors expect honesty and full disclosure, and uncovering such significant details late in the process can severely undermine confidence in the management team and the viability of the investment.

2.???? Lack of a demo or having no product at all

The DD process involves thoroughly assessing the product and its use cases. In one instance, Mark and his DD team found that a company trying to raise funds had no product to showcase. The company claimed to have a developed product and a customer base, which initially sounded promising. To verify these claims, Mark’s team engaged a skilled system administrator to rigorously test the product. As the DD team delved deeper into the claims, it became evident that the product did not exist. This revelation was an immediate deal-breaker. For investors, complete honesty from the founding team is essential. Misrepresentations waste valuable time and resources and erode trust, which is fundamental to any successful investment relationship.

3.???? Reliance on the DD team to solve revenue issues

Mark recounted a unique experience when a group of about 30 interested members encountered significant issues while reviewing the financials of a potential investment. Initially, the founder's projections seemed promising, with revenue and costs purportedly doubling each year. However, upon closer examination, it became clear that these figures were based on unsubstantiated assumptions about month-over-month growth. The core issue wasn't just the financial review itself but the founder's apparent lack of understanding and management of his company's finances. When the DD team suggested the need for a Chief Financial Officer (CFO) to produce accurate financial data, the founder reacted defensively, arguing that it was the team's responsibility to create these financials. This misunderstanding highlighted a critical red flag: the founder's company had no proper financial oversight, relying solely on a bookkeeper without a dedicated financial strategist.

4.???? The business plan has a small Total Addressable Market (TAM)

The total addressable market (TAM) is a critical factor that can make or break an investment decision. Mark shared an experience that highlighted the importance of thoroughly understanding the actual size of the market. Initially, the founders presented what seemed to be a vast and promising market opportunity. However, as the analysis deepened, it became evident that the market was not as expansive as it first appeared. The market had to be segmented repeatedly, narrowing the scope further. By the end of this process, even if the company managed to capture 100% of this segmented market, it still would not translate into a highly valuable enterprise. Therefore, entrepreneurs must identify a large TAM and ensure their target segments are substantial enough to support significant growth and value creation.

5.???? Concern with the integrity of the founding team

A critical aspect of due diligence, often overlooked but immensely important, is the integrity of the founding team. As per Mark, there have been instances where supposed "outside counsel" were significant company shareholders, raising serious ethical concerns. In one notable case, a founder, pleased with the due diligence process, offered stock to all the team members. As the due diligence lead, Mark explained that such an offer would likely be perceived as offensive and unethical, as it could be seen as an attempt to influence the due diligence report.

Warning Signs After Investment

1.???? Only investors are angels with convertible notes or stock

A convertible note guarantees the investor of equity after a certain investment round. The challenge of having only angel investors with convertibles is that there can be valuation disagreements that can bring up dilution concerns for entrepreneurs. Moreover, if a company needs more time to reach certain milestones, the angel investors must be convinced to extend their maturity date. The best solution for this scenario is to negotiate the extension because debt holders typically understand that calling their note prematurely could result in the company failing and them receiving nothing in return. By allowing the note to ride longer, investors can maintain their potential for future returns with minimal immediate downside.

There are strategic ways to navigate financial pressures for early-stage businesses primarily backed by angel investors through convertible notes or stock. If a company needs more time to reach its milestones, it can approach its debt holders to request an extension of the maturity date. This negotiation is often feasible because debt holders typically understand that calling their note prematurely could result in the company failing and them receiving nothing in return. By allowing the note to ride longer, investors can maintain their potential for future returns with minimal immediate downside.

2.???? Non-angel investors may have liens on the IP

Debt holders always take precedence over equity holders; sometimes, they may even hold liens on the company's intellectual property (IP). This dynamic can significantly impact the company's financial strategy and decision-making process. For example, in a scenario where all investors hold convertible notes, a debt holder could theoretically call in their note and enforce their lien on the IP. However, this raises a pertinent question: if the company struggles to monetize the IP, what makes the debt holder believe they could do better?

One such case involved a company where debt holders agreed to extend the repayment period by two more years, recognizing the challenges in monetizing the IP. This decision required a deep dive into the situation, and ultimately, the company managed to attract the interest of two large corporations to evaluate the IP. Despite this interest, the IP was not quite ready for commercialization. This experience highlights the importance of debt holders and the company collaborating to solve problems and sort the financials.

3.????? The company is defaulting on loans

When a company defaults on its loans, and the angel investors are equity holders, the situation becomes particularly challenging. Equity holders have limited options in such scenarios. One potential course of action is negotiating with the note holder, seeking an extension to allow equity holders to recoup some or all of their investment. However, this approach is often complex, especially when dealing with institutional lenders like banks.

Unlike tax obligations, where the strategy might be to "pay the least and latest," lenders prioritize maximizing their returns as quickly as possible. If a lender believes they can recover an additional amount, even if it means completely wiping out the shareholders, they will likely pursue that route. This stark reality underscores the precarious position of equity holders when a company faces loan defaults, as lenders' primary focus is on recouping their funds swiftly and thoroughly, often at the expense of equity investors.

How To Overcome Business Challenges and Earn Good Returns

As mentioned before, investing in early-stage companies is risky, and most ventures fail even after raising capital. However, intelligent investors turn their investments into profits with a strategic approach. Here are a few key points to consider while angel investing:

Understanding failure rates: It's essential to acknowledge that nearly 80% of investments may fail, but it is not the end of the world. For example, a Seattle investor experienced 35 consecutive failures, but his first investment in F5 kept him in the black overall.

Diversify the portfolio: By spreading investments across multiple companies, investors can offset losses with potentially high returns. The general recommendation is to invest in around 20 companies to achieve a 20% to 30% annual rate of return over a decade.

Understand the necessary investment Scale: Individual investors must invest significant capital to diversify their portfolios effectively. To build a portfolio of $7.5 Mn, 10% of the portfolio must go to high-risk-high-return early-stage deals, around $750,000 over 20 companies (almost $35,000 in each).

Invest in alternatives: For those unable to meet the high capital demands, alternative investment vehicles like the Keiretsu Capital Fund can provide access to diversified startup investments without the need for a large individual portfolio.

By understanding these principles and leveraging diversification, investors can navigate the high-risk landscape of startup investments and potentially achieve substantial returns even when some ventures fail.

About the Speaker

Mark Neuhausen is a seasoned technology executive and investor with extensive experience in driving innovation and growth. He has held senior roles at prominent companies like Microsoft, Amazon, and Hewlett-Packard, where he led strategic initiatives and product development. He is an active angel investor in the Pacific Northwest and provides mentorship to early-stage companies brimming with high-growth potential.

Watch his full keynote at Keiretsu Forum here.