As a startup, finding and procuring funding for your business is a vital step to enable growth. Impressing potential investors is only the first step in securing funding. Passing the due diligence process is just as important as putting together a stunning pitch deck. To ensure this all-important discovery phase goes well, avoid the red flags that may cause venture capital and angel investors to back out of a potential partnership.
Eventually, startups will require more funding than friends and family can provide, funding that angel investors or venture capital firms can supply. The first step to a partnership with one of these investors is the pitch meeting to interest them in your startup. If the meeting goes well and a partnership is agreed to, the startup must still go through the due diligence process.
Unorganized or nonexistent data room
To properly prepare for the due diligence process, a good first step would be to create a data room for your startup and grant investors access. A data room is typically a virtual file room where important documents and data, such as financial documents or customer contracts, can be securely stored.
The data room can be preloaded with standard due diligence requests but can also be added to as additional requests are made. Having a preexisting data room available can speed up the due diligence process and convey a sense of organization and professionalism.
Lack of founder integrity
Trust is irreplaceable for any partnership to work, including a financial one. As such, breaking that trust between the potential investor and the founder, even in a minor way, will eliminate the possibility of an investment. Behaviors to avoid include:
- Overstating historical results.
- Misrepresenting the use of investor funds.
- Misrepresenting the development progress of a product.
An investment in a startup is the start of a long-term relationship between the investor and the founder. That relationship needs to be based on trust and any display of a lack of integrity will rightly cause the investor to walk away.
A weak or misunderstood customer base
As part of their investigation, investors may also review your current client or customer base. After speaking to customers, if investors discover that customers aren’t as enthralled with the product or service as had been represented, this can suggest a lack of customer outreach or a fundamental misunderstanding of customer wants.
Similarly, a small customer base can also be a red flag for investors, particularly in cases where a single customer accounts for the majority of revenue. In both cases, this may indicate that the potential growth of the startup may be limited unless it is better able to accommodate its clients.
Issues or incompetence within the founding team
One question investors consistently ask themselves during the due diligence process: Are they coachable? Refusing to accept advice or listen to an opinion doesn’t bode well for a potential partnership. Investors often have experience some startup founders may lack and, after investing so much capital behind your business and your idea, they’d like you to succeed. Guidance, mentorship and general advice are part and parcel of a relationship with a VC or angel investor and are one of the benefits of such a relationship.
In addition to coachability, investors will assess whether the founding team is competent. There will typically be three to four areas that need to be covered: operational, technical, financial and marketing. These areas do not need to be covered by separate individuals. Often, a founder can cover two or three and the others can be covered by other founders, employees, previous investors or maybe even a mentor. Investors will often probe for competence with some standard questions, based on company type.
If the company is:
- A manufacturer, what is the contribution margin?
- A software company, who does the coding?
- A subscription company, what is the monthly recurring revenue?
- A consumer products company, what demographics are you targeting?
Failure to answer any of these questions, correctly or at all, reveals a gap in the founding team that may increase the risk of investment beyond what the investor will accept.
Other considerations
Startups raise multiple rounds of funding from multiple funding sources, so a complex cap table isn’t an aberration. However, a cap table can move from complex to messy and drive off potential investors. Investors need to understand how they will get a return on their investment. If the cap table is so complex that they can’t determine how, when or why their investment will be returned, then the cap table itself has become a risk to the investment.
Investors will also examine any intellectual property (IP) a startup relies upon. This includes verifying whether the IP is owned by the company. If it isn’t, and it’s owned by a founder, an affiliated university or another third party, they need to understand what rights and exclusive rights the startup has to that IP.
The relationship between investor and startup founder is based on trust, so it stands to reason that the most impactful red flag for potential investors is either a lack of trust or a breach of trust. No sound financial partnership can be established on inaccuracies, whether they were purposeful or not. Impressing potential investors with a pitch is just the first step, now you’ll need to show them you are a trustworthy organization.
Need guidance on next steps with your startup? Anders CPAs + Advisors works with startups and entrepreneurs on their financial needs so they can focus on what they do best. Contact an Anders advisor to discuss your goals and how we can help you achieve them.
Every day at Anders, we serve as a catalyst for those striving to achieve their highest potential and carry this mentality on to our clients and community. Through a collaborative approach and a combination of tax, audit and advisory services, we help our clients achieve their goals.
Kyle Krahl is a manager in forensic, valuation and litigation at Anders with more than 10 years of experience valuing businesses and performing merger and acquisition due diligence. With experience seeing all angles of the financial due diligence process, Krahl is an asset for companies throughout M&A transactions.
