Due diligence is the name of the game in angel investing.
That’s what we here at Angels & Entrepreneurs take so much pride in: scouring the financials of crowdfunding startups so we can pick the ones with the most potential for you – the angel investor – to receive incredible returns on your investment.
Well, through the years, we’ve picked up a few tricks of the trade that make this evaluation process more tried and true.
And while there are no hard-and-fast rules to startup investing, there are some important things to look for when making your decision.
Therefore, in the spirit of the teach-a-man-to-fish ethos, we compiled a list of 10 red flags we feel angel investors need to be aware of.
While one of these criteria alone isn’t necessarily grounds to outright eliminate a startup from investment consideration, they are a sign that you must dig a little deeper before making a decision.
Without further ado, the 10 red flags angel investors need to know…
Company A made less money in 2021 than 2020. It made less in 2020 than it did in 2019.
To put it plainly, that’s concerning.
Now, this might seem obvious – the company made less money; that’s bad! – but there is still nuance involved that might explain (and potentially excuse) declining revenues.
Let’s say a company recently pivoted its strategy. For example, maybe it transitioned from a business-to-business to a business-to-consumer model. Sometimes, companies decide to focus on margins or change a suboptimal business plan.
However, if revenue declined quarter after quarter or year after year with no change in business model or strategy, this is problematic.
Surprise! To grow a business, you need money.
However, there are a lot of ways for businesses to get said money (Hello, angel investors!).
Some of these influxes are more sustainable than others. For example, let’s look at grants…
Grants are good! They allow companies to do important R&D and continue along their growth paths.
Money from grants improves a company’s bottom line in terms of profit – but it can also help mask a lack of revenue from customers.
It is problematic if the grant is about to expire and the company has nothing to replace that influx with.
That’s why it’s important to discern where a company’s money comes from and how likely it is to continue reaping the rewards.
High Debt Compared to Operating Income
When debt mounts, problems arise.
If a business takes on too much debt, servicing (i.e., paying the interests) could become problematic.
High debt can produce high profit, but too much leverage can destroy a business and/or limit options in the future.
It’s not all that different from maxing out a credit card and all of your lines of credit – as a result, you might not be able to cover an emergency expense or buy something you really need.
Generally speaking, a debt higher than 6X EBITDA is considered too high for many industries; however, it’s important to compare this ratio to the overall sector.
In some industries – namely ones where companies must invest heavily in fixed assets or are impacted by downturns in the economy (think infrastructure, utilities, oil and gas, real estate, etc.) – a higher debt-to-EBIDTA ratio can be justifiable.
High Leadership Salaries Despite Low Revenues or Significant Losses
Most startups operate on extremely lean budgets.
Often times, the founders of a company wait years before reaping the rewards of their labor.
However, sometimes they don’t – even if there aren’t that many rewards to be had.
It’s not complicated; if founders are overpaid, there is less money to grow.
Also, this can be a sign of founders being unsure about their own venture. As a result, you – the investor – bear the risk.
The same can be said about a founder who has other jobs than the venture of interest. If they’re not fully committed to the business, should you be?
As you surely know by now, cash is vital for early-stage companies.
Every now and again, you’ll see a startup use its money to repurchase stocks in attempts to return value to shareholders…
At such an early stage, wouldn’t that money be better used to develop new products, expand into new markets, or increase sales?
It’s important to dig in and decide if a startup is making the best use of its limited resources.
Conflicts of Interest
It is normal for founders to provide funds for their company – surely, you’ve heard the term “bootstrapping.”
Generally speaking, this isn’t a bad thing. In fact, it shows a certain commitment and belief from that founder.
However, most founders aren’t sitting on a fountain of liquidity to pour into their venture. As a result, they have to turn to other means.
Sometimes, those means can be more harmful than helpful and create conflicts of interest for the company.
Some things that indicate a potential conflict of interest are loans with very high interest rates and/or unfavorable repayment terms; money owed to other companies owned by the founder; or a high principal compared to revenue and/or operating profits.
Small Gross Margins
Hot take incoming – margins are important.
A company might be able to capture a significant market share by undercutting their competition, but if they’re losing money on each sale, how long can they keep that up?
When margins are consistently low compared to competitors or industry standards, it is generally not a good thing.
When possible, it’s useful to do some benchmarking to determine a given industry’s standard – for example, for a software-as-a-service company, margins less than 50% are subpar.
Speaking of benchmarking…
It is good practice to compare the valuation of the company with the valuation of peers or recent transactions in its given industry.
High revenue multiples can be justified if the company has a significant advantage over its peers (e.g., multiple patents, valuable technology, etc.).
These high multiples can also be justified by a hot market like cybersecurity or robotics.
However, if a company presents a $100 million valuation despite only having $20,000 of revenue through its first two years, chances are that valuation is inflated and investors would be wise to pass until that company proves worthy of such a steep price.
We predict revenues will be $200 million in 2025 – that sounds good, but what do you have now to make me believe that?
Lots of Small Rounds and No Institutional Money
Investment rounds come in many shapes and sizes.
And, surely, there is no reason to criticize a company that’s just getting off the ground for being unable to rake in the big bucks from investors.
However, if a startup has held multiple rounds of funding and was only able to raise small amounts of capital every time – and institutional investors are passing on the opportunity – this is not a good sign.
At this point, it’s fair to question the company’s viability…
Maybe the business has not figured out a promising strategy, is not scalable, or failed to deliver results. In each of these cases, you’d be wise to stay away.
Fluffy, Vanity Metrics
Sign-ups, app installs, beta users – these are all metrics that show product adoption.
However, these need to be converted into revenue.
If a company showcases fluffy metrics and these results are not accompanied by tangible results in dollar signs, this could spell trouble.
Rather than put weight in these vanity metrics, look at more revealing figures, such as monthly active users, revenue (better if recurring), conversion rates, retention rates, customer acquisition cost, and a customer’s lifetime value.
These are metrics that show how much customers pay for the product, just how important it is to them, and perhaps most importantly, how efficient and effective the company is at acquiring and retaining customers.
So there you have it. From now on, when looking for startups to invest in, remember to watch out for these 10 red flags. You’ll be glad you did.
Thank you I’m trying to learn as much as I can..
Thank you for this article. This will really help me in my
due diligence. I usually don’t invest in a company that
was not recommended by A&E. However, on rare occasion
I might like a company that was not recommended. If that
happens, I can you this information and make my own
informed decision. Thanks again!
I would like to add some major red flags: