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Trouble in Startup Paradise: Watch Out for These 10 Warning Signs Before You Invest

Posted by Erica Duignan Minnihan on Aug 8, 2016 4:00:00 PM

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Most people who talk about angel investing or early stage investing in general often accompany it with a stern warning: “Be ready to lose all of your investment.”

And while this is definitely a possibility, we know that avoiding the companies that implode in a spectacular fashion is half the battle to building a portfolio with a strong IRR. For every company that goes completely bust, you need to generate a 2x return from another investment just to break even.

So here are our top ten warning signs to look out for when you are considering an investment.

  1. There’s no financial model. Nothing scares me more than someone who is willing to go into business without having run the numbers. We get it, your product or idea may be SO cool. But we need to know if it has a chance to make money. And most businesses are complicated enough that a simple model that can show how the unit economics work and highlight any issues arising from scale is essential. This is a must-have.
  2. There’s no plan to be profitable. Now, we know investors in some pretty big tech unicorns had little understanding of how the company would monetize for some time. And some of them have gotten there (Facebook) and some are still burning cash away (Twitter). But as an investor, I like to be concerned about whether the Company will actually make money. There are a lot of “tech” companies out there (particularly in lifestyle services) that have been subsidizing the fabulous lifestyles of Millennials, while acknowledging they can’t earn a red cent for investors with their current business models. This should scare you.
  3. The founders don’t have skin in the game. When the founders have a cushy banking job to fall back on, you should be nervous. If they haven’t invested significantly in the business, they will be much more likely to pack it in and head home when things get tough.
  4. The market is very crowded. Some markets just seem too attractive to new entrants. One example of this is the food/grocery delivery space. It started off as a very unique idea, but because there are no barriers to entry, you now have every possible permutation of food in a variety of stages of preparation being marketed by far too many companies. And I can’t walk out my front door without someone from Hello Fresh tackling me and asking if “I like to eat healthy”.
  5. The founders are just “playing” at the startup game. Some people think it sexy and glamorous to have a startup. They probably work from the Soho House or somewhere similar. Once they realize how soul-crushing it can be, they are likely to be out the door and on to the next “cool” job. Beware these people, they are often recent business school grads.
  6. The burn rate is out of control. Is the company burning through tens or even hundreds of thousands of dollars in cash while they “figure it out”? This is a warning sign. It’s fine to invest in a company that is still trying to find product market fit, but if they are careless about spending your investment dollars on too many mistakes, parties, and failed marketing efforts, you could be in for trouble.
  7. They can’t meet milestones before they run out of cash. The company has 9 months of runway, but it will probably take 18 months before they can meet the milestones needed for a follow on investment. This is a complicated and sad story, but also one that is dangerous for you as an investor. Unless you enjoy throwing good money after bad.
  8. There are some overcapitalized competitors in the space. This is one of the toughest challenges. The founders you invested in are diligent, hard working people who are trying to solve a problem in the market. And then all of a sudden the space becomes hot and some competitor that just raised $20 million is splashing all that money around in a crazed attempt at hyper-growth. Let’s hope you can ride out the storm, because those are rough waters you don’t want to be in.
  9. They haven’t found product-market fit. Finding product-market fit is the holy grail for startups. But sometimes you just can’t quite get it. No matter how great the product is, be sure you are tracking market adoption. Building great things is for some reason a whole lot easier than convincing thousands or millions of other people to buy them.
  10. They aren’t ready to handle fast growth. This can be the worst way to die. But it typically happens as a function of some of the other mistakes that have been mentioned. Very simply, if the business model monetizes customers over a long period of time, and the company starts growing very quickly, that growth can actually end up killing the company. It just can’t handle the cash burn and flames out unless someone comes in with a big investment.

 

Topics: Venture Investing, Invest in Startups, Return on Investment