Red Flags and Warning Signs: What Could Trip Up a Startup during VC Due Diligence (Medium article written by Lauren Epstein)
To secure VC funding, a company must be special — not only having significant positives, but also avoiding serious negatives.
These negatives are often uncovered during due diligence, an exploratory process that VC’s conduct with a company of interest prior to issuing a term sheet.
In general, due diligence is intended to serve two purposes:
1. Assist in building an investment thesis to inform a proposed investment in the company; and
2. Uncover any potential problems.
Trust me — VC’s hope not to find problems. We only dive into the resource- and time-consuming process of due diligence if we are excited about a company. We’re hoping for good news!
However, the reality is that due diligence can reveal problems.
Below is consolidation of some of the main types of red flags and warning signs that can come up during due diligence from the perspective of the team here at OMERS Ventures.
Business Model
A company’s business model is one of the most important components we look at during due diligence. It is also often the source of red flags.
1. Bad Unit Economics: If a company cannot acquire customers at a cost that is materially lower than the revenue it will generate from those customers, the business may have no future.
2. Quality of the Financial Model: A financial model that contains bad, baseless, or improper assumptions is a double red flag: it calls into question both the decision-making of the team and the fundamental premise of the business model.
3. Shaky on KPIs: Not knowing what your KPIs are or not knowing their measure and movement is bad sign.
Key Takeaway: Have a solid business model that tracks your KPIs, with strong unit economics and reasonable assumptions.
Growth
As VC’s dig into a company, one of the key things we are examining is growth history.
1. Slow, Uneven, or Negative Growth: Anything other than strong growth is a warning sign that will cause us to ask questions.
Key Takeaway: If you have slow, uneven, or negative growth, be upfront and provide an explanation as to why it should not be considered a problem.
Market
A company’s market contains both its customers and its competitors — two groups vital to success or failure.
1. Small TAM: Having a small total available market that is not growing is a significant problem. It may be possible to mitigate, but any such explanation must be compelling.
2. Not Knowing or Not Revealing Competitors: Demonstrating ignorance or lack of transparency about competitors is a real no-no. Please never tell a VC that you have no competitors for your customers’ business. Trust me; you always do.
Key Takeaway: Find a big and/or growing market, and be upfront and knowledgeable about your competition.
Team
A strong, capable team is one of the most important factors in VC decision-making. Numerous and significant red flags can arise here.
1. High Turnover: Employee retention is key at every level. High turnover among the senior team is particularly concerning as it can show a lack of cohesion.
2. Above Market Compensation: Executive pay that is higher than market average — either now or in forecasts — can call into question the team’s priorities.
Key Takeaway: A dedicated and cohesive team with strong decision-making abilities is a must.
Intellectual Property
For most technology start-ups, rights to intellectual property are fundamental to operations.
1. Unclear IP Rights: A company must be able to show a clear line of ownership or (at minimum) the right to use all key components of their operational technology. Any ambiguity in this area is a huge warning sign.
Key Takeaway: Clean up your IP rights prior to fundraising.
Fundraising Background / Cap Table
A company’s fundraising background and cap table can raise many red flags.
1. Complicated Cap Table: A complicated cap table is often the result of complex earlier fundraising rounds that introduced multiple share classes and/or byzantine rights and liquidation structures.
2. Overly Complex Deal Terms: A complicated cap table can lead to having overly complex deal terms, which arise as a result of earlier rounds with similar characteristics such as ratchets, liquidity preferences, and retraction rights.
3. Imbalanced Cap Table: An imbalanced cap table can create misaligned incentives. This can occur, for example, if a non-management investor holds significant or potentially controlling ownership or if the CEO herself does not have material ownership.
Key Takeaway: A clean, balanced cap table and straight-forward fundraising history are key assets.
Behaviour
The behaviour of the senior team — and particularly the founder(s) — is of critical importance in determining the potential success of an investment and the long-term partnership it creates.
1. Lack of Integrity: Warning signs about a person or team’s integrity can take numerous forms but often involve not being forthright about aspects of the business, history, market, competition, or other key factors.
2. Not Being Responsive During Due Diligence: If a founder is not responsive, delays providing information, or obfuscates when asked for specifics, this is a red flag.
3. Deal Fatigue: How a founder handles herself during negotiations can have a negative impact on the likelihood of reaching a deal. As one OV partner put it, “Deal fatigue is a real thing.”
Key Takeaway: Be honest, forthright, and responsive.
Conclusions
This list only some of most common examples of red flags we see; it is far from comprehensive. If you are a founder and are concerned that some of these (or other red flags) may apply to you, don’t panic! Here are two ways to help mitigate any issues:
1. Always be upfront and disclose clearly and fully; and
2. Have a clear, reasonable, and honest explanation.
If the problem can be fixed, work with the VC to do that. If not, help explain why there are ways around it or why it should not be seen as a fatal.
It is very rare that a company will sail through due diligence without raising any warning signs. The key is to manage and minimize them as much as possible.