Cut down on the work and avoid the worst deals in startup investing with these ten warning signs
This is the last post in our startup investing series and if you learned one thing from the previous 12 articles it should have been…investing in startups is a ton of work.
From understanding the finance for early-stage companies to researching a company’s specific market, being able to spot the best equity crowdfunding deals is a lot harder than picking a few stocks for your portfolio.
Even after doing all the analysis and due diligence to find the best deals, there is still a mountain of uncertainty around startup investing. Even experienced angel investors typically see half of the companies in their investment portfolio flop within a few years.
The amount of work that goes into analyzing startup investments and the uncertainty around even the best companies means your best time spent will be that first once-over to weed out the worst startup deals.
Being able to just glance through equity crowdfunding campaigns, picking up on a few warning signs, to avoid spending hours digging deeper into financials will make your life infinitely easier as an investor.
Weeding Out Bad Investments with these Startup Warning Signs
For that, I use a short list of startup investing warning signs that I’ve developed over a decade of early-stage and venture capital investing.
No warning sign will catch all the bad deals and there will be some startups that trigger a few warnings signs but go on to produce huge returns. It’s not a perfect system but it’s one that has served me well over years of investing and advising.
We’ve already looked at a few warning signs of poor management in equity crowdfunding deals. Most of them were things you would only pick up on after talking with the startup entrepreneurs.
The warning signs below are issues you should be able to pick up on through a read of the equity crowdfunding campaign. You might have to open up the financial statements provided by the company but most of these startup warning signs should be evident before you do too much analysis of the company or the deal.
Warning Signs of Weak Startup Management
- Nobody on the team has any industry experience. Management should have somebody on the founding team, staff or in advisory that knows how the industry works. It’s not enough to just be a good manager.
- Nobody on the team has finance experience. Maybe this is just my prejudice as a finance guy but I want to see someone on the founding team, staff or in advisory that understands the numbers. It’s ok to be a dreamer but put a number on it for me.
- Management has unrealistic assumptions of market share. You may have to do some quick math here. If the pitch says the market size is $100 and management is projecting $10 in first year revenue…they’re assuming they can grab 10% of the market (sales/total market). Most startups see low single-digit market share starting out.
- Management has an unrealistic timeline. We all know that management is overly-optimistic but to believe that a development-stage company can go from zero to investor exit in three years is ridiculous. Look for rational expectations and milestones along the way.
- Management believes there is ‘no competition’. You may have an innovative product for an under-served niche but there is ALWAYS competition. Denying so only means management is naïve or bull-headed.
Financial Warning Signs in Startup Investing
- No financials at all. Even the earliest-stage company should have some projections of costs and a review of money spent to date. I’m not interested if the founders or their friends, family and fools haven’t spent any money developing the company.
- Sales within three years. This might not be as relevant in some industries, especially pharmaceuticals where it takes years of testing just to produce a product. For most startup companies though, I want to see it making sales in at least a few years. It probably still won’t be turning a profit but it better have some money coming in the door besides mine.
Market Warning Signs for Crowdfunding Investing
- Total market size is under $100 million. If a startup isn’t going to get more than 3% or 5% of the market, that market needs to be big enough that a small slice of the pie is still worth millions in sales. I would cringe at anything under $100 million and will have a hard time investing in anything with a market of less than $200 million. Check out our prior post on how to research the market for equity crowdfunding deals.
- Projections for costs are way outside even those of the publicly-traded competitors. Startup companies may book faster sales growth than larger competitors but they will also likely pay higher operating expenses. This one takes a little more work than the other warning signs but it’s easy enough to compare the startup company’s financial projections with annual reports of competitors. Startups won’t be as efficient as larger-scale mature companies.
- The company is targeting a very broad market or one that is too niche. This is the Goldilocks warning sign. I want to see a fairly large market for the product but not the broadest level possible. Startups can’t compete against everyone in the market but have a fighting chance if they narrow the market to a niche where there is less competition.
You’ll develop your own list of startup investing warning signs as you invest in more deals and see more companies go bust. You’ll never catch all the losers and you’ll miss investing in a few huge payouts. The point isn’t to achieve a perfect startup investing portfolio. Be extremely happy to narrow the field down, avoid the worst startup offers and fill your startup portfolio with great companies.