2min read Completing your due diligence with care before investing in a startup is an indisputable rule in the world of investing. However, to ensure that your deal is going to work out as close to your expectations as possible, you need to go beyond due diligence. In today’s article, we will discuss how to do exactly that using three core strategies: finding the full answer, spotting red flags, and scanning for what isn’t being said in the startup’s pitch.
Reaching the Full Answer
The first strategy is to find the full answer. In talking with startups, I find the investor must always probe for the final answer. A single question rarely reveals the full answer.
I spoke with a startup recently who said, “We’re raising a million dollars and we have raised half of it already.” On the surface, it sounded like they had $500K invested in the business. So, I asked, “You have $500K in the bank already from your raise?” They responded, “Well, not exactly. We have several investors telling us they are interested in investing.”
After four more questions, it came out that they had $100K in the bank and around $300K in soft-circled commitments. It’s good progress, but not exactly the half a million we heard at the beginning.
Never take the first statement as the final answer. It takes at least 5 questions to get down to the real answer, and as an investor, you want to know the real answer.
Spotting Red Flags
The second strategy is actively scanning for red flags. These indicate something is wrong. Some red flags to beware of include:
- The founders are not investing any of their own money into the business.
- The cap table is crowded with many small investors, meaning the earlier funding was a challenge.
- The team is incomplete. Either the solo founder wears too many hats, or everyone is a tech developer, meaning no one is outselling the product.
- The team lacks awareness of the industry, especially the regulatory side.
- There are no KPIs or operational metrics to review.
- Plans are generic and lack specific customer names or revenue amounts.
- They have loads of debt, and previous investors have no further interest in funding or supporting the business.
- The business appears to be set up to be the CEO’s lifestyle business.
- They offer hockey-stick projections with no apparent supporting evidence.
- There’s no board of advisors or directors. The team you see is what you will get.
- The financials use year 1, and year-2 naming, rather than actual years.
What Isn’t Being Said
In due diligence, what isn’t being said or shared is as important as what is. When a startup pitches its idea, you should be skeptical of founders that don’t mention potential risks or discuss their experience in the industry or their traction.
Here are other key items the investor should look for in a startup’s pitch:
- what needs to be done and what risks exist in the deal
- market size and growth rates reflect the market the team is pursuing
- financial projections show the startup’s understanding of their business
- information about the founding team including industry experience, commitment to the startup, and no criminal records
If a startup leaves any of this information out, it may be an indicator that something is wrong. Use the five-question rule from above to find the true answer.
Read more on the TEN Capital eGuide: Due Diligence and Leading the Deal
Hall T. Martin is the founder and CEO of the TEN Capital Network. TEN Capital has been connecting startups with investors for over ten years. You can connect with Hall about fundraising, business growth, and emerging technologies via LinkedIn or email: firstname.lastname@example.org