Early-Stage Startup Red Flags to Watch For

When you invest in startups, a portion of them will fail.

Meaning you’ll lose some or all of your investment.

If you’re going after companies with billion-dollar potential, it’s simply inevitable.

In fact, many notable venture capitalists, including Fred Wilson of Union Square Ventures, say that if you don’t have some failures, you’re not taking enough risk.

He says the failure rate in a good venture capital fund should be around 40% to 42%.

That said, there are certain red flags I’ve identified (some by learning the hard way) that signal the wrong kind of risk.

So today we’re going to look at three warning signs that are specific to early-stage companies.

Red Flag No. 1: Logo Collectors

Big-name partnerships are a great way to make your startup look solid. Even when it’s not.

So just because a startup has a deal, partnership, a letter of intent – whatever – with a big-name company, don’t take it as a sure sign that things are about to take off.

For example, many consumer goods startups claim their product is “about to be in Target” (or Wal-Mart, Costco, etc.). What they don’t say is that it’s probably a test run (at best), and the chance of nationwide distribution is tiny. If they do land a deal with a major retailer like Target, keep in mind that the margins will likely be tiny as well.

If a startup’s primary proof of traction is a few nice corporate logos in its pitch deck, with little revenue to show for it, I quickly walk in the other direction.

Some startups simply obsess over making deals with established companies. They think it just might be the answer to raising money, making payroll, signing even more deals, etc.

It does make raising money easier for the founders. But that’s not a good thing for investors. So unless it’s a large stable contract and there are plenty of other customers… WALK AWAY.

Red Flag No. 2: Too Many Founders

There is no “best” number of startup founders. But in my view, fewer is better.

If a startup has four or more founders, I’m always a little wary. Especially if they haven’t worked together before.

The problem lies in compensation and motivation. As you add founders, each one’s stake in the company is reduced.

More founders means less incentive per worker. What often happens is that some founders feel like they’re working harder than the others. Jealousy and distrust can result.

“Why am I going to bust my butt when Joe isn’t doing squat and has the same equity stake?”

This scenario is more common than you might imagine. It hurts productivity and could ultimately kill the business.

This is also why it’s worrying if the founders haven’t worked together before. They need to have a good feel for how their co-founders operate… what to expect from their partners when times get tough.

My ideal seed-stage startup has one or two founders. If it’s two or three, I’m looking for a team that has worked together before and has preferably known each other for at least three years.

If it’s a single founder who has deep experience in the space, with their own money on the line and great traction, I am always interested. Industry doesn’t matter much at that point.

Chariot, a transportation company I invested a small amount in back in 2014, is a great example. The founder, Ali Vahabzadeh, invested his own money to get the company off the ground.

Over the last two years, he’s built Chariot into an impressive company. And last week, Ford acquired the startup for $65 million.

A bootstrapped startup where the founder has invested mostly their own money is the opposite of a red flag. I would say that’s a green flag!

Red Flag No. 3: Unreasonable Projections

At the seed stage, when companies are just starting, projections are sure to be wildly inaccurate.

I often think how silly it is to make long-term projections at this point in the game. If a company’s projections are for 10X year-over-year growth, and there’s no evidence that it can do it, that’s an obvious warning sign.

But there is valuable information to be gained from looking at projections.

I tend to focus on the unit economics. How much a company expects it to cost to acquire customers (cost per acquisition, or CPA), and how much revenue it expects that customer to generate over their lifetime with the business (lifetime value, or LTV).

Great startups are constantly working to improve their CPA and LTV. Asking founders about these metrics, and how they’ve changed over time, is always worthwhile.

It helps to know something about marketing, but the basic metrics are straightforward. Look for companies that make more off their customers than it costs to acquire them and that can continue to improve this customer funnel.

Projections also give us a chance to see how the founders envision their business down the road.

Just remember, these aren’t established companies. So don’t expect their early projections to hold much water. I like founders who set the bar relatively low. They’re the ones who know their investors have long memories when it comes to forecasting.

Bottom line, don’t put too much stock in projections. It’s simply another tool to use when evaluating startup opportunities. Use it to get a feel for the founder’s vision and their unit economics.

There’s nothing wrong with a little optimism. Great founders often sound like they’re ready to take the world by storm. Just be sure the startup’s not basing its current valuation on “projected” growth that hasn’t shown any signs of materializing.

What are some telling red flags you watch out for? Not just in startups but in microcaps or stocks as well. Let us know in the comment section.

Have a great weekend, everyone.

Adam Sharp
Founder, Early Investing