After viewing thousands of presentations and pitch decks over many years, even the most experienced angel investors — and VCs — can overlook red flags that are subtle and not immediately apparent. I know this from firsthand experience: Along with many wins there are some investments I wish I’d turned down. I missed the red flags.
So that you minimize the likelihood of learning the hard way, what follows are my top subtle red flags angel investors should heed when evaluating a potential investment. By staying vigilant and knowing what to look for, you can make informed decisions and stay away from opportunities that you determine aren’t worth the risk.
An out-of-balance team
A key factor when you’re considering an investment is whether business expertise and technical know-how of the founding team are in balance.
Even the most experienced angel investors and VCs can overlook red flags that are not immediately apparent.
I’ve heard pitches from many life science companies with deeply credentialed and innovative technical founders with absolutely no business expertise on the team. Conversely, I’ve seen companies filled with many superb business professionals that are deficient in their technical prowess. A founding team must always have relevant, gifted technical expertise to be viable.
Without a fine-tuned balance of business acumen and technical ingenuity, a startup may struggle to develop their game-changing product, bring it to market, scale the business and attract customers and investors.
Frequent staff turnover
Frequent and high turnover is often a red flag for investors as it usually indicates instability and internal conflicts within the founding team. Turnover disrupts the company’s operation, culture and growth trajectory. It’s a red flag that drama is consuming the company while its mission is mostly sidelined. A revolving door showing that the company can’t retain top talent will negatively impact its financial prospects, both short and longer term.
Instability in a founding team can show up in ego-driven abrasive management, favoritism and unfair compensation — issues and inequity that will cause people to leave.
Tweaks in leadership are normal and healthy as a company grows. But when these changes occur too frequently, investors should pay particular attention as it often suggests deeper issues in the business.
A lifestyle business with no exit plan
The founder of a lifestyle company is motivated to create a sustainable, profitable business that allows them and employees to enjoy a particular lifestyle. They have no intention to grow rapidly or achieve an exit by acquisition or IPO. They may, however, look to seek investment to expand their product or geography.
Here’s what you need to know about a lifestyle business. It relies on the owner’s expertise and personal relationships. Without a succession plan, the business is vulnerable if the owner leaves or is no longer able to run the business.
Even though you’re an investor, you may run into secrecy around “opening the curtain” and getting close to the details of the business. Because the company depends solely on the owner, your exit options are limited. The owner likely has no interest in selling the business, and valuations are lower in the event the owner decides to sell.
I know of a few companies that fit this profile. Investors who thought they were funding a good deal that would pay off are still looking for a return on their investment or an exit bonus more than 20 years on.
The founder is a charismatic liar
When you find a company you’d like to invest in, it’s critical to vet the character and integrity of each person on the leadership team. Pay extra close attention to the founder.
While charisma in a founder is a valuable asset, that charisma can leave you spellbound. A charismatic and non-charismatic founder should get the same thorough vetting. We get our best lessons from the school of hard knocks. I made a small investment in one particular startup. Unfortunately, other investors had larger funding stakes in this company. We all lost our capital.
I was swayed by the charismatic founder of an AI company who dazzled with his ability to persuade. Initially he was truthful, which is why I didn’t see the red flags. But when he won a prize for his innovative company the recognition went to his head. He lied about the business numbers. Investors uncovered the false numbers when they sensed something was amiss and probed to find out.
They discovered two sets of books: a made-up one for investors; the other with the real numbers. This is a cautionary tale for startups to have an independent accountant who reviews the firm’s books on a regular basis and shares the results with all stakeholders, including investors.
Although a founder may claim they’re transparent, make sure they prove it. Red flags that they may try to hoodwink you:
- They show successes and say nothing about challenges.
- They make commitments but don’t deliver according to the commitment.
- They fail to respond in a timely manner when you contact them or respond weeks later because they’re avoiding you.
- They don’t want to answer your hard questions and tell the truth. Don’t be tempted to excuse it.
Other warning signs: Do company leaders present a far-fetched vision of exponential growth? Does the founder withhold critical information you need to know? If something looks too good to be true it probably is. If you encounter any signs of dishonesty or inconsistency in the founder’s statements and actions, run for the hills.
A Romeo and Juliet leadership team
While there have been effective teams where the founder has a romantic or spousal relationship with a staff member, there are huge risks.
From an employee standpoint, the couple is untouchable even if one of them is a poor performer. Only the partners can partake in pillow talk about the business.
If the relationship sours it’ll have a negative impact on this business. Employees will feel forced to take sides, which will be disastrous for the business. A startup I considered funding had a couple going through a divorce. As the divorce became more contentious, the business suffered and eventually shut down.
If a spouse team leads the business, you may run into a lack of diversity of thought and perspective. The traits that attracted them to each other may be traits that perpetuate the status quo, leaving them closed to other’s perspectives.
A power couple may hog power to the point key team members feel intimidated and hesitant to fully contribute. When creativity and innovation are stifled, the company will find it difficult to grow, pivot or adapt to changing market conditions.
As an investor you must thoroughly research and understand the companies you’re considering investing in. You need to wear two hats: one for vigilance; the other for trust. You must remain both vigilant and trusting throughout your relationship with a company you’ve helped fund.
Don’t think that now that you’ve vetted and funded a company you can turn away and trust the founder and their team to honestly and ethically build the business. A founder who lacks an ethical core will not hesitate to do everything possible to get their hands on your money.
The brutal truth is that a founder can change after initially appearing to be honest — recall the founder of the AI company I funded who flipped after winning a prestigious award.
While it may sound like the startup ecosystem is teeming with scoundrels, the overwhelming majority of founders are honest, even the charismatic ones. My advice is to keep your heart and head in balance. That way you’ll protect yourself from investments that go nowhere, and you’ll weed out the odd needle in a haystack fraudster lurking in your prospective founder roster.