At SeedInvest we place great emphasis on due diligence before launching an early-stage company on our platform (historically we’ve accepted just ~1% of startups that apply),  and rightly so. Startup investing is inherently risky, and the vast majority fail outright, or fail to produce a return for their investors. We work behind the scenes to perform several categories of due diligence appropriate for a typical venture capital investment based on the size and stage of the company. However, responsibility for making an informed investment decision ultimately lies with the investor to assess the claims around a company’s investment thesis and pitch deck. Understandably, startups want to present themselves in the best light in order to maximize the chances of accessing early-stage capital. It’s essential to validate optimistic figures and statements underlying a company’s selling points to ensure they accurately represent the company. While we strongly encourage our investors to carry out their own due diligence before making an investment, we also understand that this is a labor-intensive task, and not everyone is privy to the collective experience and industry knowledge of our team. Our team’s combined knowledge and experience means most of the information in this article pertains to companies and/or investment opportunities outside of those on our platform.
The due diligence process
There are three broad pillars of due diligence carried out by our team: business and operational, legal and confirmatory, and document review. Collectively, these encompass everything from reviewing a company’s organizational structure, checking whether the legal entity is operating and in good standing, conducting background checks, reviewing legal documents (and the rights, preferences, and protections contained therein), analyzing a company’s performance, sales pipeline, investment terms, and growth strategy. For a more comprehensive breakdown of our due diligence considerations, visit our Blog.
When our internal investment committee is assessing a company, a key focus area is the type of security on offer. Offering preferred stock or convertible notes (assuming these are converting into preferred stock) is typically the most appropriate format for an early-stage company, and gives the investor important protections such as a liquidation preference. If a company is looking to issue common stock, that’s typically a “no go” because they lack numerous rights, preferences, and protections early-stage investors should both expect and demand given the level of risk they are assuming. Similarly, when a Safe Note is on offer, it’s important to remember that, by design, Safe Notes are not debt instruments, and so do not have the same protections and provisions as convertible notes. Offering Safe Notes is not necessarily a non-starter for our investment committee (although it definitely isn’t preferred), and of course every company is different and should be assessed on a case-by-case basis.
The valuation is another essential area reviewed by our team before hosting a company on our platform. When looking at the proposed valuation, it is important to ensure it is supported by actual business traction. Valuing an early-stage investment is an extremely opaque and subjective exercise. By virtue of the sheer volume of dealflow, with anywhere between 1000-1500 companies a month applying to raise with us, our team is primed to judge whether a company’s valuation reasonably aligns with existing industry comparisons. If all this seems overwhelming – fear not! We’ve collated the major red flags to help you curate a personal checklist of the right questions to ask when undertaking due diligence on a potential investment opportunity.
Common fundraising red flags
- Shying away from acknowledging competition: If a company believes they have no competitors, this could be indicative of insufficient market research and/or an example of the company purposely trying to appear more unique than they are. It is unusual that a company stands alone in its field, and existing competition is a sign of market validation.
- Unrealistic financial projections: For the most part, financial projections are going to be wrong, as it usually takes a company much longer to become profitable than anticipated. Projections should instead be used to gauge how a founder is thinking about their business and, specifically, how to drive growth. Focus less on the numbers themselves and more on the growth drivers and the assumptions being made.
- Maintaining an investor vs entrepreneur mentality: Investors should be viewed as a resource to be leveraged, not as the opposition. It should be cause for concern if a founder takes a combative tone, struggles to take feedback, or is easily rattled when an assumption is challenged. A strong management team should have experience, drive and people skills. On SeedInvest, investors and founders are able to communicate directly via webinars, online message boards, and in-person events, providing the perfect opportunity to assess these factors.
- Overstating market potential: Be wary of aggressive claims! If a company says they have huge market potential, think about what percentage of that market is feasibly suited to its product/service. The serviceable obtainable market is a better indication of market potential than the total addressable market. Be thoughtful about the market size, and wary of selective data choices by the founder.
- Using intellectual property (e.g. patents) as the major selling point: These are only as valuable as the money a company has to defend those claims, should anyone infringe upon them. Patents, while valuable, should be viewed as a plus, but rarely should they be the sole reason for investing.
- Use of funds: As an early-stage investor, ideally your money should be contributing to a company’s growth initiatives, such as growing the headcount, increasing marketing spend, and investing in a more robust product and/or service offering. Your investment should not primarily go towards things like outstanding debt and back wages. Question what the proceeds are going towards, and to whom any debt is owed.
- Misaligned incentives: Founders are obviously looking to raise at the highest value as possible, but they must understand that there is a palpable tradeoff between the best terms/dilution for the investor and the timing of the investments. The best founders act as stewards for their investors’ money, maintain a level of trust and care about the company’s share value. You as an investor need to ensure you have the rights, preferences, protections, and upside in line with the level of risk you are assuming as an early-stage investor. In particular think about what type of security you’re buying, and whether you have voting rights.
Ultimately, investment decisions are highly personal, and are not black and white. Generally, there are no straightforward “right” and “wrong” decisions; for most early-stage investors the one common mistake is not diversifying sufficiently, especially as doing so can mitigate the impact of volatility. We strongly encourage investors to undertake their own due diligence before making an investment decision. In light of this, on each company’s raise page on SeedInvest there’s a discussion board  where investors can ask questions and engage directly with the founders and management team. When carrying out your own due diligence it’s vital to thoroughly analyze the underlying thesis – cut through the nuance and look at the cold, hard facts.
In SeedInvest’s lifetime, tens of thousands of companies have applied to raise with us. Our team has worked with hundreds of founders, facilitated countless investments and seen more deals than many early-stage venture funds. As a result of this wealth of combined knowledge and experience, most of the advice in this article pertains to companies and/or investment opportunities outside of those on SeedInvest. Take a look at our current offerings.
 SeedInvest’s selection criteria does not suggest higher quality investment opportunities nor does it imply that investors will generate positive returns in investment opportunities on SeedInvest. Learn more about due diligence in the SeedInvest Academy (/academy/how-to-assess-a-startup-investment)"and our vetting process in our FAQs (/faqs)""
This post was written by Alice Hankin on November 18, 2019
7 Red Flags Early-Stage Startup Investors Should Avoid