When a startup is raising capital, it typically wants to paint itself in a positive light in order to attract investors. As investors conduct due diligence, how can they tell the difference between flowery marketing language and reliably sourced claims? What red flags should investors keep an eye out for as they assess an investment opportunity? Learn more about due diligence red flags and things an investor may want to keep an eye on in this week’s blog.

Due Diligence Red Flags

Due diligence is an important step of the investment process, where investors may want to consider the startup’s history, current position, future plans, founding team experience, and other factors in order to make an informed decision about making an investment. While a startup’s vision and momentum are important, the due diligence process can serve to pressure test the startup’s narrative against facts, figures, and narratives to holistically assess the investment against an investor’s risk tolerance and investment thesis.

So, what are some things that investors may want to keep an eye out for during the due diligence process?

Documentation and Housekeeping

In many cases, a startup will provide a data room or the ability to review historical financials. Investors should expect a basic level of order in a data room. If it looks like a digital “junk drawer”, investors may want to look a bit closer at the facts and figures. If one documents lists a different revenue figure than another document, an investor may want to ask additional questions to confirm the accuracy of the startup’s financials, for example.

Cap Table

Investors will also typically look at previous financing and the startup’s cap table, which should be clear and documented. If there is unresolved founder equity, a messy cap table, or previous funding that didn’t help a startup achieve the previously outlined growth milestones, investors may want to ask additional questions to understand the startup’s current position based on previous funding and existing investors.

Vanity Metrics

Certain metrics like Total Addressable Market, Serviceable Addressable Market, and Serviceable Obtainable Market can look great in a pitch deck, but may not always directly correlate with results and could be ambitiously overstated. TAM, SAM, and SOM as metrics may not be maliciously overstated, but a founder may be truly optimistic about hitting those metrics, despite the possibility that they could be out of reach. Therefore, investors should carefully consider vanity metrics, ensure they are backed up by reliable sourcing and narratives, and pressure test ambitious founder expectations.

Claim Sourcing

A founder can rattle off claims all day. But do these claims have a reliable source and are they able to be backed up appropriately? Or are they coming from a place of flowery marketing language? Pitch decks and fund summaries can serve as marketing materials. It’s important for investors to be able to identify “marketing language” compared to claims that have appropriate sourcing to accurately contribute to the narrative the founder is attempting to shape.

Founder History

Investors may want to look at founder history during the due diligence process. Does the founder have a record of success or failure? If the founder has experienced a failure, was it a good-faith business failure or was there misconduct or regulatory non-compliance? What was the nature of the failure? There is a difference between a founder previously being one of the unlucky 9 out of 10 startups that fail vs. misconduct or non-compliance.

Key Considerations

As briefly mentioned, one of the challenges in due diligence is distinguishing between a founder’s optimistic vision compared to reliably backed up claims and sourcing. The following are some key considerations for differentiating these two types of language during the due diligence process.

Hedged Language and Narratives

Investors may want to be cautious of founders the rely heavily on narratives instead of data. Despite this, early-stage companies do inherently have limited data and marketing language is expected in public-facing materials where investors are marketing their company as an investment opportunity. However, investors may want to assess if there are defensible data points in addition to narratives when conducting due diligence.

Unrealistic Market Projections

If a startup is assuming that it will be able to achieve a large market share without a clear, defensible go-to-market strategy, an investor may want to dig a little deeper to see where the startup is getting their numbers from. For example, investors can compare the startup’s unit economics against industry benchmarks to see if the projected market shares are rooted in data instead of hope.

Final Thoughts

Due diligence serves as a process by which investors can pressure test the claims that founders are making about their startups, before putting money into the startup. Investors can expect some level of marketing language, but may also want to assess claims, sourcing, organizational materials, and founder history in order to make an informed decision during the due diligence process.

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.

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