Common Green & Red Flags Angel Investors Consider when Funding Startups

Angel investors seek promising startups to invest in, it's the riskiest asset class, but they also need to be aware of the risks and rewards, be purposefully cautious and avoid potential pitfalls. In this environment of economic uncertainty and volatile markets, investors can focus on aspects that ARE secure & strong, like a capital-conscious founder, a startup's leadership (founders, leadership team & advisors), their traction with customers, product-market fit, founder-market fit, market drivers and realistic and valuations. Investors seek to invest in innovation that aligns with your investment thesis. However, they also need to be careful when investing, as startups can be risky and may not always succeed. Overall, angel investors should conduct thorough due diligence and carefully consider all the factors before investing in a startup.

Some research indicates that a third of angel investments are made after less than 10 hours of due diligence. However, research conducted by Fundify.com on the amount of due diligence hours necessary for certain exit multiples for angel investors, shows a significantly more return of greater than 7X if angel investors do more than 40 hrs of due diligence per startup.

Due Diligence: It matters. A lot.

Green flags that help solidify investor decisions

I'm an optimist. Identifying green flags during my search for new portfolio companies or conducting deep due diligence is a promotion-focused endeavor. I like to go here first and speak to the founder about the investment opportunities with their associated risks in detail. Why? Because the red flags come up naturally when you build relationships and trust first. Here are common green flags for angel investors to continue diving deeper into due diligence with a startup:

1. Founder-market fit: Angel investors want to invest in founders who are deeply invested in the industries they are serving, who either have experience in the industry from their own career paths or personal experience (for example, an actuary building a new InsureTech SAAS platform for efficiency of operations or a cancer survivor who used a medical device starving for innovation and created a better product due to all of the challenges within and surrounding the problem).
2. Creative revenue streams. In this volatile economy, founders who rely on creative revenue streams and solutions to fundraising will get more green light during the investment process. Alternative funding and revenue opportunities that are a good fit for your industry allow investors to respect and dive into the "how and why" there are alternatives. Typically this creativity leads to richer discussions around fundraising, and assumptions, showcasing the deep knowledge of the founder around their revenue targets, KPIs, and forecasts. If founders can have these realistic conversations, green flags stop popping up like poppies in the fields of California.
3. Coachable founder because of the joy mentorship and advising brings to angel investors. Angel investors often bring not just their money, but also their expertise and experience to the table. They may be able to provide valuable advice and guidance to startup founders, helping them to navigate the challenges of starting and growing a business. When the entrepreneur is receptive to coaching, being mindful of recommendations, being introspective of potential new competitive advantages, and taking action on some of the RIGHT feedback, that is a huge green flag to continue due diligence.
4. Potential for high returns in one of the riskiest asset classes: Angel investors are willing to take on the risk of investing in early-stage companies because of the potential for significant returns if the startup is successful. It's hard to calculate a realistic estimate of future valuation, but when a clear path to market with credible financials, the return on investment is clearer
5. Product-market fit. I know, it's cliche, but it's true. Having product-market fit with a validated product and eager customers with a market thirsty for your product, is a huge green flag. I get asked a lot by entrepreneurs, "how do I show I have product-market fit before I honestly have it?" There are footprints in your sandbox / industry that you can demonstrate to highlight progress towards the goal: early customer interest through customer interviews, early revenue for CPG, LOI from BtoB customers, etc

Red flags that diminish trust in investor decisions

There are several red flags that may cause an angel investor to think twice before investing in a startup. Red flags that indicate weaknesses in these "green flag" areas may cause an angel investor to not continue in due diligence. When discussing red flags during due diligence, there are ways a founder or their company can mitigate those red flags, so I added them to the considerations below. Some common red flags include:

1. Lack of a clear business model: Angel investors want to see a detailed plan for how the startup will generate revenue and grow over time. If the business plan is unclear or incomplete, it may raise concerns about the startup's ability to succeed. Can be mitigated by: advisory support from the innovation ecosystem
2. No market need or potential: If a startup's product or service doesn't solve a significant problem or address a clear market need, it may not have much potential for growth or success. Can be mitigated by: This is a hard one because entrepreneurs should be building from a need in the marketplace maybe it's not being communicated quite right.
3. Lack of enough traction or validation: Angel investors look for startups that have already demonstrated some level of traction, such as revenue or user growth, or have been validated by industry experts or other investors. This "enough" piece to the traction varies between investors because everyone has a slightly unique thesis to better connect with their ideal portfolio companies. Can be mitigated by: Tieing a bow on partnerships entrepreneurs have with a letter of intent (LOI), pushing for impact data, usability data, etc.
4. Limited market potential: Angel investors want to invest in startups with a large addressable market and significant growth potential. If the market potential is limited, it may be a red flag that the startup will struggle to grow and generate significant returns for investors. Can be mitigated by: conduct a SAM, TAM, SOM analysis and get to the bottom of how big your market it.
5. Poor financials: Angel investors will scrutinize a startup's financials to assess its financial health and growth potential. If the financials are weak, inconsistent, or unreliable, it may indicate that the startup is not a good investment opportunity. Can be mitigated by:
6. No clear target market: A startup that does not have a clear target market, or whose target market is too broad or ill-defined, may struggle to gain traction and scale. Can be mitigated by:
7. High burn rate or unrealistic funding needs: If a startup has a high burn rate or unrealistic funding needs, it may be a sign that the founders lack financial discipline or are overestimating the potential of their business. This type of mindset does not sustain over challenging times or fickle customers. Can be mitigated by: Review of the financials with the team.
8. Weak or disjointed team: Angel investors want to see a strong management team with a proven track record of success. The startup team's skills, experience, and ability to execute are essential factors for success. If the team lacks experience, has a history of failures, or has not demonstrated the ability to execute on its business plan, it may be a red flag. Additionally, investors may be wary if the founders have personality clashes or conflicting goals. Can be mitigated by: recruiting good key hires or plugging gaps in Advisory Board with the right expertise.
9. Intellectual property or legal issues: Investors may be wary of startups with intellectual property or legal issues, such as patent disputes or lawsuits, as these issues can be costly and time-consuming to resolve. A startup without intellectual property protection may be vulnerable to copycats or competitors, reducing the potential for long-term success. Can be mitigated by: ensuring a good legal counsel is introduced to the startup.
10. Lack of transparency or trustworthiness: Angel investors want to work with founders who are open, honest, and trustworthy. If a startup's founders are secretive or uncommunicative, or if they have a history of questionable business practices, it may be a red flag for investors. Can be mitigated by: this is a tough one to mitigate, for entrepreneurs, always be authentic and funders, and don't hold back yourself in trusting the process, team, or startup.
11. Overly aggressive valuation: If the startup's valuation is too high, it may indicate unrealistic expectations or an overestimation of its potential for growth and profitability. Can be mitigated by: For founders, seek validation of your valuation from comparables or ask investors for valuation help.

Overall, angel investors are looking for startups with a clear business plan, strong financials, experienced leadership with capable founders & a problem-solving team, significant growth potential, a clear market need, and realistic funding needs. Red flags such as lack of traction, unrealistic expectations, legal issues, and lack of transparency or trustworthiness can signal potential problems and cause investors to pass on an opportunity.