It’s impossible to predict which investments will bring investors returns. But it is easier to spot companies with a high chance of failing.  

Investors should heed warning signs and indicators signaling potential risks in an investment opportunity. Recognizing red flags, yellow flags, or crucial data points is essential for informed decision-making, reducing the risk of financial loss. 

At KingsCrowd, we aim to give investors a comprehensive list of warnings applicable to equity crowdfunding deals. We’ve categorized them into red flags, denoting a high risk for investors’ returns, and yellow flags, suggesting areas for deeper investigation. Depending on the context, yellow flags may indicate that the investment could be unfavorable.

Red Flags

Low runway

Why does it matter? A company’s runway, the duration it can operate with current funding before requiring additional financing or achieving profitability, is a crucial factor that investors should consider. Investors should be concerned if the company has a limited runway.

What should investors do? Before committing to a company, investors should assess its runway, calculated by dividing its cash by the monthly burn rate. KingsCrowd’s company pages and Deal Explorer provide this information, as does Wefunder’s “Details” section. If uncertain, investors can inquire on the company’s raise page Q&A section. Founders’ responsiveness in addressing such queries indicates their relationship with investors and their communication and leadership style.

Investors who encounter an enticing startup with a low runway should scrutinize the funds raised in the current deal. Is it sufficient for 12-18 months of runway? If not, investors must recognize the heightened risk of bankruptcy. Inquiring about the reasons for a low runway is crucial. It may indicate challenges in securing funding or concealed financial mismanagement.

Lastly, investors should question founders with low runway and limited crowdfunding amounts about alternative funding sources. Some founders may mitigate the risk associated with a low runway through personal wealth, institutional backing, or anticipation of external grants.

Lawsuits

Why does it matter? Investing in a company with a history of legal issues or current lawsuits poses significant risks. Legal troubles, whether due to non-compliance with regulations, patent theft, or customer disputes, can incur substantial costs and, in severe cases, impede a company’s operations or product sales. Moreover, lawsuits involving founders and executives can damage the company’s reputation, hinder fundraising efforts, and erode customer trust.

What should investors do? Before investing, it’s crucial to comprehend the reasons behind the lawsuit and assess potential consequences for the company. If a lawsuit has the potential to tarnish the company’s reputation or hinder its financial obligations, investors should consider other opportunities.

Shareholders selling shares

Why does it matter? In a Regulation A offering, when shareholders sell shares, a portion of the funds raised doesn’t contribute to the company’s growth but goes directly to these shareholders. This diverts capital that could fuel the startup’s expansion, providing early returns to existing shareholders at the expense of new investors. This not only hampers the company’s growth but, in extreme cases, may signal a lack of confidence among some shareholders in future returns.

What should investors do? While raising the topic in the Q&A section may not always yield a transparent response, investors can consider certain indicators. A low company valuation may suggest potential failure, while a high valuation may indicate limited prospects for acquisition or an initial public offering at a higher valuation. In either case, exercising caution and passing on the deal could be a prudent move.

Outrageous revenue-to-valuation multiple

Why does it matter? For startups generating significant revenue, like $100,000 annually, at an early development stage, the revenue-to-valuation multiple is crucial for assessing accurate valuation. Investors may face a suboptimal return if the startup is raising with an excessively high revenue-to-valuation multiple. Acquirers or the stock market are unlikely to value a company above its actual worth, potentially resulting in a lower return for investors.

What should investors do? Investors can find the company’s revenue multiple on KingsCrowd’s deal pages to gauge whether the valuation aligns appropriately with the revenue generated.

Revenue drop

Why does it matter? A substantial revenue drop, like 50% or more from one year to the next, may indicate issues such as poor demand, execution challenges, or intensified competition.

What should investors do? Initially, investors should consider external factors like pandemics or recessions causing the drop. If not, seeking detailed explanations from founders is crucial. Based on the provided explanation or its absence, investors can assess the company’s potential for exponential revenue growth, considering factors like team competence, market fit, and the offering. If doubts persist, passing on the investment may be more prudent.

Uncapped future equity

Why does it matter? Investors supporting companies through SAFE or convertible notes don’t receive shares until a future funding round, typically at a valuation cap or discount. Without a valuation cap, investors face the risk of conversion at a less rewarding price, potentially diminishing returns.

What should investors do? In most cases, if the company lacks exceptional appeal, it would be prudent for investors to pass on such an opportunity.

Repurchase rights

Why does it matter? Repurchase rights, also known as buyback rights, in the context of startup investing, refer to the ability of the company or other shareholders to repurchase shares from an investor under certain conditions. They add a risk to the investment opportunity, as a startup’s leadership team could trigger these rights to only give a small return to investors.

What should investors do? When facing repurchase rights in a startup investment, investors should carefully review the agreement. This involves understanding the triggers like employee departures or missed milestones. Evaluate how it affects liquidity—whether selling shares is restricted, especially at a set price. Check the company’s stability and risk plans related to repurchase rights: can the repurchase rights be easily triggered? Also, ensure the agreement provides adequate investor protections, balancing interests between both parties.

Yellow Flags

Part-time founders

Why does it matter? In the startup world, rapid growth is pivotal for outpacing competition, winning investor confidence, and quickly reducing dependence on external funding. When a founder works on their company only part-time, the limited time and potential distraction may impede rapid growth. Moreover, a part-time founder may exhibit less commitment than a full-time counterpart, increasing the risk of early surrender or early recognition of impending failure.

What should investors do? Recognizing the reluctance of top-tier startup accelerators to admit part-time founders, investors can mitigate risk by preferring part-time founders who explicitly commit to transitioning to full-time post-raise. Alternatively, if a founder’s part-time commitment is due to activities beneficial to the company, such as working with partners or in research, it could be a strategic asset.

Uncompliant with Reg CF requirements

Why does it matter? Every startup raising money through crowdfunding must file a C-AR form every year by May 1st to provide updated financial information to investors. Companies that have been uncompliant with these requirements may stay uncompliant in the future. This could prove a lack of understanding of the regulations from the founders, an intent to hide information, or a lack of execution capabilities.

What should investors do? While this may not be a reason for passing on an investment, investors should bring up the conversation with founders.

Low Founder Ownership Percentage

Why does it matter? A founder with a small ownership stake, particularly in the early stages with the prospect of further dilution in subsequent rounds, may raise concerns among investors about diminished motivation and incentives for success.

What should investors do? Investors should seek signs that the founder’s motivations extend beyond financial returns. Investigating the history of co-founders who may have departed is crucial; conflicts between previous founders could indicate leadership issues, elevate the risk of implosion, and hinder rapid growth.

Down Round

Why does it matter? A company raising at a lower valuation than its previous round may indicate past overvaluation or current difficulties, compelling the need to lower the price to attract investors.

What should investors do? Investors should assess the risk of imminent failure and whether the company can offer a satisfactory return. Sometimes, a down round can present an opportunity to invest at a discounted rate.

Past failed raise

Why does it matter? Startups unable to secure a previous crowdfunding round may face challenges in attracting investors, indicating potential issues with their network, marketing strategy, or overall attractiveness as an investment. The risk of struggling to secure future rounds, potentially leading to failure, is heightened.

What should investors do? Investors should delve into the reasons behind the previous funding failure, assess any improvements made by the company since then, and evaluate whether the startup is more likely to attract investors.

Other Indicators

Unclear valuation

Why does it matter? Some companies fail to clearly disclose their valuation on raise pages, creating uncertainty for investors. KingsCrowd’s analysts often calculate valuation based on share prices and outstanding shares, but this method introduces a margin of error. Lack of transparent valuation information may lead to investments in overvalued deals.

What should investors do? Investors should proactively seek clarification on the raise page’s discussion section to confirm the valuation before investing. The likelihood of favorable returns may be diminished if the valuation appears high compared to industry peers.

Quickly identifying red flags can help investors save time by quickly passing on bad investment opportunities. To learn how to identify the best investment opportunities, investors can also dive into KingsCrowd’s comprehensive guide to crowdfunding due diligence.