It’s impossible to predict which investments will bring investors the highest returns. But it is easier to spot companies with a higher 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.

All of these factors are evaluated on each KingsCrowd raise page under the “Deal Considerations” checklist in the side navigation:

Deal Considerations Checklist Screenshot

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.

Existing Shareholders selling shares

Why does it matter? In a Regulation A offering, when existing or insider 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? Insiders selling shares is not always an issue, but investors should ask in the public Q&A to find out why (and how much). Form 1-A filings for Reg A offerings should disclose how much is being sold. It’s not uncommon for growth-stage companies to offer founders the ability to take a little off the table so that they can put all of their focus on growing the company and not have to worry about paying for rent, food, etc. However, giving founders too much equity may demotivate them from pursuing future success. Furthermore, if other early investors, Board members, or employees are cashing out and the company is still early, investors should ask why would someone on the inside be selling shares if they still believed in the future prospects of the business.

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. Investors can also reference the KingsCrowd analysis of revenue-to-valuation multiples by industry here.

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.

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.

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 by capping the upside potential, as a startup’s leadership team (or a third-party SPV fund administrator) could trigger these rights to buyback shares, potentially preventing investors from realizing future returns.

What should investors do? When facing repurchase rights in a startup investment, investors should carefully review the agreement. This involves understanding the triggers like whether the repurchase can be exercised for any reason by the company, or only under certain conditions – such as if the company were to exceed the 12(g) public reporting threshold (common in Wefunder SPV repurchase rights). Evaluate how the repurchase price is determined – typically it’s the higher of either the original purchase price or fair market value as determined by a third party. Also, it may help to mitigate the risk if a lead investor or other admin who votes on behalf of the investors (such as Wefunder or Republic) has to approve the repurchase.  

Non-compliant with Reg CF requirements

Why does it matter? Every startup raising money through crowdfunding must file a Form C-AR form every year by May 1st (or 120 days after their Fiscal Year end, if other than 12/31) to provide updated financial information to investors. Companies that have been non-compliant with these requirements may stay non-compliant 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. Research in the SEC EDGAR database to see how many (if any) prior Form C-AR filings have been filed.

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 (i.e. lower valuation)

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.

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.