5 Red Flags Every Angel Investor Should Watch For in Startup Due Diligence
Angel investing in startups is high-risk but potentially high-reward. To maximize your chances of success, thorough due diligence is critical. By evaluating key areas like founder qualities, product-market fit, financials, and competitive positioning, you can better identify which startups are worth the investment and which carry significant risks. Below are five red flags every angel investor should look out for during due diligence.
1. Founder Qualities: The Most Important Factor
When evaluating a startup, the founder’s qualities are just as important as the product or market opportunity. A founder’s resilience, adaptability, and leadership qualities can make or break a startup, especially when times get tough.
At Evergreen Mountain Equity Partners, we use a proprietary assessment to identify founders with what we call the “Entrepreneurial Adaptive Innovator” (EAI) traits. These founders display key qualities such as:
Resilience: The ability to navigate setbacks and remain motivated.
Humble Assertiveness: Confidence combined with openness to feedback and collaboration.
Strategic Accountability: Ownership of their actions, quick to pivot when necessary.
Red Flags: During due diligence, watch for founders who show signs of inflexibility, lack of accountability, or an inability to accept feedback. If a founder consistently overpromises or avoids discussing failures, it could signal challenges ahead.
Download our free white paper covering the key traits of successful founders.
2. Product-Market Fit: Evidence of Customer Demand
Product-market fit is the foundation of any successful startup. Without it, even the best business model is unlikely to gain traction. During due diligence, check whether the startup has proof of product-market fit, such as steady customer retention, positive feedback, and growth in paying customers.
Red Flags: High churn rates, customer complaints, or a lack of repeat business can indicate poor product-market fit. Additionally, if the product is overly complex or only a fraction of the target market is using its full functionality, it might struggle to capture a larger audience.
Pro Tip: Don’t rely on founder claims alone. Request data on user engagement, growth rates, and customer feedback to assess the product’s demand and potential for scalability.
3. Unrealistic or Unclear Financial Projections
Financial projections are essential to understanding a startup’s growth potential and planning. However, overly optimistic or unclear projections can signal red flags. Reliable financial projections should be backed by reasonable assumptions, and growth should appear sustainable rather than exaggerated.
Red Flags: Look for projections that seem overly ambitious without clear justifications. If a startup expects 300% growth without explaining the basis for this forecast, it might be wishful thinking rather than realistic planning. Another red flag is inconsistency within the financials, such as margins that don’t align with expected revenue or costs.
Pro Tip: Challenge the startup’s assumptions and ask for specific milestones they plan to reach. If they struggle to explain their projections clearly, it may indicate a lack of planning or financial inexperience.
4. High Customer Acquisition Cost (CAC) with Low Lifetime Value (LTV)
Two of the most critical metrics for evaluating a startup’s growth efficiency are customer acquisition cost (CAC) and lifetime value (LTV). A healthy ratio between these metrics—typically an LTV at least three times the CAC—indicates that a startup is able to generate significant revenue relative to the cost of acquiring new customers.
Red Flags: If a startup has a high CAC but a low LTV, it means they’re spending more on acquiring customers than they’re earning from them. This unsustainable ratio indicates the startup will likely struggle with profitability and may need excessive funding just to maintain growth.
Pro Tip: Evaluate the startup’s LTV-to-CAC ratio to determine whether its growth model is sustainable. Ratios below 3:1 are usually a red flag, as they suggest high cash burn with limited revenue potential.
5. Small Market Size and Lack of Competitive Differentiation
A startup’s market potential is heavily influenced by the size of its target market and the competition it faces. Startups operating in large, growing markets have more room for expansion, while those in niche or shrinking markets face limited growth potential. Additionally, startups that lack a clear competitive advantage or unique selling proposition may struggle to gain traction in crowded markets.
Red Flags: Look for indications of a small addressable market or a lack of differentiation. If a startup is entering a crowded space without a clear competitive edge, it’s likely to face steep challenges. Furthermore, if the product doesn’t offer a unique solution, it may struggle to gain market share from established players.
Pro Tip: Ask the startup to describe its competitive advantage and assess the scalability of its target market. If the startup can’t articulate a clear differentiation strategy, it may face difficulty standing out from competitors.
The Importance of Rigorous Due Diligence
Due diligence is essential for identifying critical red flags and making informed investment decisions. From evaluating founder qualities to analyzing financials and market potential, each area of due diligence offers valuable insights into a startup’s viability. At Evergreen Mountain Equity Partners, we emphasize founder assessment and use our proprietary tools to help identify those who demonstrate resilience, adaptability, and strategic decision-making.
If you’re interested in exploring startup investing and want to learn more about our approach to due diligence and founder selection, reach out to us at Evergreen Mountain Equity Partners. Our comprehensive due diligence process and founder assessment help us make informed, data-driven investments, and we’re excited to help you do the same.
