5 Red Flags That Scare Away Venture Capital

While it may be best to bootstrap our startups, some ideas are just too big for our bank accounts and we need big money to scale them globally as fast as possible.  In the cases when a giant bankroll is the only thing stopping us from world domination, we turn to VCs to fund our ventures. 

On the flipside, VCs are approached daily, perhaps hourly, with the next groundbreaking technology or social media phenomenon.  However, on average, they invest in only 1% of the deals they encounter in any given year, which means they are experts at saying “NO”.  So how do they sort the good from the bad and kick the losers to the curb before they even open a pitch deck?  By using filters.  Like a grease monkey inspecting a broken down transmission, VCs use checklists to see the worst first and move on as quickly as possible.  If there’s a red flag, they will find it before you can even finish leaving your message on their voicemail.

Here are a few of the deal-breakers VCs will spot with their sixth sense and how you can avoid them:

1) Your reputation is everything.  Transparency is king in the new world order and you better know what’s on your rap sheet because the first thing a VC will do after hearing your name is vet you out online.  What’s your history?  Who have you worked with?  Are there any bad reviews or blemishes on the Google search: “your name here”?  If there are, get out in front of it and respond to the allegations.  Honesty and transparency are the pillars of your social currency and you can’t afford any skeletons hanging in your closet. 

2) The capital structure of your startup is the next item investors will review during their due diligence.  Is it neat and clean with a 40/40/20 combination between you, your co-founder, and your angels?  Or is it a tangled mess split amongst 5 friends and 10 not-so-close acquaintances?  If it’s the latter, start reining it in and buy back shares from your early FFFs.  VCs want to invest in you, not in your 2^nd cousin who “dabbles in the tech game” and controls 40% of your startup with no experience.  Your early backers can become your newest headache when VCs won’t touch your cap table with a 10-foot pole.  Don’t have the cash to buy them out?  Then build new agreements to exit them during the next round or convert them to common stockholders during your series A.

3) “So, who owns this thing anyway?”  VCs aren’t stupid and they have been around the block enough times to know that 8 out every 10 of their investments will be scrapped for parts.  In the end, the only thing of any value will be the intellectual property (IP), so it’s natural to want to know who owns the rights.  Make it easy for VCs to see who owns the IP rights and how much it will be worth should their investment go down in flames.

4) Bags and bags of convertible debt.  Did you take a €100k loan with “favorable” terms and convertible options for the lender?  It probably felt great to see your bank account flooded with new funds and keep the servers running for another 12 months, but at what cost?  It’s entirely possible that you won’t have the funds to pay back your debt and will be forced to convert it to equity at considerably unfavorable terms.  Even what you can pay back, lenders often tie in warrant coverage into their loans that they can exercise at a later date (typically 3-7 years or before a sale or IPO).  In both cases, every other shareholder gets diluted and that’s like rat poison to VCs.  Know the terms of your loan inside and out before you sign on the dotted line and make regular payments straight through the maturity date to reduce your liabilities.  Also, be upfront with new investors to avoid wasting both their time and yours when they find out later.

5) Skype and Dropbox do NOT replace daily interaction.  In our day and age, it’s entirely possible to build and run a startup with people scattered all over the world.  It’s a cheap (actually free) and convenient way to widen the range of your access to talent and an increasingly popular way to partner with co-founders and hire early employees.  However, as VCs get involved, they want everyone in the same room and when your CTO in Romania won’t relocate his family to join the rest of the team, startups hit a snag and investors walk.  Avoid this red-flag with upfront commitments by all essential team members to live in (or commute to) the same city when it’s time to raise big money and scale.

6 – 100) Core competencies, legal issues, product diversity, competitive threats, poor management, erroneous financials, lack of board advisors, unrealistic valuations, regulatory concerns, lions, tigers, bears, and tsunamis.  There are a hundred more hurdles to cross before successfully raising venture capital, however, screwing up on the above non-negotiable items is a surefire way to have the VC walk away before you can even order your coffee.

Take care of these five issues upfront and then start knocking down the rest as you go.  Raising venture capital is not an event, but the cultivation of dynamic relationships.  Be honest, open, and remember the long-game.  This probably won’t be your last venture and even if they say no today doesn’t mean they won’t say yes next time.

Let us know other headwinds you’ve encountered during your fundraising campaigns in the comments below.  Good luck and happy hunting!