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Due Diligence Red Flags

Due diligence is the routine process by which investors diligently investigate the
entrepreneur and his/her company to confirm the authenticity of a business endeavor.
This may entail researching business founders and their management team, reviewing
documents, endless amount of questions, and asking for references. In a recent study
conducted by the University of New Hampshire’s Center for Venture Research,
angels who practiced increased due diligence received more overall profitable returns.
Experience has also shown that without performing detailed research to verify an
investment prospect, an investor is taking a significant risk. By executing effective
due diligence, many investors may save money and may even help companies avoid serious
legal complications. The following are some of the “red flag” warnings
that angel investors may encounter when conducting due diligence:

Entrepreneurs who do not invest their own money in the venture

When a business owner invests his/her own personal money into his/her company, it
indicates confidence about his/her initiatives. Angel investors certainly do not
want to take the risk of investing in an enterprise if the entrepreneur does not.
It is also a proven fact that when business owners do use their own savings for
their endeavors, angels are more likely to take them seriously, and they are able
to raise more capital from friends, family, and other associates.

Entrepreneurs who obtain small amounts of capital from numerous investors
Angel investors are aware that friends and families provide the best source of seed
funding; however, having dozens of investors, especially the inexperienced and unsophisticated
ones, can be problematic. Entrepreneurs may be distracted by numerous amateur benefactors.

Lack of product diversity
Angels tend to avoid business deals when they encounter companies that only offer
one product or service which targets only one market. If a product that is introduced
into the market fails, then the whole company will not succeed. To ensure sales,
a company should have some diversification of goods and services to be successful.

Claims of “no competition”
In today’s business world, every company will encounter competition. Entrepreneurs
are simply fooling themselves when they make a claim that no competition will exist
once their products and services are introduced to the market. Business owners should
always do market and competitive research before introducing their company to investors.
They should also stress during their presentation why their particular products
and services have a competitive advantage.

Inappropriate use of proceeds/existing liabilities
Another indicator of a poor investment can occur when it is discovered during the
due diligence process that the entrepreneur is in excessive debt. If the entrepreneur
is able to successfully raise angel capital, portions of the investment funds will
most likely be used to pay pre-existing debt and/or to cash out early investors.
Extensive liabilities may be a clear indication of poor financial management skills.

Lack of participation of early investors
If, for some unknown reason(s), other investors do not want to invest in a company
or if the previous investors do not want to reinvest, angel investors will conclude
that it is an indication of a lack of confidence in the company.

Poor management history and unsettled management team issues
Angel investors like to invest in businesses with a solid, balanced management team.
This team should be assembled with only skilled and experienced professionals given
the field. If the management team does not have a history of settling disputes cohesively
or a proven track record of learning from previous mistakes, then angel investors
will most likely stay away from the investment.

Family-related ventures
Most angels tend to shy away from investing in family businesses because of the
dynamics and drama that may arise in the workforce. Often times, entrepreneurs feel
obligated to hold on to their close friends and relatives to work for them, even
though their role may be marginal or insignificant. This will always hinder company
growth.

Multiple licenses for practicing technology
Each company could benefit immediately from a technology license; however, obtaining
multiple licenses for practicing technology can be problematic for a company in
the long run. Low realizable margins can result from the licensing fees’ cost
of goods.

Predicting exceptional projections
It is unrealistic for entrepreneurs to forecast exceptional financial projections
for their company since the market is never predictable. This type of explosive
value is called a “hockey-stick” projection growth, and angels are aware
that it is impossible to expect such calculations. Not only should entrepreneurs
take into account the unpredictability of the market, but also to possible technical
glitches that may occur throughout the company’s development.

Incomplete financials
Inexperience, inadequate financial management skills, and poor judgment in hiring
experienced advisors are indicative of incomplete financial documents. Financial
statements that lack many significant assumptions will lead to doubt in an entrepreneur’s
abilities and to the entire investment.

Lack of board of advisors, board of directors, or the presence of only internal
parties

Business owners should establish an experienced board team with knowledge and skills
in leading a company. In addition, they should also seek advice beyond their established
team since external board members and advisors can validate the company’s
ideas. By not seeking external members and advisors, an entrepreneur’s leadership
and credibility can come into question.

Controlling business owners
One of the main reasons why entrepreneurs seek capital from outside sources is to
hire skilled people to take over different responsibilities of the company. However,
some entrepreneurs can be extremely controlling over every aspect of their business,
making it extremely difficult for employees and investors to work in a balanced,
harmonious atmosphere. Angels tend to avoid investing in companies with aggressive,
controlling entrepreneurs.

Unrealistic valuation for the company
Entrepreneurs may request an excessive amount of capital for their start-up compared
to what the angel investors suggest. This unrealistic amount, especially if the
discrepancy significantly differs from an angel’s ideals, can signal potential
problems. 

Non-negotiable agreements
Angel investors like to negotiate the terms with their prospective investment; however,
entrepreneurs may create a contract that is not favorable to their investors.

Complex shareholder issues
Shareholder problems can range from an investor occupying an unfair amount of stock
in a company to the acquisition of a silent, foreign investor. Examples like this
can be disruptive and may complicate an investor’s terms.

Intellectual property protection/ownership problems
Some difficulties may exist when entrepreneurs protect their intellectual property.
Often times when angels get involved in businesses with pending intellectual property
matters, they end up hiring a third party to fix the existing issues. Business owners
should first straighten out all their issues concerning intellectual property protection
and ownership rights for their products/inventions prior to seeking angel financing.

Pending regulatory issues
During due diligence, a company may be discovered to have pending regulatory issues,
which should be resolved prior to seeking angel capital. Some issues include products/services
that may require FDA approval or licensing that is needed to operate their business.

In the due diligence process, investors will conduct a comprehensive background
check on a company’s founders, management team, and board members to establish
the credibility of their prospective investments and/or to find any business-related
felonies. They may also check federal databases and consult with the Securities
Exchange Commission for possible securities infringements. Most angels who conduct
a thorough due diligence may come across many “red flags” or indications
of a poor investment, which may strongly influence their decision to decline a deal. 
Entrepreneurs should be aware of all possible findings and repair any unresolved
matters in order to successfully raise the needed capital for their start-ups.

Source

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