Deal Breakers, Part 2: A Red Flag List from Top VCs
In Part 1 of the Deal Breakers series I dove into the red flags, which many VCs have when it comes to Founders. While I crowdsourced the list from 20+ investors, many more started to share their own red flags with me via email and twitter. Since then I’ve since added to the piece and will continue to try and edit it for the sake of knowledge sharing and transparency.
Following the publishing of that post I received a great deal of feedback from Founders. Some positive and some negative (especially when they disagreed with the red flags). However, much of that feedback has led me to reach back out to my same network of investors and get some more specific, nitty gritty red flags that have to do with various parts of the business itself — the product, the market, the numbers, the team, etc.
With this post I’m aiming to provide warning signals for entrepreneurs who may be getting turned away without knowing why (hopefully investors are more transparent though). I hope you find the list to be useful but advise you to take it with a grain of salt because as one of my favorite fellow young VCs noted, “at end of the day, investors can find any reason to say no, so they’re buying into the team / vision, regardless of stage. Numbers can be great but execution is more important. Every rule has an exception.”
Give me your feedback or send me more red flags by tweeting me @BoatShuman.
Product Related
“Companies where the product isn’t already awesome” — When a founder says they now need to hire a designer, red flags are going off. Quite a few well-known investors have been quoted stating that “UX is built into great products from the beginning.” Although that is a popular opinion, most VCs will also have a big picture conversation with you around product, the roadmap and the process of how decisions will be made. You can have a great MVP that lacks certain features, but showing an incredibly high level of thoughtfulness and execution around the original product and the future is critical to landing investment.
Neutral or negative customer calls — Investors are going to speak to customers during diligence. It’s always better to give an investor a heads up if there was an issue that will surface during a customer call…if they know it’s coming, it carries less weight, and you don’t look sneaky.
Not talking to your customers — Many early stage investors are going to ask you about how often you speak with customers. Starting from day 1, it’s important to build in a continuous feedback loop from customers, that includes: customer calls, emails, etc. If you don’t have the ability to articulate, with confidence, the feedback you’ve received from customers or how often/how many customers you’ve spoken with, then a red flag is going off. It’s tough to build a great product without feedback.
Market-Related
When an entrepreneur says “we have no competition” — This is by far the most commonly submitted red flag from investors. VCs want to know that you’ve not only done your homework on your direct competition, but that you’ve been thoughtful about potential substitutes. People have a finite amount of time and money to spend, so you’re most likely taking a consumer’s time away from using or spending on something else. Being thoughtful about this topic is the main thing, but knowing as many granular details about your competition is always helpful as well. As mentioned above, investors will do diligence, so they’ll figure out your competition regardless. The more you can help them out, the faster and easier their diligence will be. Have crystal clear thinking about your product and how you view where it fits into the market.
Having a huge incumbent addressable market — Benchmark’s Matt Cohler said:
“This might sound counterintuitive, but when you’re trying to build something new or disruptive within a huge existing market it can be much harder to get into a position of leverage and leadership than if you start with a smaller market and grow or reshape it over time. Thefacebook/Facebook, Uber and even Google (in terms of the web search advertising market) are all great examples of this.”
Unrealistic valuation expectations — When there is a huge disconnect between expected private company valuation v. public market comps or when a founder wants a valuation that is 40X top-line revenue, but public market comps are trading at 4X best, you probably only have a limited number of investors that are willing to play ball. If you’re not sure which ones they are, ask around the investment community.
Metrics Related
Sky high burn rates — Bill Gurley has said on the record numerous times that “unlike valuations, which can be fixed, burn rates are a permanent outcome.” Founders need to be thoughtful about their burn and be able to articulate why each dollar is being spent in a certain way. Capital inefficiency is a turnoff, and scrappy founders who are willing to sacrifice personal dollars for the future of their companies, is a turn-on.
LTV:CAC — LTV = Lifetime value of customer. CAC = Customer acquisition cost. According to most VCs, this should be 4–5x. 3x is okay but most businesses have fixed costs, and the 3 will quickly compress to 1.5–2 when you are doing several hundred million in revenue. Use this as a benchmark as this is a pretty strong rule of thumb.
If revenue growth is slowing <~30%, and all new future growth initiatives are coming post raise — VCs see this a lot. Founders will often say “once we get this deal we’ll grow by X” or “as soon as we turn on this channel the CAC will drop by Y.” Unfortunately these things don’t tend to work out the way that we all hope/project, so many VCs look at these types of comments or slowing growth as a red flag.
When all of your business comes from one customer — What if that customer walks away? Everyone is familiar with the 80/20 rule, but the further along a company gets, the less VCs want to see their revenue concentrated to very few clients. There are always exceptions to the rule, especially at the seed stage, but quite a few Series A investors and beyond brought this up in various forms.
Generating demand primarily through direct paid marketing — What many people don’t realize is that many of the top consumer companies today grew organically for the most part in their early days. Matt Cohler noted that “users and customers acquired through direct-response advertising tend to be of lower quality than those acquired organically, and acquiring this way gets harder and more competitive as you get bigger — not a great foundation, and from an investment perspective, not great evidence that you’re creating something people deeply want.” The best companies have found ways to create incredible products that people want to talk about and share with their friends. There is nothing better than seeing word-of-mouth helping to grow a business because paid is a dangerous and competitive game to get into; especially before you’re at scale.
If nothing is particularly compelling in the metrics — Some investors have no hard set rules, but everyone has said that without anything particularly compelling that it is a pretty easy pass. Meaning, VCs would rather have a few points of greatness (e.g. CAC is really low even if other parts of the business aren’t strong yet), because their view is that you can improve things, but if nothing is great, then they question whether you can ever be great.
If consumer facing, what is the unfair advantage around distribution — you can’t just say PR or brand. Be as formulaic as possible — both around depth of channels, scalability and sustainability over the long term.
Gross dollar retention is less than logo retention — Losing big customers is a big concern for VCs. SaaS investors are looking for negative churn and losing big money customers doesn’t help with this.
Services salaries not included in COGS — Manipulating the data to make things look better to a VC isn’t a great way of going about things. It’s okay to have lower gross margin when you’re a young company, but pretending to be a SaaS business if you’re a tech-enabled services company is a dangerous game to play for both you and the potential investor. It’ll drive strategy in the wrong direction and put things in a bad place.
“Outs” in contracts — When customers have the right not to proceed with the full value of the contract. An example of this is when a customer wants to start with 2 sites and expand to 10, but with the ability to get out of expanding to 10 sites.
Consumer products with gross margins < ~25% and no path to margin expansion — the question is, “does scale actually lead to reducing COGS, or is it more likely to lead to margin compression from new entrants?” Consumer products is a tough game to play and Founders can easily over raise and find themselves in a difficult position when it comes to generating returns for their investors and themselves. Having <25% margins will most likely hold you back from even getting there.
Marketplaces / subscription businesses with customer payback period > 1 year, or multiple purchases (e.g. the business only breaks even on CAC after multiple, distinct purchases) — It’s easy for investors to get caught staring at GMV numbers for marketplaces. However, for companies like Uber, Zeel, Minibar and others, that take a percentage of total revenue flowing through the system, investors are really keeping a close eye on net revenue and how that relates to CAC. Many marketplaces these days are trying to create additional revenue streams via SaaS revenue or ad revenue, so it’ll be interesting to see how this impacts the other metrics of the business.
When a business is pre-renewal (or signs multi-yr contracts upfront), but does not know how to track/measure customer success — How do you gain confidence that customers are using and liking the product? If you don’t have data around usage or engagement then that is often a reason VCs will quickly become concerned and probably pass. They’ve been burned by aspirational purchases (security, workflow, collaboration etc.) that ultimately don’t get adopted by a wider user group and will result in churn.
Improving numbers by reducing quality of customer experience — we’re not in private equity so we don’t want to see a “customer first” company making decisions that will improve margin, but throw their values down the drain. These types of shortcuts are red flags and should be avoided.
For content businesses, when 90% of traffic is from social (primarily facebook) — this is a large flag — huge duopoly these days with Facebook and Google and very hard to underwrite a strategy that depends solely on traffic earned through social click bait.
No true marketing plan — When Founders pitch a consumer brand, they need to be able to articulate what the brand stands for, who their customers are, what the various customer personas are, and what the channels/strategies are AND how they want to test them. Although some of these may not be fully flushed out and you plan to hire a marketing person, it’s important to investors that you’ve done your homework, been resourceful and learned about the basics.
Churn >5% for SaaS businesses — 5% becomes a larger and larger total number over time as you grow, which is going to put more pressure on your sales team to maintain a strong growth rate. Do everything in your power to keep churn below 5%.
Team Related
Team DNA — If it’s a consumer transaction business, VCs bias heavily towards founding teams that have acquisition DNA in the business. Often times we’re looking for “Founder/ market fit” and that usually means either someone who has experienced the pain point themselves before, and/or worked in the industry OR a Founder with strengths that match the core competencies of the business.
In-House tech — If you’re building a company where tech is a core competency, but it’s not in-house, then it’s usually a quick pass for investors. Some firms are getting more comfortable with the idea of managing off-shore dev teams, but it’s an interesting topic of conversation that’s easier to have if the tech isn’t core to the success of the business.
A huge miss (+/- 50% variance on budgeted financials) — No one expects financials to be accurate but they are directional for how a CEO will manage future cash flows. Goal setting is an important skill for a CEO to have. However, poor goal setting can hurt employee morale and the health of the business as well.
Over hiring — Marc Andreessen has discussed that in times of plenty, it’s easy to think bringing on more workers will fix everything. However, he also points out that this creates a culture where “your managers get trained and incented ONLY to hire as [the] answer to every question.” Ultimately, “[The] Company bloats and becomes badly run at [the] same time.” So be thoughtful about your hiring strategy and be able to discuss the reasons behind hires, along with their roles and responsibilities.
Raising too much money, at too high of a valuation, too early — This was alluded to in the market section, but also included here because this fundraising strategy has a lot to do with how the Founder is running the business. Just because you can get $15M from a family office at a $100M valuation before you have true product-market fit, doesn’t mean that you should. Often times it leads to more problems than not as you’ll eventually have to grow into that valuation and it’ll put unnecessary pressures on you during the next fundraising round.
Not knowing the right tools — A big part of being a Founder is being resourceful and learning from other founders/people who have been there before. While early stage investors don’t expect you to be perfect and know every business intelligence or marketing tool in the world, we do have the expectation that you have a basic understanding of what CRM system you’re going to use if you’re a SaaS business, or what email marketing platform you want to leverage as an eCommerce brand. Not knowing these makes an investor question the work/research put in ahead of time.
The list goes on and will continue to be updated. Moving forward though I’d love to evolve Deal Breakers into more than a series about VC red flags, but I’d like it to be about all sorts of deal breakers — these could include deal breakers that CEOs have in regards to potential hires, deal breakers that CMOs have when evaluating marketing tools, deal breakers that LPs have when evaluating VC funds and so much more.
I want to thanks investors from Bain Capital Ventures, NEA, Lead Edge Capital Correlation Ventures, Greycroft, Primary Ventures, Stripes Group, BDMI, Boston Seed Capital, Sigma Prime, Charles River Ventures, RRE, Benchmark, First Round, Vayner RSE, Lerer Hippeau and many more for either sharing their red flags with me directly or putting them out there in the public domain.
If you have any ideas shoot me an email at Shuman.Jason@gmail.com or find me on twitter @BoatShuman.
-Jason Shuman
