Business Model Red Flags in Startups

Angel investors know well what it takes to invest in a startup. There are way more reasons to say no to an investment than to say yes. The whole investment process, from deal screening to due diligence, should always give out clues about whether we’re dealing with a good or bad investment.

Here we are going to share some business model characteristics that should be treated as red flags. A red flag here means a serious key issue that you should investigate deeper. It should not be an immediate turnoff. Rather, it’s a signal that you should not ignore easily.

Business Model Red Flags

Red Flag #1: Graveyard of similar companies

If you found similar companies that are now dead, this is a huge red flag for the startup applying to you.

When this is the case, you need to carefully examine what went wrong with these companies. Is something inherently wrong with the business model or customer need? What has changed now? In the best-case scenario, past companies may have died due to the wrong market timing. Maybe something has changed now that makes this business model sustainable.

Red Flag #2: Low traction over a long period

This applies to companies who launched their products long ago: nine months for instance. If they are receiving strangely low traction, you have to question their validity.

It could be that the founders didn’t make good marketing progress. Even worse, it could be due to the low demand for the product. Investigating the situation closely is a must before making your investment decision.

Red Flag #3: Lots of users on freemium, very few on premium

Notice the difference in the number of paid users relative to free users. If the difference is alarmingly huge, this is a cause for a red flag.

As an investor, you have to measure the customers’ willingness to pay. Huge demand for free usage won’t make a sustainable business model.

Red Flag #4: Huge marketing costs

Track down the past marketing costs of new users. If the cost is relatively huge and doesn’t seem to decrease over time,  you should be concerned.

Larger marketing costs directly turn to lower profitability. It could still make for a successful business. However, the startup will not turn into a giant profitable company.

Red Flag #5: No scalability

This is not the case for most software companies. For other industries, you need to check if the business is really scalable. Can the business sell significantly more with fewer increases in costs?

Scalability is essential for any startup investment. Without scalability, the business will be turning to more of a manufacturer or SME model.

Red Flag #6: No clear profitability plan

This is the case when the founders have big plans on how to grow but not how to make money. It happens most often in software platforms that are free of charge.

Yes, growth is essential and a big number of startups don’t become profitable in the early stage. However, a clear plan has to be there on the table. Growth is nothing if it can’t be translated into cash.

Final Thought

As we mentioned, none of these red flags should result in an immediate rejection. They should only result in a further investigation to know the real causes behind them.

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