As an investor, how can you spot the red flags of start-ups?
In the world of start-ups, effective financial management is often the cornerstone of success. From finding an idea, to setting up a business, from the first investment rounds to exit, looking after your financial health is crucial. Prevention and timely response are always the best medicine.
At Klaar.me, we are fans of efficient and transparent financial processes and management. We deal with a wide variety of clients on a daily basis and see a lot of what goes on behind the scenes at start-ups in particular, and we’ve learnt some important truths over the years.
Today we share some of our findings with you. This is very valuable information, especially for investors, so that they can pay attention to the right aspects, such as how and what questions should be asked of start-ups before making an investment, so that the investment made will actually work out as well as (or better than) desired?
What competences are in the team?
As an investor, you should find out the actual competencies of the team before you start investing in a start-up. Is there anyone in the team with previous experience in financial management? How does the company plan to manage its finances and cash flow? Does the company even know where the money comes from and where it goes? Do they understand the principles of pricing products/services and how much it costs them to bring in new customers? Are there also financial projections that support the business model’s strategy or do they just go with the flow?
In our experience, it’s a red flag when a team has no experience in financial management, no understanding of how to carry out funding rounds and there is nobody in the team who would take charge of the finances. Oftentimes, we also see how a person with a different area of expertise is put in charge of the finances, who does not understand the importance and content of it, and so it’s very easy to end up using the money in a way that does not meet the purpose, having an ill-considered pricing policy, and the company has no strategy on how to use the money raised in the most effective way. Lead investors would always be advised to do a competency mapping of the team, which will help avoid many problems in the future and help them fill the competency gaps.
Does the company have a sound financial strategy?
One of the biggest red flags is if the company has never raised funding before and therefore has no concrete plan of action. We’ve seen many times that even good ideas with a good technical solution fail because of poor financial management, or no management at all, the wrong pricing strategy and a failure to monitor the costs and cash flow of the business. Don’t underestimate the benefits of a well-thought-out strategy and a good financial plan! It takes a lot of the burden off your shoulders (both as an investor and as a team) to know where the money is going and how it will be handled, and what steps are being followed to stick to the financial plan and plan new funding rounds if necessary.
Are the company’s financial processes aligned with the business model and are they efficient and transparent?
The competence of the team plays a big role here. Is there someone in the team who can see the bigger picture, not just solve day-to-day accounting problems? Are financial processes automated and digitalised, and what are the software circles? Are the financial processes in line with the company’s business model? We’ve seen that looking at a company’s profit and loss account and balance sheet does not actually reflect the company’s business model, and so the huge potential to gain the information needed to manage by aligning accounting and financial processes with the business model is missed. The inefficiencies we see most are in the sales process, where there is no software solution that fits the business model, it is not automated and interfaced with accounting software, and sales data is analysed on an aggregated basis. Also, in such cases, settling with customers is often slow, which also has a negative impact on the company’s cash cycle. In addition, it often happens that no account is kept of intangible assets and development costs, and the cost structure of the company is not well thought out. Automated financial processes give investors the certainty that financial data cannot be manually modified in Excel, but come from real sources that can be verified.
How and why keep track of your investment?
If you have made an investment as a lead investor, the first thing we would recommend is that as an investor you stay involved throughout the life of the business and don’t disappear. As mentioned above, a well thought out business model and corresponding financial processes, built to maximum efficiency, are essential to maintain and gain insight. It’s considerably easier to create a financial overview and have an overview of key performance indicators when data is reliable and decisions can be made quickly. This is a good opportunity for lead investors to set high standards for investor reporting. When creating an overview, it is important to get an overview of the profitability of the company’s services or products – it is particularly important to distinguish and understand where the company’s losses are coming from – are the services or products mispriced or are the losses due to expansion or development activities? We’ve often seen overly complex financial models, which are hugely time-consuming to update manually, and in some cases impossible to update, because in reality they do not fit the business model of the company, and the software in use does not support the collection and transmission of such data. Transparent reporting also helps to prevent and detect fraud and misuse of money at an early stage. Efficiently structured financial processes make it possible to make smarter decisions in significantly less time and support the company’s growth.
How to exit as a winner?
In reality, the winning exit and its strategy starts before the investment is made. Addressing problems early in the life of an investment also helps ensure a more successful exit at a later stage and maximise the return on investment. If focus is not maintained in the earlier phases, later due diligence processes, for example, can take a very long time and include unpleasant surprises. Bring an external financial expert to maximise your returns!
As an investor, it is important to be careful and demand quality and clarity from the start-ups you invest in. Don’t invest blindly, invest wisely! And if you have any doubts, come and consult Klaar.me specialists!
