Due Diligence: The Investor's Microscope
You’ve done it. After countless emails, pitch meetings, and follow-ups, an investor is "penciling in" on a deal. They're excited about your vision, and you've received a term sheet. This is a huge milestone, but it's not time to pop the champagne just yet. Now comes due diligence—the intense, meticulous process where the investor and their team of lawyers and accountants put your company under a microscope. Their goal is to verify all the claims you made during your pitch and to uncover any hidden risks.
Due diligence is not a process to be feared; it's an opportunity to build trust and demonstrate that your company is as solid as your pitch deck claimed. However, certain issues—or "red flags"—can quickly erode that trust and derail your funding round. Being prepared means knowing what investors are looking for and cleaning up any potential problems *before* the diligence process even begins. Here are the top five red flags that investors look for.
1. A Messy or Inaccurate Cap Table
The Red Flag: Your capitalization table is maintained on a multi-tabbed spreadsheet with questionable formulas, or worse, it doesn't accurately reflect all verbal equity promises. There are unsigned stock option agreements or confusion about founder vesting schedules.
Why It Matters: The cap table is the legal record of ownership. If it's a mess, it creates uncertainty about who owns what. Investors need to know exactly what percentage of the company they are buying. A messy cap table signals a lack of financial discipline and can lead to legal disputes down the road from disgruntled ex-employees or advisors. It’s one of the fastest ways to kill a deal.
How to Avoid It: From day one, document every single equity grant with a formal, signed agreement. Use professional cap table management software (like Carta or Pulley) instead of spreadsheets. Ensure all founder shares are subject to vesting. Before you even start fundraising, have a lawyer review your cap table to ensure it's clean and accurate.
2. Weak or Non-Existent Intellectual Property (IP) Protection
The Red Flag: Your core technology was built by a freelancer without a proper IP assignment agreement. Your brand name isn't trademarked. You have no formal process for protecting trade secrets. The ownership of the code, brand, and other critical IP is ambiguous.
Why It Matters: For many startups, especially in tech, IP is the most valuable asset. Investors are not just investing in your team; they're investing in the defensible technology or brand you've built. If the company doesn't unequivocally own its IP, an investor sees a massive risk that the core asset could walk out the door or be claimed by someone else.
How to Avoid It: Ensure every employee and contractor signs an agreement that includes a Confidential Information and Invention Assignment Agreement (CIIAA). This legally transfers ownership of any IP they create for the company *to* the company. Work with a lawyer to file for trademarks and patents where appropriate. Create and enforce internal policies for handling confidential information.
3. Undisclosed Liabilities or "Skeletons in the Closet"
The Red Flag: During diligence, the investor uncovers a pending lawsuit from a former employee, a significant tax liability you hadn't mentioned, or a major customer who is about to churn. You tried to hide or downplay a significant problem.
Why It Matters: This is all about trust. Investors know that no company is perfect. They expect there to be challenges. The issue isn't the problem itself, but the fact that you weren't upfront about it. Hiding a problem suggests there might be other, bigger problems you're also hiding. It destroys the credibility you've worked so hard to build.
How to Avoid It: Be transparent. Create a "disclosure schedule" that lists any potential legal, financial, or operational risks. Frame the issue, explain its context, and outline your plan to mitigate it. It's far better to control the narrative and discuss challenges on your own terms than to have an investor discover them on their own.
4. Unfavorable Customer Concentration or Contracts
The Red Flag: A single customer accounts for 50% or more of your revenue. Your key customer contracts have a "termination for convenience" clause, allowing them to cancel with 30 days' notice for any reason. Your sales pipeline seems to consist of a few large "whale" prospects with no smaller, faster-closing deals.
Why It Matters: High customer concentration creates significant revenue risk. If that one big customer leaves, your revenue could be cut in half overnight. Unfavorable contract terms show a lack of negotiating power and create instability. Investors are looking for predictable, diversified revenue streams.
How to Avoid It: Actively work to diversify your customer base. While landing a big customer is great, ensure you have a strategy to acquire a broad set of smaller customers as well. When negotiating contracts, push back against "termination for convenience" clauses, or at least try to secure a longer notice period and a cause requirement. Show investors a healthy, multi-stage sales pipeline.
5. Inconsistent Financials and Unrealistic Projections
The Red Flag: The metrics in your pitch deck don't match the raw data in your financials. Your financial model is based on wildly optimistic, "hockey stick" assumptions that you can't back up with a clear, data-driven go-to-market plan.
Why It Matters: This is another trust-breaker. It suggests either a lack of attention to detail or an attempt to mislead. Investors know projections are just educated guesses, but they need to be grounded in reality. They are testing your understanding of your business's drivers. A model that projects exponential growth without a credible plan for achieving it shows a lack of strategic depth.
How to Avoid It: Ensure your financial statements are accurate and have a clear audit trail. Every number in your pitch deck should be easily traceable to your core financial documents. Build your financial model from the bottom up, based on clear, defensible assumptions about your sales funnel, conversion rates, and market size. Be prepared to defend every single one of those assumptions.
Due diligence is a rite of passage for any funded startup. By preparing for it proactively and addressing these common red flags, you can streamline the process, build immense trust with your potential investors, and significantly increase your chances of closing the round and securing the fuel for your next stage of growth.