5 Reasons I’ll Automatically Pass on Investing in Your Startup

Fix these basic problems first before looking for investors

Avoid these red flags when you pitch to investors. Photo by Girl with red hat on Unsplash

I spent last week listening to 100 pitches for early-stage startups. I’m exhausted.

My angel groups typically invest in roughly 1 out of every 100 applications. That means 99% are passes. For at least half the pitches, it’s obvious within a minute that they’re no-goes, so instead of listening closely (sorry), I started taking notes on the reasons why so many were obvious drops.

Before you waste weeks or months of effort pitching, make sure you’re ready for investors. Here are 5 reasons I noted that were automatic drops, as well as a few additional reasons many were unlikely to go beyond the pitch.

1. No Product Yet

Friends and family will support you bringing your vision to fruition. Grant opportunities and accelerators can help, too. Investors, including angels like me, invest in a completed product.

We’ve all heard stories about entrepreneurs with nothing but a powerpoint presentation (or less) who received millions in funding from investors to build the product. They’re great stories. People win billions in the lottery, too. It just won’t be me or you.

Sure, if Tim Draper happens to be a neighbor or your mother is bff with the CEO of IBM, by all means, pitch them. If your previous startup made a VC firm a billion dollars, their door will be wide open. If you’re the former CEO of DeBeers, finding investors for your jewelry startup will be a snap. For the other 99.997% of startup founders, investors want to see a product, not an idea.

Ideally, that means not just a finished product but customer revenue. Getting to the “in-revenue” stage is without a doubt the most important milestone for finding investors. For many investors, pre-revenue startups are an automatic pass. Some, like me, are willing to consider other types of customer validation such as pilot programs and evaluations. But at a minimum, there needs to be a working product in customer hands before we’ll consider investing.

2. Opportunity Too Small

I see a lot of pitches where the company estimates reaching revenues of $15M in 5 years. Thank you for your honesty. I see a whole lot more where the company promises they’ll reach $100M in 5 years, but I’m pretty sure they won’t even get to $10M.

There’s a lot of fantastic businesses with revenues under $50M. Even $10M businesses can be a goldmine. Niche products have a much higher chance of success than shoot-for-the-moon venture businesses. I’ve worked in niche businesses; I’ve built niche businesses; I love niche businesses. But niche businesses are not viable venture investments.

If the company doesn’t have a coherent story for how they’ll reach a run rate of at least $50M within a few years, I may love you to death, but sorry, as an investor, it’s a pass.

3. Corporate Structure

If the startup is structured as an LLC or S-corp, or is not a US-entity, that’s an automatic no.

LLCs and S-corp structures are perfect if the goal is to build a profitable small business without outside investors. But if you want investors, the company needs to be structured as a C-corp.

Only C-corps are eligible for major tax incentives offered for startup investments. LLCs and S-corps require all investors to include the company’s financials in their personal income tax filings which is a major hassle for a small investment.

Overseas startups may be great investments. But if you’re a US citizen or resident, the lack of tax incentives for non-US startups, required yearly IRS and FBAR reporting, and legal and tax uncertainty make it difficult to invest.

If you’re looking to raise money from US investors, the company needs to be US-based C-corp, and ideally a Delaware C-corp, before pitching to investors.

4. Deal Structure

Offering common shares? Sorry, non-starter.

So is a convertible note or SAFE with no valuation cap.

As is a pre-money SAFE instead of a post-money SAFE.

If those are your deal terms, there’s no point in pitching. The only structures I’ll consider investing in, in the order of preference are:

Preferred shares
Post-money SAFE with valuation cap
Convertible note with valuation cap, discount, and interest and a maturity no longer than 24 months.

5. Business Model

Particularly with the hardtech deals I tend to focus on, I see a lot of exciting new technologies paired with a business model of licensing the patents and processes to customers instead of making products themselves.

Licensing is a great business model. It requires a tiny fraction of the capital required to build production facilities. It allows the founders to focus on the R&D they’re good at instead of building and running factories.

However, licensing only delivers 2–3% of the value of the product so revenues are small. With no costs other than personnel, it’s easy to be profitable, but only on a small scale. Strategic partners and industry giants won’t pay a huge multiple to acquire the company when they can license the technology for a fraction of the cost, so the exits are to private equity or acquire-hires at too low a multiple to generate venture returns.

If you’re building a licensing-based business, I’ll root for your success, but sorry, I won’t be investing.

Other Red Flags

The above issues are easy to check and weed out applicants quickly. For startups that avoid these show stoppers, I have to take a closer look. Usually there is at least one issue that prevents the discussion from progressing far.

No competitive moat: the most common reason startups with have a great product in an exciting market fail to resonate with investors is if they have no way to protect the business from the inevitable competition once they gain attention.
Lack of domain expertise: It’s not unusual to hear a pitch from founders developing a new consumer product who have no experience in the complex world of consumer packaged goods. If you’re making a new soda, get someone from Coke on the team before pitching to investors. I want to invest in founders who know the pain points personally, know the go-to-market strategy intrinsically, and have deep customer connections.
Valuation is too high: this is an obvious one, but if the valuation doesn’t match the stage of the company, the risk profile, and the market potential, I’ll invest in something more attractive.
Raise is too large: raising $3M on a $6M valuation in the earliest round is far too much dilution. Early raises need to be limited to 10–20% of the valuation or else the company will hit a wall later.
No board: If I’m investing, I expect a lead investor to be on the board to represent my concerns in the boardroom.
Weak pitch: The pitch doesn’t need to be perfect, but it does need to be professional. Yes, we do judge books by the cover, especially at the early stages when there isn’t much else to go on.

None of the above applies to friends and family who are more interested in supporting the founders than generating ROI. It doesn’t apply to strategic investors who have other reasons to want the company to succeed beyond financial returns. And not all applies to venture capital funds that have different goals and constraints than individual investors.

But if you’re raising a pre-seed/seed round from angels, angel groups, and micro-VCs, most will have a similar list of reasons to cross you out of consideration. Make sure none apply to you so you get our undivided attention while you tell us why your startup will be the greatest investment I’ll ever make.

Imagine you’re the CEO of startup that invented teleportation. But…the system still has a few bugs that may take years to fix, if ever. Do you hold off offering service until everything works perfectly? Or do you hide the problems and go public now in an IPO worth a trillion dollars? What will your VC investors say? How about the board? Find out in the Silicon Valley novel — To Kill a Unicorn. American Fiction Award finalist for Best Mystery of 2023 and Best Debut Novel.