You’ve done it. After countless hours of building, pitching, and networking, you have a signed term sheet from a venture capital firm. But before the money is wired, you face one final, formidable hurdle: the due diligence process.
This is not a formality. It is an exhaustive, deep-dive investigation into every aspect of your business, and the financial scrutiny is the most intense part. For many promising startups, this is where the deal falls apart. Seemingly small accounting errors or inconsistencies can blossom into major red flags, eroding the trust you’ve worked so hard to build.
As a firm that bridges the gap between accounting rigor and investment strategy, we’ve seen firsthand where founders go wrong. Here are the seven most common financial red flags that can kill your funding round, and how to ensure you’re prepared to pass with flying colours.
1. The “Shoebox” Approach to Bookkeeping
The most fundamental red flag is messy, inconsistent, or incomplete financial records. If your bookkeeping is a chaotic mix of spreadsheets, uncategorized transactions, and missing invoices, it signals a lack of discipline and control to investors.
- The Red Flag: Investors can’t verify your revenue claims, understand your cost base, or trust any of your financial statements. If the basic recording is flawed, everything built upon it is questionable.
- How to Fix It: Implement professional-grade cloud accounting software (like Xero or QuickBooks) from day one. Have a clear process for categorizing all income and expenses, reconciling bank statements monthly, and keeping all documentation in order. This isn’t just about compliance; it’s about building a trustworthy data foundation.
2. Financial Projections Untethered from Reality
Every founder presents an ambitious “hockey stick” growth chart. But investors will immediately test the assumptions behind it. A financial model that isn’t logically linked to your historical performance and operational plans is a work of fiction.
- The Red Flag: Your model shows revenue doubling, but you can’t explain the corresponding increase in marketing spend, headcount, or customer acquisition cost (CAC). The numbers don’t tell a coherent story.
- How to Fix It: Your financial model must be a dynamic, assumption-driven tool, not a static spreadsheet. Every projection should be backed by a clear, defensible assumption (e.g., “We will hire two new developers in Q3, increasing salary costs by X, which will allow us to ship Y feature and increase customer retention by Z%”).
3. A Vague or Indefensible Use of Funds
Investors are not giving you a blank cheque. They are investing in a specific plan. Being unable to clearly articulate exactly how you will spend their capital and what milestones it will help you achieve is a major concern.
- The Red Flag: When asked how you’ll use the £2 million, you give a generic answer like “marketing and product development.”
- How to Fix It: Provide a detailed breakdown. For example: “40% (£800k) on hiring 5 senior engineers to build out our enterprise platform. 30% (£600k) on performance marketing to lower CAC to £50. 20% (£400k) to expand into the German market. 10% (£200k) as an operational cash buffer.”
4. Murky Unit Economics
Sophisticated investors are obsessed with unit economics—the direct revenues and costs associated with a single customer. If you don’t know your Customer Lifetime Value (LTV) and Customer Acquisition Cost (CAC), you don’t truly understand your business model.
- The Red Flag: You can’t answer the question: “How much does it cost you to acquire a new customer, and how much profit will that customer generate over their lifetime?”
- How to Fix It: Track these metrics relentlessly. A healthy, scalable business must demonstrate that its LTV is significantly higher than its CAC (a common benchmark is an LTV:CAC ratio of 3:1 or higher). Be prepared to show how this investment will improve that ratio.
5. Non-Compliance with Tax and Employment Law
Failing to manage VAT, PAYE, or employee contracts correctly is not just a financial issue; it’s a legal liability that an investor will have to inherit.
- The Red Flag: An audit reveals you’ve misclassified employees as contractors, have outstanding VAT liabilities, or haven’t properly enrolled staff in a pension scheme.
- How to Fix It: Ensure you are fully compliant with all HMRC regulations from the start. This is where the value of a qualified ICAEW Chartered Accountant is indispensable. We ensure you meet all statutory requirements, preventing costly surprises during due diligence.
6. No Formal Cap Table or Shareholder Agreements
A capitalization (cap) table is the definitive record of who owns what in your company. A messy or informal cap table – or worse, verbal agreements about equity – can create legal nightmares that will halt any deal in its tracks.
- The Red Flag: Early angel investors have no formal share certificates, or a co-founder dispute arises over equity splits.
- How to Fix It: Maintain a clean, legally sound cap table from your very first funding. Ensure all shareholder agreements, option grants, and convertible notes are properly documented by a solicitor.
7. An Over-Inflated and Unjustified Valuation
While valuation is a negotiation, coming to the table with a number that has no basis in reality signals that you are either naive or unreasonable.
- The Red Flag: You claim your pre-revenue startup is worth £20 million based on a competitor’s valuation, without understanding the differences in your market, team, or traction.
- How to Fix It: Build your valuation argument from the bottom up. Use recognised methodologies (like Discounted Cash Flow or market comparables) and be prepared to defend your assumptions. Show you understand the benchmarks for your sector and stage. This demonstrates that you are a credible and rational partner for an investor.
Passing the Test with Confidence
Navigating due diligence successfully is about demonstrating that you run a professional, well-managed, and transparent operation. It requires building an “investor-grade” finance function long before you even start fundraising.
This is precisely the gap that Consult EFC’s Fractional CFO service fills. By bringing in strategic, C-suite level financial expertise on a part-time basis, you can ensure your books are immaculate, your financial models are robust, and your strategy is sound – all at a fraction of the cost of a full-time hire.
About the Author
Consult EFC. We are experienced ICAEW Chartered Accountants and Investment Bankers. With over 20 years of experience in both the Big Four and the M&A landscape, we provide high-growth startups and SMEs with the integrated financial expertise needed to scale successfully and secure investment.
Contact us today for a FREE consultation.
