Startups are high-risk investments. While that may sound harsh, it’s the most practical way for potential investors to approach a new business to protect themselves and their investment. Thus, a technical audit is essential as it takes an in-depth evaluation of a business’s technological infrastructure and assets to better inform its decision.
So, what are the top 5 red flags investors should watch for during a startup’s technical audit?
Excessive Technical Debt
On paper, a startup can look like the perfect investment opportunity, but scratch the surface and it can be a different story. As an investor, it’s easy to focus on the everyday financial reports and projections but these only paint half the picture. Technical audits reveal the true scale of a company’s technical systems and processes and whether there is excessive technical debt.
Businesses are no strangers to technical debt, best described as the cost of cutting corners to a solution rather than choosing one that is most efficient. It can occur through rapid workforce expansion or by branching into newer markets. It’s not an expense you can easily cover or repay; it can take time away from other key functions if a company neglects to maintain a clean or manageable tech base.
Startups want to get their product out as fast as possible which puts development teams under immense pressure. Some are forced to take shortcuts to meet demands and speed up project delivery. It can be a risky endeavor – 40 to 90 percent of new products introduced fail to succeed in the market within two years of launch, according to Columbia Business School.
It does, however, create a new form of debt – technical debt – which must be addressed somewhere down the line. Poor design choices and bugs are just a few elements that contribute to technical debt, and it’s an increasing problem.
Forbes estimates businesses spend between 23% and 42% of their development time on technical debt. It’s usually the result of rushed software development or poor management.
When a technical audit sheds light on this, it should be scrutinized closely because it’s a troubling sign. While some technical debt is reasonably acceptable, excessive technical debt isn’t. You must fully assess whether the startup has a viable plan to manage and reduce its technical debt. If there is no plan, stagnation is a real possibility.
Compliance and Security
CB Insights reports regulatory and legal challenges cause the demise of 18% of all startups. It’s a staggering number but one that is likely to increase as governments clamp down on data breaches and non-compliance.
The digital landscape is a minefield for any business. Security measures, compliance protocols, and regulations must be followed to the letter to avoid penalties and industry fines. You can’t overlook these as an investor because they can have a serious impact on potential profits and returns.
A thorough technical audit highlights compliance concerns, assesses security protocols and data encryption, and discloses what security measures are in place. If a startup has poor data protection policies, relies heavily on outdated software, or doesn’t have regular security audits, it’s a significant warning sign. It could mean the startup doesn’t prioritize these factors, which could be disastrous if the worst should happen.
For example, the Irish government fined Meta over $1.3 billion because it transferred data from its European users to U.S. servers without sufficient data protection in place. While the tech giant plans to appeal the decision, it will have implications for years to come.
As another example, Luxembourg fined Amazon a hefty $780.9 million in 2021 because it tracked data without user consent. It also failed to provide users with an opt-out option from the trackers.
While these are extreme examples of questionable data compliance penalties, they are very real outcomes for two powerful tech giants. They’ll have a lasting impact on the parent companies, subsidiaries, and investors for years to come. That’s why technical audits are vital tools for investors and why you can’t overlook compliance concerns.
A startup with poor security management or data protection problems should sound alarm bells for every potential investor.
A High Technology Staff Turnover Rate
Every industry has an average employee turnover rate, but some are higher than others. Typically, a high turnover rate, particularly among key development or tech staff, can negatively impact an organization. When companies have a seemingly “revolving door” in their tech department, it can be a worrying situation and could indicate trouble behind the scenes.
A startup’s high turnover rate should be a warning to investors, as such churn can seriously disrupt company operations, stunt growth, decrease morale and productivity, cause distrust between management and workers, and tarnish the reputation of the company.
Say a startup manufacturer has been in operation for just over 12 months. In that first year, the staff turnover among engineers was 48.7%. That far exceeds the national average of 28.6%, so it’s a clear indication there’s something wrong.
While it could come down to burnout or stress, it could also be the result of poor management or hiring unskilled workers. As an investor, you must take a very close view of the turnover rates during a technical audit as it could indicate a lack of much-needed stability within the company.
Unclear Roadmap
A product roadmap is used to attract potential investors by showing them the development visions, goals, and attainable milestones. Startups that jump from one development strategy to the next – with no justification – can spark confusion among investors. When a roadmap is vague or lacks credible details, it indicates there’s a misalignment within the team which can throw future growth into doubt.
This is a clear red flag you can’t ignore.
When a technical audit discloses instability in vision and goals, you can’t simply brush that aside and hope for the best. Startups must be able to guide and reassure you of their objectives. Missed opportunities occur when there is no clear vision, which impacts investment returns.
It’s vital to scrutinize a startup’s roadmap during the technical audit. You can use the information to learn enough about the management of the company to either rule it out as an investment or feel confident to press forward with it.
Poor-Quality Code
A potential problem for a startup is having a poor-quality source code. This can be caused by several factors, including time constraints, using unskilled developers, and rushed development. A technical audit can analyze the source code for performance, readability, and maintainability.
If a startup’s base code is complicated or lacks documentation, it could mean substandard code has been used. Poor-quality code can lead to system failures and difficulties with expansion, so it’s a potential area of concern for investors.
When you’re looking to invest in a startup, you must review its source code to understand its testing practices, and code reviews, and ensure it adheres to coding standards. It should be able to demonstrate robust software development.
Why You Can’t Ignore the Warning Signs
Investors should never ignore warning signs from a technical audit because it can reveal a host of issues, including:
- Inefficiencies
Inefficiency in one or two areas can reduce profit margins for investors and hamper growth. Being able to identify these with a tech audit can give you a clearer understanding of the startup’s investment viability.
- Unaddressed Challenges
Unaddressed problems can create a gradual decline in productivity which causes serious challenges that sink an investor’s profits.
- Weaknesses
Poor infrastructure and mismanagement at the top are two major weaknesses that can doom a startup from the outset.
- Underperforming
When a startup underperforms, it could mean mismanagement or poor management decisions are being made, and thus doom your investment.
Technical audits provide you with a wealth of information regarding these signs of trouble before you become an investor. They highlight a business’s goals, its shortcomings, and its current technological state. When there are warning signs, like scalability or legacy code issues, you can discuss them with the business’s management team to get the answers you need.
It doesn’t mean an end to your investment but rather shows you what must be addressed before you decide to invest. It also serves the business, showing them areas that need immediate improvement.
For example, a SaaS startup may look viable on paper but could have questionable codebase issues and a great deal of technical debt. Within 18 months, there could be several cybersecurity breaches and growth could stall. Since the company could take a loss, you would as well.
Why Due Diligence Matters for Investors
Many investors don’t take notice of a technical audit. Sometimes, it’s because they have investment inexperience, other times it’s because of poor preparation. It’s easier to focus on things you know or understand, like business plans, financial reports, and forecasts. While these may be in your skill set as an investor, you have to go further.
Due diligence helps you to:
- Get a clearer understanding of a startup’s true potential
- Make fact-based decisions
- Mitigate potential investment risks
You have to know a startup inside and out. You need to know their strengths and weaknesses to invest with confidence. A technical audit gives you that in-depth look at the technological side of the startup which is invaluable.
Final Thoughts
Investing in a startup can be incredibly profitable but does come with risks. Technical audits help you assess the viability of a startup as an investment option and find its weaknesses and infrastructure. It’s not about finding reasons not to invest but about knowing the intimate elements of the startup to make a more informed decision. Many red flags can result from a technical audit, including poor coding, unclear roadmaps, high turnover for developers, excessive technical debt, and compliance and security issues. But it’s vital to acknowledge these because they can help you make a better, more informed decision when investing and safeguard your finances.
