Hundreds of thousands of companies are formed each year. Many of them are in significant need of capital, which presents opportunities for investors.
While initial investing isn’t for everyone, those with a high tolerance for risk may find it an exhilarating and potentially rewarding hobby. The possibility of getting on the ground floor of the next Uber or Facebook, however speculative, may be a compelling prospect.
Suppose you hear about an exciting new company that is looking for investors. You’re aware that most startups end up failing in the first few years, but you think this one could be a big hit. What is your job?
1. Consult the Management
Ultimately, you are investing not just in a product or an idea, but also in the people who run the company. No matter how innovative or promising the business concept may seem, the venture is unlikely to succeed without capable management. You need to evaluate not only the founders, but also those who promote the investment. An initial review can often be done online. For those with professional licenses (such as brokers, accountants, and lawyers), you can check their license status and any disciplinary history. You want the people who run or are associated with the company to not only have clean records, but also a track record of success in other companies. Look for qualities like experience, intelligence, creativity, integrity, discipline, and leadership skills.
2. Determine how the business will make money
Many companies are based on an intriguing concept. But the company must be able to translate that concept into a product or service that it can produce and sell at a profit and in sufficient quantities to generate a reasonable cash flow. What is the startup’s monetization plan? What is the market demand? Who are the competitors? What is the marketing strategy? Is the business scalable and has the ability to grow rapidly without sacrificing quality or profitability? If the company cannot provide good answers to these questions, its chance of success is doubtful.
3. Trust the advisors
If you’re shopping for a used car, it’s a good practice to have a mechanic look over the vehicle to make sure you’re not getting a lemon. The same principle applies when evaluating a startup. It is crucial to use qualified professionals, such as a lawyer and an accountant. Make sure your advisors are familiar with new businesses: A lawyer who specializes in personal injury cases is probably not a good fit. You may also want to consult with experts in the business sector in which the startup operates. Your advisers will provide you with various insights that you would not have on your own. They will also help you earn the respect of the company.
4. Thoroughly investigate the start-up
Ask lots of questions and request lots of documents. If the company is concerned about disclosing confidential information, it may ask you to sign a confidentiality agreement. You and your advisors will want to examine the startup’s business plan, offering memorandum, financial statements, budgets, capitalization table, and corporate documents (articles, bylaws, prior investor agreements, etc.). If the documents are of poor quality or incomplete, it is a bad sign. Be careful with internal financial statements; statements prepared by an external CPA have more credibility. Audited financial statements are best, but they are less common due to their cost. If your research raises red flags, insist on full explanations.
5. Review the Investment Documents
Your advisers can be of great help here. At a minimum, you want to be fully informed about how the deal is being structured and what rights and obligations you and the company will have. Your attorney can advise you on what document changes might be best for you and help you negotiate with the company. Your accountant can let you know if the valuation seems reasonable. Do not proceed unless everything is fully documented. You should not invest on the basis of a handshake or mere verbal guarantees.
The initial investment requires patience and hard work. Although there are no guarantees, you can reduce your risks and increase your chances of success by following the principles discussed above.
