Hundreds of thousands of businesses are formed every year. Many of them are in significant need of capital, presenting opportunities for investors.
While startup investing is not for everyone, those with a high risk tolerance can find it a stimulating and potentially rewarding pastime. The possibility of getting in on the ground floor of the next Uber or Facebook, speculative as that might be, can be compelling.
Suppose you hear about an exciting new company looking for investors. You are aware that a majority of startups end up failing within the first few years, but you think this one could hit it big. What do you do?
1. Check out the Management
You ultimately are investing not just in a product or an idea, but in the people running the company. No matter how innovative or promising the business concept may seem, the enterprise is unlikely to succeed without capable management. You should assess not only the founders, but also those promoting the investment. An initial review often can be done online. In the case of those with professional licenses (such as brokers, accountants, and attorneys), you can check their license status and any disciplinary history. You want the people running or associated with the company to not only have clean backgrounds, but also a record of success in other ventures. Look for qualities such as experience, intelligence, creativity, integrity, discipline, and leadership ability.
2. Determine How the Business Will Make Money
Lots of 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 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, having the ability to grow rapidly without sacrificing quality or profitability? If the company is unable to provide good answers to these questions, its likelihood of success is dubious.
3. Rely on Advisors
If you are buying a used car, it is good practice to hire a mechanic to look the vehicle over to make sure you are not getting a lemon. The same principle applies in evaluating a startup. It is crucial to use qualified professionals, such as an attorney and accountant. Make sure your advisors are familiar with startups-an attorney specializing in personal injury cases probably will not be a good fit. You may also want to consult with experts in the business sector in which the startup operates. Your advisors will provide various insights you would not have on your own. They also will help you command respect from the company.
4. Thoroughly Research the Startup
Ask lots of questions and request lots of documents. If the business is concerned about revealing confidential information, it can have you sign a nondisclosure 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 shoddy or incomplete, that is a bad sign. Be wary of internal financial statements; statements prepared by an outside CPA have more credibility. Audited financial statements are best, but are less common because of their expense. If your investigation raises red flags, insist on complete explanations.
5. Review the Investment Documents
Your advisors can be of great help here. At the very least, you want to be fully informed as to how the deal is being structured and what rights and obligations you and the company will have. Your attorney can advise you as to what document changes might be in your best interests and help you negotiate with the company. Your accountant can let you know whether the valuation seems reasonable. Do not proceed unless everything is fully documented. You should not invest based on a handshake or mere verbal assurances.
Startup investing requires patience and hard work. Although there are no guarantees, you can reduce the risks and boost the chances of success by following the principles discussed above.
David Burgess is a partner with the Business Law Group in San Jose, California. He is a graduate of Stanford Law School and has over 30 years of experience in business and corporate law. For more information or to contact him, visit his firm’s website at www.buslawgroup.com