Doing Business | Financing

March 20, 2013

9 Things You Need To Know For Startup Investing

Startup investments can be rewarding both financially and personally. By investing in a startup you are contributing to job creation and capital formation.

Even though picking winners is not an easy game, making a home run with a startup investment means that the returns could yield between 5x to 100 times returns on the initial investment. However, it is crucial to conduct the appropriate due diligence on the business, market, competitive landscape and founding members to mitigate against risk.

At the company I co-founded for instance, RockThePost, an investment platform for startups, we help with the due diligence process by only showcasing highly vetted startups. Each entrepreneur and their high level officers have to pass through background checks in order to even be considered, in addition to pitching the business venture to our investment committee, which is comprised of four financial experts, and led by the former Chief Financial Officer of E*Trade Financial, Robert Simmons.

Below are some of the most important tips when considering making an investment in a startup company.

1) Invest in a domain you know. 

One of the best ways to reduce risk is to understand the market that startup operates in. This will provide you with a better sense when projecting the potential success of the venture. Make sure that the business has a scalable model so that it can grow to a level in which you will be able to get your money back as an investor.

2) Drill into the track record of the founders.

 The people behind the company are the most critical factor, especially for early stage companies. This is mainly due to the fact that products need to be iterated several times until they are able to find where they fit in the market. Just like Jim Collins’ book “From Good To Great”, it is all about having the right people sitting in the right seat. Eventually they will end up finding the right direction. Here you want to focus on their background story (previous companies, education, etc.) and what type of value they bring to the table.

3) Diversify your investments. 

Instead of putting all your eggs in the same basket make multiple investments. This will increase your possibilities of success and will also help to reduce the risk involved. It will also increase your chances of getting your money back with some returns at a liquidity event such as a public offering or an acquisition by another company. In the end, these investments are for the long run so try to be patient.

4) Join an equity crowdfunding platform to get access to deal flow.

If you are struggling to find deals, the best way to remedy that is to go online. By registering on investment platforms you will be able to navigate different deals. Especially if you are new to startup investing, you may want to see as many deals as possible before pulling the trigger. It is important to learn about the market before making any type of investments.

5) Examine the monetization strategy. 

The first dollar is what really matters. As an investor it is critical to see how the company is going to be able to scale down the line. The startup in question needs to be charging for its service at a reasonable price. There is no point to investing in a company that cannot sustain itself financially so a clear path to monetization is key.

6) Explore the market. 

It is absolutely critical to see what competition the startup has and what kind of competitive advantage they have been able to put in place in order to beat everyone else in the race. The competition could acquire the startup instead of cloning their work, so investigating the appetite in the market could be beneficial. Moreover, you want to make sure that the startup is operating in a big market. The founding team should be focused on customer development and they should definitely listen to what clients are saying. Feedback is key in the event the startup needs to pivot or iterate the product until they get it right. The specific idea is not as important as the team’s approach, and the size of the market.

7) Investigating the financials. 

Calculating projections to 5 years is almost impossible but the founding team should be able to at least showcase the roadmap of how they want to build the story towards becoming a profitable company. It is very interesting at this point to review the burn rate of the company and if what they are doing with their money actually makes sense.

8) Research their use of funds. 

As an investor, you need to understand what, why, and how the startup intends to spend the money. Having a good idea of what to do in this section would give you a better sense when testing the entrepreneur’s vision. In addition, review the salaries and see how much the founder intends to pay himself/herself. For a seed round, the absolute maximum salary should be $150,000 (depending on the amount raised and the experience of course). Also, try to understand if the funds that the startup is raising would be enough to accomplish important milestones that could help the company to either become profitable or to raise additional rounds of financing.

9) Review the legal documents.  

Look at the articles of incorporation, by-laws if available, investor agreement, subscription agreement, term sheet, etc… This step is all about getting familiar with how the company is structured and who is involved (directors, investors, advisors). Additionally, here is where you want to pay special attention to how the startup has structured the deal and what percentage of ownership in the company you are receiving for the amount of money that you are investing.

To conclude, as a potential investor in a startup company you should follow your gut. Ask yourself if this business addresses a real concern or problem in the marketplace, and bottom line, if it makes sense. If you do not see a real usage, you should definitely move on without hesitation. Additionally, never invest money that you cannot afford to lose.

 

Text by Forbes
 

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