Tips to Consider Before Investing in a Start-Up

What You Should Consider Before Investing in a Start-up

While the economy is steadily improving, 75 percent of all start-ups will fail, often in the first year. Before jumping “all in” and investing in a start-up, investors must be sure to carefully evaluate the business opportunity to determine whether the potential return on investment (ROI) outweighs the risks.Things to consider before investing in a start-up

Below are a few key due diligence tips to consider before investing in a start-up business.

Stick with What You Know

It can be tempting to dive into a “hot” industry. However, investors are generally more successful when they focus on industries in which they have firsthand experience. While investors certainly don’t need to be experts, possessing a general knowledge of the market can help evaluate a start-up’s business plan, products and services, executive team, potential for growth, and potential competition.

…investors are generally more successful when they focus on industries in which they have firsthand experience…

If it is not within your experience, get the opinion of an experienced adviser whom you trust. You want an unbiased, and even skeptical, analysis – one that provides insightful questions to assist you in your decision-making process.

Pick the Right People

A start-up is only as good as the managers behind it. While every start-up needs a great product or service, it is also imperative to extensively vet the leadership team. Whether it’s performing an Internet search, interviewing prior business partners, or conducting a professional background search, it is important to verify that the management team has the knowledge, experience, and skills to not only run the company successfully, but also steer its growth.

A start-up is only as good as the managers behind it.

The investing maxim is: “I prefer to invest in a company with grade A management and grade B product rather than grade A product and grade B management.” Of course, one prefers top notch on both accounts.

Fill a Market Void

The products and services offered by the start-up company must fill a void in the market or otherwise have something novel to offer the public. In its business plan, the start-up should be able to demonstrate what steps it has taken so far to research the market, develop the product or service, and outline what remains to be done, and a projection of the time and money needed to get there. The company should also be able to demonstrate that it has a leg up on the competition, i.e. whether its product/service is better or whether it will make it to market first.

Crunch the Numbers

Investors should receive detailed information showing the start-up’s financial condition, with projections of costs and revenues. The business should provide a current balance sheet, profit and loss statements, tax returns, audited financial statements (if feasible), and accounts payable and receivable. Investors should also ask for an accounting of all the start-up’s non-tangible assets, particularly intellectual property.

It’s All About Timing

What is management’s proposed end-game? Knowing how to get in and how and when to get out are key to start-up investment decisions. To make the most of your investment, it is advisable to select a start-up that has a viable plan for cashing you out on your investment – unless the plan is to create a pure and continuing revenue generator, especially one with ongoing tax benefits (for example, oil and gas or real estate investments) – in short, a “cash cow.” 

Management should be able to tell you how your illiquid investment in their start-up company will bear fruit: going public, getting acquired by a large company in the industry, or, if the investment includes a combination of debt and equity, convertible debt, or preferred stock with liquidation preferences, how that is intended to be repaid.

Preference For a Track Record, Even Prior Failure 

Management with a prior history of start-up efforts, even if unsuccessful (see Steve Jobs, for example) can prove helpful in overcoming the normal growing pains of a young business. People often learn from failure better than a prior success that came easy.

People often learn from failure better than a prior success that came easy.

Even a prior mixed success may have been filled with helpful lessons, with management learning of traps to avoid, how not to make bad hires and cash and time management tricks necessary for a growing company to master. The most frequent error causing an early demise of an otherwise good business idea: undercapitalization.

Are you thinking about investing in a start-up? Would you like to discuss the matter further? If so, please contact me, Dan Brecher, at 201-806-3364.