Tips Before Investing in a Startup Company

Investment Tip
Try to invest in a startup which operates in a market you understand. This will reduce the risk, as you will know about the success potential of the startup.
Before you take out your checkbook to invest in a startup, thinking it to be the next ‘Facebook’, it is essential that you are completely aware about it. Investing in a startup company can earn you both, good profits or incur heavy losses. It all depends on whether or not you asked the right questions before taking the decision. Many investors pose the right questions to the owners of the startup during the due diligence process.

Ask the owner if the business has a scalable model, because this will expand the business and allow you to get your money back. Try to investigate the backgrounds of people, ideas, and funds related to the startup, before you decide to sign on the dotted line. Remember, the owner should be able to add value to the venture. This Buzzle article will guide you about the questions to ask before investing in a startup company.

How much money can I risk and what will be the returns?

Like any other investor, you will have to take a tough call about how much money you would like to risk. Since it is a startup, there are no guaranteed returns. The risk of the business going into losses is far more than that of an established one with a set customer base. Hence, don’t risk more than what you can afford. You will also have to check what the return on your investment will be. You have to understand that since it is a startup, it will take time to grow. Hence, it may so happen that the ROI may be less during the initial years, but will get better when the business picks up momentum. If your calculations do not show an impressive annual return, you should rethink about investing in the startup.

Who are the other investors and how many have already invested in the startup?

If you find that there are other investors who have already accepted the offer, then it may be a risk worth taking. Studying the capitalization table will tell you about the number of investors and if the stock has been released. As an investor, don’t just get swayed easily by the owner’s impressive sales pitch when he tells you that you will be their only investor. While this is acceptable in case of a small startup company which does not require too much investment, it may not work when the company grows. It is important that there are more than two or three investors, so that in case of losses the burden will get divided. This will reduce the financial pressure on an individual investor. Remember, don’t put all your eggs in the same basket, try to invest in multiple ventures. Ideally, the owner should also contribute towards the financial investment in the startup.

What does the business do and who is the owner?

First and foremost, you must understand the activities of the business. You must know the products and services it offers, what comprises your target market, how the product or services are unique, and the if demand for them will continue to increase. This will give you an idea about the functioning of the business. It is important that the owner has entrepreneurship skills to steer the business to success. Investigate the qualifications and professional history of the owner. Try to judge if he will be able to shoulder the responsibilities that the position requires. Ask him about his goals, plans, strategies, and milestones for the venture. This will help you to ensure that the venture will not end up a headless chicken.

How did the owner calculate the amount required for the startup?

As a responsible investor, you should know how the owner came up with the amount for investment. He will have multiple budgets along with financial estimates ready in his business plan. This, he will incorporate in order to impress you, but you should ask him about the methodology through which he reached the said amount. Try to negotiate the amount. He may also try to pitch the idea to two or three investors, in order to get all of you bidding and benefit from the competition. However, if you are not convinced about the investment amount, or the way it was calculated, it is advisable not to jump into the venture.

How can I connect with your top 3 customers?

Ideally, you can visit the top 3 customers who give maximum business to the firm, with the owner. You should get to know who they are, how was the startup able to do find and convince them, what they think of the startup’s products or service, whether they live up to their expectations, what are the improvements that need to be brought about, etc. Getting to know all these details are important for you as they will tell you if the customers are satisfied with the products and services, and will continue to have business relations with the owner over a period of time. This will tell you about the profitability of the venture.

How to monitor business growth?

Your prime interest as an investor is gaining maximum profit from your investment. Hence, you should ask the owner to have a reporting system or mechanism in place where you will be notified about the progress and development of the business. Public companies have to report their business results quarterly or yearly, but private startups do not have any such mandatory requirements. Hence, it becomes all the more important for you as an investor to keep an eye on where the startup is heading. You must keep a tab on the transactions and finances of the startup so that you know that your investment will perform better. Many investors also serve on the board of directors in order to get firsthand updates about the functioning of the company.

What are the plans for future funding?

You must be convinced about the startup’s revenue model, and its ability to work. You must question the owner about the sources for gathering funds in the future. He cannot be overly dependent on you for the financial needs of a developing company. You may not necessarily be able to invest large amounts in the business. One of the ways for the firm to raise capital is to avail loans for financially supporting its expansion plans. The other option is to reinvest part of profits in the business. If the startup has a steady customer base with good revenues, future funding should not be an issue. You must be aware of how the venture plans to financially fund itself in the future.

How will I get my money back and when?

You must have a clear business exit strategy for yourself. Your investment must be such that you will be able to withdraw it after a certain period of time. Hence, you must mention a clause in the paperwork related to your investment about the period of withdrawal, otherwise your money will lie locked-in for a long period of time. You should also be clear about the timeline for distributions. You should also have clarity about the capital return once you decide to withdraw. You will also have to check if there are any stock options which are available for you. Keep a close watch on how the owner calculated the deal offered to you, and the percentage of ownership that you will receive against the investment.

What do the sales and revenue (financial history) till date indicate?

Before taking an emotional investing decision, you must go through the existing financial documents to understand if the company has booked any kind of profit. You should also know about its sales projection and revenues. Understand the assets, liabilities, development cost, revenue management, etc. Many times, fraudulent owners may project different figures in the financial documents to make you invest in their venture. Hence, it is advisable that if you are not able to understand the financial documents, have them evaluated through an accounting professional who can find faults, if any. Once he verifies that the financial position of the startup looks favorable and the information represented in it is genuine, you will feel a lot more assured about your investment.

Apart from the questions mentioned above, you must also ask about the team handling the venture, the legal documents related to the business, the burn rate for the raised money, the advisers, the customer acquisition cost, the competitors, the monetization strategy, the allocation of funds, etc. Now that you know the questions to ask before investing in a startup, do not hesitate to ask these before entrusting the owner with your hard-earned money.