Investing in a startup can be extremely rewarding, both personally and financially. When you invest in a startup, you’re putting money into the macroeconomic engine that creates jobs. Additionally, you’re part of somebody’s capital formation strategy. You are close to an angel — the answer to somebody’s prayers.
The question is: How do you pick a winning startup? There’s no easy answer to that. However, when you do pick a winner, your return on investment could be anywhere between 400% and 8,000%. That’s definitely a successful investment of your money, and it leaves you with plenty of margin of error when you consider risking your money on other startups, which may end up failing.
Still, you want to exercise due diligence when it comes to investing in a startup. Throwing money blindly at any appealing idea, which happened during the ill-fated dot-com bubble burst, is almost certainly a losing bet. Do your homework and you’re more likely to pick a winner.
Some venture capital firms won’t even consider investing in a startup until the founder and officers have passed background checks. They’ll also make sure the idea has been vetted by a financial expert who is a consultant with the company. Those are great examples to follow if you’re considering investing in a startup.
If you’re not a financial expert yourself, you should enlist the aid of someone more experienced in this discipline. Here are some more tips for investing in a startup.
Buy what you know
Peter Lynch was famous for advising stock investors to buy what they know. The idea was that if you’re using a product (such as toothpaste) and decide that you like it, and you notice that other people like it, then the toothpaste company is likely a good investment.
That advice holds for investing in startups. Are you technology expert? Invest in a high-tech startup. Are you a retired restaurateur? Invest in something related to food service.
Bet the jockey, not the horse
You might be particularly enamored of an idea that is being pitched to you. You might even ask yourself why you hadn’t thought of it yourself. Does that mean it’s a good investment? Not necessarily.
Even though the idea is great and the market research suggests the company has the potential to make millions, you still need to get to know the key players. Does the founder have any experience in that space? Do the partners have a history of success when it comes to marketing?
You’re really investing in people, not the idea. Make sure that the people are worth the investment.
Diversify Don’t put all your money in one startup. As noted previously, you can afford more than a few misses if you hit one that’s a real winner. Try to entertain pitches from various entrepreneurs and invest some money in several companies, rather than putting all of your money in one firm.
Crowdfunding is the latest online craze in investing. It enables you to minimize risk while still making an investment in what appears to be an attractive startup. With crowdfunding, you’re investing a little bit of money into a startup while numerous other people do the same.
The idea is that a lot of people can invest just a little bit of money each in order to get the whole thing funded. It’s a great way to get started on investing in startups while minimizing your exposure.
Validate the market research
One of the first things you want to do when evaluating any startup as a candidate for investment is to check the market research. At face value, does it look plausible? If not, then you should probably move on to the next candidate.
If it does look good, then do your own research to validate the accuracy of the information it contains. Is the market research correct about the extent of the competition? Is there really a demand for the product or service being offered?
Validate the financials
Once you’ve validated the market research, it’s time to check the financial projections. Almost all projections that go out 5 years are based on guesswork, to some degree. However, the company founders should have some idea of how the business is to become profitable in the coming years. You’re looking for a framework here, not necessarily a 100% accurate mapping of how the company will perform.
Validate the budget
Once you’ve validated the market research and the financial projections, take a look at the budget. You’ll be investing a significant amount of money into the company, so how does it plan on spending that money?
Is the company spending the money in such a way that it can accomplish the goals contained in the financial projections? Take a look at the salaries to be paid to the founder and the officers. Are they extremely high? As a rule of thumb, any founder paid more than $150,000 a year is probably receiving too much.
Check the legal documents
You’ll need an attorney for this, unless you happen to be one. Make sure the articles of incorporation are in order. Go over the corporate bylaws, the subscription agreement, and the investor agreement. Be sure to familiarize yourself with the corporate government, so you know which people are the key players. You’ll also want to be clear on the percentage of the company that you’ll own once you’ve made your investment.
Aside from investing in a startup, there are other ways you can invest money and still enjoy a healthy return. This is true even if you only have a small amount of money to invest.
One option is to trade penny stocks. As the name implies, they aren’t very expensive. However, the returns can be phenomenal if you pick the right ones. Fortunately, there are resources available to assist you with selecting penny stocks that have the potential to explode in value.