Investing in startups can be exciting. You’re backing entrepreneurs, helping new technologies grow, and potentially introducing some disruption into longstanding industries.
That said, such investments are also inherently risky. You’re funding a company that is oftentimes just gaining traction or just starting to make sales – meaning there are ample opportunities for both failure and success.
So how do you make sure you’re effectively evaluating each new investment opportunity? There are a number of questions to ask before you invest – addressed to the startup founders, to your CPA or other financial professionals, and even to yourself – to help you ensure that you’re making the best decision for your individual goals, risk tolerance, and investment strategy.
- The top question recommended by the SEC is: “Is the seller licensed?” In order to avoid fraud, it’s important that investors check the seller’s background before offering any personal or financial information. Both FINRA and the SEC have such resources available for investors, and FINRA also provides a complete list of regulation crowdfunding portals. Likewise, any offer or sale of securities must be registered or exempt from registration, and this can be checked via the SEC.
- “What are the risks – and can I stand to lose this amount of capital?” Things like lawsuits, challenges to intellectual property, difficulty achieving follow-on funding, too many competitors, and failure to find product-market fit are all risks that could eventually hurt an investor’s chances of seeing a return on investment. Keep in mind the often-quoted “golden rule” of investing: Never invest money that you can’t afford to lose. Open and frank conversations with your financial professionals will allow you to better understand how to spend the funds you have available.
- “How involved do I want to be?” Depending on the type of investment you complete, you may encounter different levels of involvement. For example, an angel investor completing a direct investment may have the opportunity to participate in decision-making alongside the startup’s leadership, whereas an investor who participates in a regulation crowdfunding offering may not have much interaction with founders or the board.
- “What is the burn rate and current runway?” These terms quantify how fast money is being spent and how long the business can survive before another round of investments is required. You’ll want to catch any indications of inefficient spending or startups reaching bankruptcy. In fact, this goes for financials in general – including being wary of overly complex capitalization tables, several pivots without revenue or customer growth, and a convoluted path to profitability.
- “What does each member of the team bring to the table?” Startups are built on their people. In a lean environment, it’s important to have the right people in the right positions. Asking about the team – including points such as industry experience, entrepreneurial experience, how much of their personal capital has been invested, and how individuals work together – can provide you with valuable insight into the day-to-day workings of the startup and the scalability of the current executive team.
- “How will I achieve diversification?” With stocks, there are clear divisions between asset classes that make it easier to spread out risk. Startups don’t always have such clarity, and spreading capital too thinly across multiple deals can backfire without any exits. Investors must be aware of how each startup investment affects their overall portfolio, which also requires in-depth due diligence concerning each investment opportunity. Your tax, financial, and legal professionals should be able to provide clarity into how each of your investments works together and how to stay true to your risk tolerance.
Of course, these are just a few important questions to ask before you invest. As you continue to evaluate each investment opportunity, additional questions can be raised that will allow you to go deeper into the potential risks and rewards – and ultimately make the best decision for your situation.
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