Smart Investing in a Startup World

Investing in privately-held companies can be both an exciting opportunity, but also an intimidating proposition. Prior to opening your checkbook, it’s important to ask the right questions and do appropriate research in order to vet companies properly. In order to find a potential investment that’s right for you, you must run your due diligence in order to avoid common pitfalls that may doom your investment.

Finances and Projections

When looking at a company for a potential investment, the first thing you should vet are the numbers provided by the owners. If you’re thinking about an investment – remember that you’re the one in control. The company should be the one wining and dining you (well, hopefully not too much, since they need capital…). However, don’t be fooled – the numbers should be realistic. ¬†Companies should take the necessary steps to hire an independent auditor or have a board member with significant credibility providing a realistic assessment of anticipated profit and loss. Don’t trust the CEO’s accountant or brother who “swears he’s a great CPA” to provide some inflated revenue calculations. Odds are, you’re putting tens, if not hundreds of thousands of dollars at risk – you can’t risk having a subjective party look into the numbers.

Look at the sales numbers and assess how accurate their projections are compared to industry standards. Projections should be realistic and based on past success. Additionally, don’t take the projections at face value – ask questions! If growth projections appear to be above the traditional market rate for a similar company in the same industry, ask why. Early-stage companies can and do grow quickly, but you have to retroactively look at finances and have calculate growth on your end. Don’t let a company’s VP of Sales tell you he plans on having bigger and bigger years – make sure they have consistently done it in the past. Finally, if the owners are not willing to put their own money in the game, or if they are hedging their bets by keeping outside employment, that is a red flag.

A Business Plan

While numbers can tell a great deal about the guts of a company, you can tell much more about the CEO or leadership team if they provide you with a strict plan. From an investment perspective, you want to see where your money is going, who it’s benefiting, and why they need more capital. For instance, if you’re working with a tech company, understand the pros of cons of investing in developers vs. sales reps. Being first to market with a great product is key; however, so are increased sales. If you get more sales, you can eventually hire more developers – though do you want to risk releasing a product that isn’t perfect?

Red Flags

The two biggest challenges we find are companies who do not have the right employees or partners in place, as well as investors who have unrealistic expectations. Team chemistry is critical to success. You can have a team of all-stars, but if they all play the same position, you are going to have trouble fielding an effective team. You need to make sure that teams work well together, and inter-department communication clicks. Ask about the leadership team – make sure they weren’t simply handpicked from the CEO and old childhood friends – this could be disastrous. You want to make sure there have been a series of objective hires. Finally, if you’re the investor, be realistic yourself! Investing can be a considered a calculated bet – you get what you pay for. Don’t assume all companies will explode with growth in the first couple of years – growth takes time. Set your expectations accordingly.

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