10 Basic Rules For Investing In Start-up Companies

Posted on Sep 19 2013 - 12:35am by Amanda Brown

Invest

Investing in a start-up firm can mean turning a healthy profit, and the chance to make a difference in the world — as long as you choose the right company. While the sales pitch may sound great, how can you really tell how much faith you should place in a young unproven company?

1. Invest in Familiar Markets

If you look at companies that do business in sectors you know something about, you are in a better place to predict whether they will be successful. If you invest in markets you know little about, you may not be able to gauge whether a company’s product is competitively priced or even makes sense to potential customers. You could be swayed too easily by someone else’s hype and enthusiasm when you don’t have the deepest understanding of the issues at hand.

2. Study the Competition

You should learn about your start-up candidate’s competition for two reasons. First, you want to know whether the start-up is bringing something more or better to the marketplace compared with what its competitors are offering. If the start-up’s offering is not unique and does not address an underserved niche, the company has little chance of establishing itself and surviving.

Second, you want to scope out more established companies to judge whether there are any that may want to buy the start-up in the future, which would give you an opportunity to take your profit.

3. Learn Who’s Who

What a start-up does is not the only important factor, but also who exactly is doing it. Make it your business to research the backgrounds of founders and team members. If a founder has launched other companies before, what were the results? What experience and skills do all the key people in the company have? How does the team as a whole work together and get along? A solid team can steer a young company through the storms that inevitably will arise.

4. Examine the Start-up’s Spending

Try to decide whether the start-up is a good steward of the funds it has already raised. Look at salaries in proportion to revenues. How fast does the company spend its money? Is it investing in the things it really needs to grow? Is the current round of funding realistically going to last until it is time to raise the next one?

5. Find the Monetization Plan

A start-up you put money into should have a clear plan to become profitable. If it has little or no revenue, the founders should be able to articulate how the company will set up its cash flow. If the firm does sell a product, the price should be set at a sustainable level to support the company over the long run. And the company should have some idea where it’s getting its next round of funding.

6. Find Out the Exit Strategy

The startup’s founders should know what the plan is to ultimately ditch its start-up status. Either their goal is to eventually be acquired by a larger, more established company, or it’s to become a larger, more established company itself, usually achieved by going public.

The exit strategy is very important to you as an investor in a start-up, because it’s the way you’re going to get the return on your investment.

7. Diversify

No matter how careful you are in choosing a start-up company to invest in, it’s the nature of these businesses that many of them fail. Increase your chances for investment success by picking more than one of them.

Ron Conway’s approach to start-up investing involves spreading your initial investment dollars over a fair number of companies, then putting more money into the ones that prove successful.

8. Read Legal Documents Carefully

Read the investment agreement with care and be certain you understand the exact structure of the deal and how much of the company you’re buying. Reading such documents as the articles of incorporation can yield enlightening information about who controls what in the company, and who sits on the board of directors. Red flags may turn up in the legal documentation at this point if there is anything shady or questionable about the organization.

9. Learn More

If, after you’ve done all the due diligence above, you still feel you need to know more, there are different forms of help that you can seek out. Investment advice ranges from one-on-one consultations to self-education tools. For example, a profile of Fisher Investments shows that, in addition to advising individuals about their investments, the company also publishes educational books and an online magazine.

10. Be Patient

It’s in the nature of start-ups to be long-term investments. Even when a start-up venture is very successful, this doesn’t happen overnight. Be ready to wait years before you start seeing your money again.

Follow these basic rules to find start-up companies you’ll feel confident investing in.

Photo Credit: Flickr/OTA Photos

About the Author
Amanda Brown

Guest Contributor Amanda Brown is a freelance writer whom enjoys playing and coaching volleyball. She loves her friends and family including her dog, Charlie; as well as traveling all around the world.