Investing in a Startup? Here Are Your Due Diligence Basics

Before you write the check, take a breath. It’s nice to think of yourself as a venture capitalist, and investing in a new startup can certainly be exciting. It can also be very risky. If you do not have experience investing in new launches, or even an existing business, you need to take a look at some basic “rules” that may help you make a wise choice.

Don’t Invest What You Can’t Afford to Lose

Well over half of startups fail within the first 5 years, and many of those fail within the first year. Keep close tabs on how the company is doing, and have an exit strategy to liquidate what you can.

You won’t get all of your money back, but you can get what has not yet been spent. When you put together a contract, get advice from expert investors on contract terms. If the startup owner provides a contract, be certain that you have an attorney who specializes in these things review it.

Never Invest Unless There Is a Clear and Carefully Crafted Business Plan

That plan must include current market research that you can verify. And if you are investing 2-3 years in, and that business plan has not been updated to reflect the current status of the business and the current market forecasts, then you need to look elsewhere. This is not an entrepreneur who is on top of their business.

Do Your Own Market Analysis

How many competitors in this niche? And how profitable are they? Is there really room for the number of businesses in this niche? Of course, if the product is one-of-a-kind and is patented or copyrighted, then the prospects are better. The key will also be that the product or service really meets a demand that is out there. It must solve a real-world problem for targeted consumers – enough of them to make the business a “go.”

If your investment is substantial, and you are new to you capital investing, might want to contract with a due diligence firm that can perform a full evaluation of the business and provide report of the potentials and the risks.

Think About a Partner

You don’t have to “go it alone,” particularly if you are new in the venture capitalist “world.” Get a partner who has solid experience and some successes under his/her belt. Partnering with someone else until you learn this business of investing will give you valuable experience. You can always venture out on your own later.

Timing Is Important

It is best to time your investment two-three years into the business. This means it has passed the first risk period and your money will be less at risk. Still, the enterprise is fragile, even if it is profitable at the moment.

Review the plan for continued growth, and have an accountant check their financials. Generally speaking, however, if a startup has made two-three years without venture capital, chances are it will do well in the future with an infusion of cash.

Know When to Get Out

If a business is doing well, you may decide to remain invested for long-term. This is a good idea, as long as you are getting a good return. However, businesses do fail even after 10 years of profitability, because the market changes and/or they do not expand appropriately.

Pet rocks were a great idea and hit the market like gangbusters for four months. It made Gary Dahl a millionaire, but then it was over. Fortunately he made enough in 4 months, and everyone, including investors, won. He was the exception to the rule, and he didn’t want to come up with any new gag gift ideas.

But a startup that is not continually looking for new ways to grow will stagnate. If you sense this is happening, it’s time to harvest and move on, even though the business is currently profitable. If you are bitten by the investment bug, you can find another good risk if you are careful.

Invest in What You Know

If you can find businesses in markets that you know well, you are in a much better position to evaluate their prospects for success, the risks, and the competition. If you invest in a niche you don’t know well, find someone who does if you can. Take their advice under consideration.

There is just no way to know if a new business is going to take off or not. Everyone laughed at Dahl’s pet rock, until they showed up in a display window at Bloomingdale’s and stores could not keep them on their shelves. You can minimize your risk somewhat, however, if you take the time to evaluate the potentials and the risks for success.

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Written by:
Dianna is a former ESL teacher and World Teach volunteer, currently living in France. She's slightly addicted to apps and viral media trends and helps different companies with product localization and content strategies. You can tweet her at @dilabrien
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