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A friend from college (and middle school and elementary school, for that matter) has talked to me a little about his company, a start-up working on technology tangentially related to Internet advertising. He's recently mentioned an opportunity for investing some money in it.

I know it's no fly-by-night scam, and the general premise of the business sounds worthwhile, and they have some reasonable-sounding partners. Furthermore, I have a significant amount of extra money sitting around, so I think I can stand the risk on putting in a couple thousand dollars, and it wouldn't really hurt even if I lost every penny. (No, I don't need advice about other things I could do with the money. Yes, my tax-sheltered retirement accounts are full.)

Most of my investing experience so far has involved mutual funds and ETFs, with the occasional short-term speculation on the headlines mostly for fun (e.g. I made about enough off some random BP options to pay my tax preparer this year). An intermediate-term bond fund is a relatively straightforward instrument. A startup like this, though, is pretty opaque. Before I respond and say "maybe, tell me more", I'd like to know the questions I should be asking.

What sort of information should I request? What should I be looking for? What are the red flags I should watch out for? What sort of pitfalls and potential gotchas might I find?

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What brings about this opportunity? Would this be a direct investment or would you be buying shares from someone else? –  George Marian Sep 1 '10 at 4:36
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I just want to say Awesome for having all your retirement accounts full! –  C. Ross Sep 1 '10 at 13:07
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4 Answers

up vote 11 down vote accepted

Here are the basic questions I usually ask any new business startup:

  • What is the one thing that they will sell that others will pay for?
  • Who are those potential clients and how easy are they to reach?
  • Where would those clients be found and who or what are the substitute competitors?
  • Why would they choose this product over the others and how safe is that advantage?
  • How much does it cost to set this up, how much does it cost to reach a single client and are there economies of scale?
  • How many clients/sales does it take to reach break-even?
  • Say I give you this investment today, what are the immediate things it will be used for?

Do these numbers/answers seem reasonable to you and is some benchmark available that allows you to see how likely this is?

Remember, particularly in Internet-based advertising ventures, the client may be indirect. The person who clicks on a Google context-based link is not directly Google's client. The person who decided to host AdWords code on their site is the direct client.

You're also going to want to see a Gant chart or some process chart indicating exactly what needs to be done, at what cost and by whom. Answers to these questions give a sense of not only how seriously they are taking the business, but also how organised.

My final question: who is your first client?

They need either someone who is going to contract the service, or have a clear indication of where income is going to come from, on their first day of trading.

Their task is to sell their idea to you by proving that it will return on your investment and be profitable. From the strength of these answers you can gauge the value of your investment to them, how critical it is, how risky the opportunity and - ultimately - the stake and returns you should expect.

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+1 very detailed. Think like a venture capitalist - you want to be pitched, and you want to see a business plan. Doesn't have to be a full on 40 page detailed report of every intricate operation. You definitely want to see financials, what you'll get in return for your stake. Finally, you probably want to meet, or at least hear details about, the entire team your friend has working for him. New venture management chemistry is a critical component to consider. –  awshepard Sep 8 '10 at 15:36
    
Also, look at other Venture Capitalists (are they professionals?) However, keep in mind that we may be heading for another .com boom so you might just keep your money in your pocket. –  GUI Junkie Feb 6 '11 at 7:51
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In addition to evaluating the business (great answer), consider the potential payoff.

If bonds pay off in the 5-10% range, the S&P500 has averged 10.5%. You should be expecting a payoff of 15-20% to invest in something riskier than the stock market. That means that if you invest $10k, then in 5 years you'll need to get out $25K (20% returns over 5 years). If you get less than this much in 5 years, the risk-to-reward ratio probably rules this out as a good investment.

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Turukawa's answer is quite good, and for your own specific situation, you might begin by being sceptical about what you are getting for investing a few thousand dollars. With the exception of Paul Graham's Y-Combinator, there are very few opportunities to invest at that type of level, and Y-Combinator provides a lot of other assistance besides their modest initial investment.

I can tell from your post that you think like an investor. It is highly unlikely that the entrepreneurial programmers that you will be backing will be wired that way.

From the modest amount that you are investing, you are unlikely to be the lead investor in this opportunity. If you are interested in proceeding, simply stick along for the ride, examining the terms and documents that more significant investors will be demanding. Remain positive and supportive, but simply wait to sign on the dotted line until others have done the heavy lifting.

For more insights into startups themselves, see Paul Graham's essays at www.paulgraham.com. He's the real deal, and his recent essays will provide you with current insights about software startups.

Good luck.

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Previous answers have done a great job with the "Should I invest?" question.

One thing you may be overlooking is the question "Am I allowed to invest?"

For most offerings of stock in a startup, investors are required to be accredited by the SEC's definition. See this helpful quora post for more information on requirements to invest in startups.

To be honest, if a startup is looking for investors to put in "a few thousand dollars" each, this would raise my alarm bells. The cost and hassle of the paperwork to (legitimately) issue shares in that small of number would lead me just to use a credit card to keep me going until I was able to raise a larger amount of capital.

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This sounds like a typical "friends and family" pre-angel round... there all kinds of legal ways to take small investments from friends and family, and I wouldn't be concerned about rules of accredited investors if the startup's lawyers are not. –  Joel Spolsky Feb 6 '11 at 5:10
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