What should I look at before investing in a start-up?

Question

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?

Answer 1

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.

Answer 2

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.

Answer 3

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.

Answer 4

You seem to have all your financial bases covered, and others have given you good financial advice, so I will try to give you some non-financial ideas. The first and most important thing is that you are investing with a long time friend, so the dynamics are a lot different that if you had recently met a stranger with an "interesting" new idea.

The first thing you need to ask yourself is if your friendship will survive if this thing doesn't go well? You've already said you can afford to lose the money so that's not a worry, but will there be any "recriminations?" The flip side is also true; if the venture succeeds, you should be able to go further with it because he's your friend.

You know your friend better (back to grade school) than almost anyone else, so here are some things to ask yourself:

What does your friend have that will give him a chance to succeed; tech savvy, a winning personality, a huge rolodex, general business savvy, something else?

If your guardian angel had told you that one of your friends was planning to embark on an internet/advertising venture, is this the one you would have guessed?

Conversely, knowing that your friend was planning to do a start up, is this the kind of venture you would have guessed?

How does "internet" and "advertising" fit in with what you are doing? If this venture succeeds, could it be used to help your professional development and career, maybe as a supplier or customer? Can you see yourself leaving your current job and joining your friend's (now established) company as a vice president or acting as a member of its board of directors, the latter perhaps while pursuing your current career path?

Are your other mutual friends investing? Are some of them more tech savvy than you and better able to judge the company's prospects of success? To a certain extent, there is "safety in numbers" and even if there isn't, "misery loves company." On the upside, would you feel left out if everyone in your crowd caught "the next Microsoft" except you?

Answer 5

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.