You may already know where to find interesting startups, but what do you do once you’re actually ready to invest? It’s important to conduct your own due diligence on a startup before you write a check. You shouldn’t only rely on a great pitch, or assume others are doing the due diligence for you.
Let’s go over some items that you should investigate.
1. Understand the Industry
While you are looking for startups to invest in, make sure you invest in what you know. If you are a high tech expert and someone comes along with the next great idea in biotech, you might get caught up in the hype. The problem is that you may not have a deep knowledge of the market. Your decision could be swayed more by the sales pitch than your actual experience, making the investment more risky. Make sure you read up and understand the industry before you put any money down.
2. Get to Know the Team
When you are investing in a startup, you are really investing in the team. When the direction needs to be changed because something is not working, having a good team is the difference between success and failure. You want to make sure that the co-founders have experience in what they are trying to accomplish. Have they been successful with another company, or, if this is their first business venture, how well do they work together? Find out what their history is with each other. Knowing who is running the business is as important as what they are trying to run. A bad team can ruin a great business.
3. Assess the Monetization Strategy
Does the company already have a strategy on how it is going to make money? Twitter focused on growing its user base at first and waited to unveil how they were going to become profitable. You should at least have an idea of a few ways that the startup can charge for its service and it should be a reasonable price that you would pay as a user. You want to make sure that the founders have a strategy even if they are not executing on it yet.
4. Size Up the Competition
You need to understand who is competing with your startup for the same customers. Are the features something that the competition doesn’t currently offer? How quickly can the competition create something similar and what would happen if they did? The competition might also have the potential to acquire the startup in question, so you’ll want to investigate the competition’s acquisition history as well.
5. Review the Adviser List
If the startup has advisers, you should call them to understand how they are helping. Are they offering advice when needed? Helping to connect with people? Or are they just a name on a slide? You should also see how long the advisory period will last. It isn’t the end of the world if the startup doesn’t have a list of advisers, but if they are using their names as a selling point in the pitch, they should be active.
6. Check the Cap Table
You should look at the cap table to see how much stock has been issued and how many investors are on the list. You can see the valuation of the company and also if there is an option pool and how it will affect the shareholders.
7. Investigate the Financials
It is important to review the financials of a startup. Why? Because it will show you the money, of course. You can see how many assets they have, liabilities you may have overlooked and any potential revenue. You can also see how they are spending the money they currently have. What did they spend the seed money on? Was it development costs? Marketing? Or did they give the founders raises and waste the money on toys? Every startup should have financial history, so make sure you take a look and understand the story it tells.
8. Review the Plans for Future Funding
How does the startup plan to use the next round of capital? They should have a solid idea of what they plan to spend it on. Typically, startups will give a high-level breakdown with sections like growth, marketing and development. It is important to get more details. Look at the bigger expenses and understand those costs. Does development mean they are going to hire more technical people? If so, how many and at what cost? Is there really a marketing plan, or just a number they came up with because it sounded good?
9. Note the Burn Rate
It can take a startup thee months or more to raise capital, so you want to make sure you understand how long the money raised will last. Will they burn through the cash in six months, 12 months or longer? I like to make sure the round will last for at least 12 months — ideally 15 months or more. This allows the startup to focus more on building a great product rather than trying to ramp up for another round of financing.
10. Look Over the Legal Documents
You should look over items like articles of incorporation, by-laws, and board and shareholder meeting minutes. This will give you some insight into how the company was formed, who is on the board of directors, who has control, and what was discussed in the board meetings. Making sure a startup is upholding ethical and legal obligations ensures your investments will not be going toward financing shady deals.
This is by no means a complete list, and everyone should have their own set of criteria when evaluating an investment opportunity. However, these 10 points should give you a basic understanding of a startup’s health before you write a check. When you first start investing, it is a good idea to invest with other angels that have more experience or are knowledge experts in the startup’s industry. That way, they can help you out with the due diligence process and find things that you may have overlooked or should at least consider before making an investment.
by Bill Clarkmay. Bill Clark is the CEO of MicroAngel Capital Partners (www.microangelpartners.com), a venture firm that gives more investors access to alternative investments. He also gives investors the ability to invest in startups online through crowdfunding.