Everything You Need to Know Before Investing in a Startup
To fund or not to fund, the question is now. If you’re struggling to find the answer, the following guide for first-time investors in small businesses might be of some help.
Small Business Investing: Opportunities, Risks, and Due Diligence
There’s a new business in town, and everyone’s talking about it? Always consider the odds when you’re trying to decide whether or not to invest in a young company. According to research, 90% of startups fail before they make any profit. However, the remaining 10% who succeed are usually worth that kind of risk.
Whether you’re a private equity investor, a venture capital firm, or something in between, the rules of investing are more or less the same – never miss an investment signal, and always do your due diligence.
Here’s everything you need to know before you embrace the risk.
The Basics of Small Business Investing
Besides funding your startup, there are two other ways to invest in a small business. You can either lend your money to be returned with interest or buy a part of it for some percentage of future profits.
You need to decide whether you will go with debt or equity investment.
Debt investment doesn’t make you a partial owner of the growing company you’ve decided to fund. Whether or not the startup succeeds and starts making money or fails and bankrupts, a debt investor gets paid back an agreed-upon sum, traditionally the initial principal balance plus interest.
If you decide that equity investment is a better option for you, funding a business will make you a key stakeholder. Depending on what you and the startup have agreed upon, you will either get a portion of its profits or a return on capital while also getting a say in how the business is run.
The Small Business Investor’s Checklist
If this is your first time funding a small business as a private investor or if you’re considering starting your venture capital firm, the following checklist will help you grasp the investment basics. Note that investment decisions require knowledge, experience, and instinct, so take your time to learn.
Discover New Investment Opportunities
First things first – how do you keep track of new investment opportunities?
We have two words for you – business insight.
While business insight means different things to different types of investors, it ultimately encapsulates the entire well of knowledge you must possess before you can start making smart investments. That includes your understanding of entrepreneurship in general, relevant markets, and investment signals.
Successful venture capitalists get business insights and actionable data from multiple sources. Constant involvement keeps them in the loop with emerging companies and market trends and helps them track their progress. It takes a lot of networking and research – or a dedicated feed of promising businesses.
Make Sure the Investment Is Worth It
Second, an investor must always do their due diligence.
In this context, due diligence refers to business insight, too, only more detail. Before you invest in any business, you must make sure the investment is worth it by looking at its future business plan, model, and strategy. As an investor, you need a holistic picture of the market, industry, and financial projections.
Understand that Investing Implies Risk
Even with all due diligence, there’s always a certain percentage of risk that investors must count in. The biggest one, of course, is losing all the money. If the new venture fails, you might not be able to get your money back for years because your investment will stay illiquid, or you might not get it back at all.
That’s why investment experts always recommend diversification.
In simple terms, diversifying your portfolio means making different kinds of investments. Your portfolio should include various types of markets, industries, and businesses. That way, if one of them fails, the chances will probably be more favorable for the other ones. Diversification takes a lot of experience.
Pick a Small Business Funding Avenue
Both equity and debt investors have multiple funding options to choose from:
● Direct investments – approaching the business you want to fund directly;
● Indirect investments – investing through a professionally managed fund;
● Online investments – via crowdfunding and co-investment platforms.
When it comes to small businesses, the most frequently used investment avenue is the fund called SBA Loans (Small Business Administration Loans). However, there are other funds and ways to invest in a small business, too, such as credit unions and banks. You can even invest using your business credit card.
Meet the Best Investment Candidates
Unless you’re a professional investor with a hectic schedule and a lot of experience, taking the time to talk to the entrepreneurs you want to fund is always a good idea. You should get to know the people behind the business plan and allow them to walk you through their assets and goals before you decide.
Negotiate Terms and Close the Deal
After carefully considering all the opportunities, risks, and options after you’ve done your due diligence and ultimately decided it was safe to make an official offer, don’t just start celebrating just yet. It’s important to navigate the negotiations well and go home with the best possible deal on your hands.
Stay in the Loop with Your Investment
When you finally do invest, there’s no rule saying that you need to stay invested in the ups and downs of the business you’ve just funded. As a key stakeholder, you might get some control over the business or not. In any case, you shouldn’t shy away from being actively involved in its progress.
Depending on how the wind blows, it might be a good idea to reinvest or flee.
Every first-time investor faces potentially ruinous temptations, and you will probably face them, too. Whether you take big risks and potentially reap big rewards or invest small and stay safe, due diligence is vital for success. Never underestimate the importance of insight and research.