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Hundreds of millions of Americans who have been statutorily and practically prohibited from investing in startups are now allowed to do just that under two new regulations. The 2012 JOBS Act created new rules for Regulation A offerings and Regulation Crowdfunding. Neither requires investors t o meet a specific net worth or experience requirement. Common sense suggests it is time to ask the expert how to do “due diligence” on a startup investment. Todd Crosland, CEO and Founder of Seed Equity Ventures, offers some advice on conducting proper due diligence. He suggests exploring each of the following questions:
Is there at least a minimum viable product or prototype with proof of concept?
If possible, you’ll want to use the product. If not, you should at least see it. If there isn’t a working prototype, be sure to ask yourself if you are prepared to invest at such an early stage. The answers to the other questions should be overwhelmingly favorable before investing in what amounts to a business plan.
Is there any initial traction with active users?
It is possible to have an active community without a product, but generally some type of minimum viable product will have to be in the market to prove the concept in the market. If the product is available and there isn’t an active user community, it may be time to move along.
Are there at least two full time team members?
Experienced investors have seen this movie before. A lone wolf entrepreneur fails because he can’t share credit, can’t delegate, can’t work well with other people or just thinks he can do it all himself. Look for a solid, committed team before you commit your hard-earned money to the deal.
Have any team members successfully founded companies in the past?
While many first time entrepreneurs are successful and some who have been successful in the past, miss on subsequent efforts, you improve your odds of making a good investment by finding teams that have been successful before.
Was the team able to raise any funds prior to this raise?
It is scary for investors to be the first money invested in a company. If there are investors who have invested before, you may also want to know if they are investing with you in the current round. Are they still true believers? As a general rule, you don’t want to invest your money to help a prior investor get paid. Remember, this isn’t your problem until you put your money in.
What is the payback period on the investment?
Most startup investments are in the form of equity and it may be difficult to determine how long your money may be tied up, but spend some time trying to understand the development cycle, the time required to get the product or service to scale in the market and how an “exit” happens, that is, how you’ll get your money back,
Have you calculated when you are expected to see a return on investment?
Depending on the cash flow projections, you may get your investment back before you get a return on the investment. Be sure to calculate your expected returns based on realistic projections. Be sure that you are willing to lose all of your investment for the possibility of achieving that return.
Is the entrepreneur’s marketing plan realistic?
By comparing the projections of the company to actual results for other companies in the same sector you can get a feel for whether the marketing plan is realistic. Investments like Facebook are exceedingly rare; be cautious if an entrepreneur suggests topping their early results.
Do you fully understand the industry?
Owning and using a mobile phone doesn’t give you the expertise to make investments in mobile technology any more than eating gives you the experience required to run a restaurant. Be sure you either really come up to speed on the industry or find experts who have to advise you.
Have you looked closely at the competition?
Don’t ever let an entrepreneur tell you there is no competition. This fallacy not only suggests a problem with the business plan, it suggests a problem with the management team. Get to know the strengths and weaknesses of the competition before you invest.
How many investors are on the cap table?
The “cap table” is the roster of owners, some of whom frequently have special rights that you may or may not be getting with your investment. Be sure you understand not only the number of shareholders but also the rights that each has. Typically, the entrepreneur has common shares that are riskier than the preferred shares the investors receive.
How does the entrepreneur plan to use the next round of capital?
It is vitally important to understand the company’s planned use of proceeds from the investment. You want to understand exactly what the entrepreneur will do with the money you invest. While thoughtful entrepreneurs will never plan to use the money on fancy cars and bonuses, you want to go deep enough to understand how the money will be used to generate a positive return on investment.
What is the startup’s burn rate?
The “burn rate” is the pace at which the company is spending money faster than it comes in. Most startups do spend more money than they generate in revenue and often continue to do so for years as they scale up. Be sure to understand not only how much the company is burning now but how long they project burning cash before they reach the break-even point when revenue will match expenses.
Perhaps the most important part of due diligence is to get to know the management team and their capabilities. As you explore these questions with the team, use their feedback to understand their personalities, strengths and weaknesses. You’ll be counting on them to turn your investment into something bigger and better.
Even if you are focused on social impact more than profits, remember that if you lose your money on an investment you can never put it to work again. If you invest well and get your money back with some return, you can reinvest that money in another social venture and have more impact. Be sure to weigh your social impact and financial goals carefully.
On Thursday, August 25, 2016 at 5:00 Eastern, Todd will join me here for a live discussion about conducting due diligence on an investment. Tune in here then to watch the interview live. Post questions in the comments below or tweet questions before the interview to @devindthorpe.
Seed Equity Ventures is a registered broker dealer with the U.S. Securities and Exchange Commission and a member of both FINRA and SIPC, providing investment banking services to startups and growth companies from around the world. Seed Equity believes the best entrepreneurs in the world should be funded, no matter who they are or where they live. Investors throughout the world, should have a voice to choose what the future should look like. They should be able to support entrepreneurs who will build that future. Seed Equity was founded to provide growth equity to entrepreneurs and their startups in exciting industries globally.
A seasoned entrepreneur, Mr. Crosland has demonstrated the ability to build successful teams and companies. Mr. Crosland was the Founder, Chairman and CEO of Interbank FX, LLC (“IBFX”; www.IBFX.com), from 2001 until he sold the firm in 2011. IBFX was a Futures Commission Merchant and Retail Foreign Exchange Dealer registered with the U.S. Commodities Futures Trading Commission. IBFX was also authorized and regulated by the Australian Securities and Investments Commission. IBFX was a worldwide leader in retail Forex trading services. IBFX offered individual traders, fund managers and institutional customer’s proprietary technology and tools to trade Forex online. IBFX saw Global customers grow to over 40,000, in more than 140 countries. Annual trading volume reached $750 billion. IBFX had 120 employees and offices in Beijing, China; Seoul, South Korea; Sydney, Australia; Salt Lake City, Utah and London, England. IBFX and Mr. Crosland have received many awards, including: The Ernst and Young Entrepreneur of the Year Award and numerous Inc. 500 awards. Mr. Crosland holds a B.A. in Business (Business Finance) from the University of Utah. He also currently holds the following Securities Licenses: Series 7, 24, and 63 and previously held series 3 and 30 Licenses.
Devin is a journalist, author and crowdfunding speaker who calls himself a champion of social good. With a goal to help solve some of the world’s biggest problems by 2045, he focuses on telling the stories of those who are leading the way! Learn more at DevinThorpe.com!