Investment Playbook: 4 Factors to Consider Before Investing

By 1996, I had accumulated some capital from consulting and started to invest in other startups. Of the six startups I invested in, three went out of business.

I learned a lot from the ones that failed. In 2000, I made my biggest investment by far in a startup founded by two Harvard dropouts -- one from its computer science department and the other from its business school.

The pair was smart and each had great work experience at two then-highly-respected companies -- Morgan Stanley and Netscape Communications. The idea was to develop software that would help companies manage business partnerships online.

Unfortunately, they could never figure out why the company existed and they lacked a passion for a specific market or technology. They never built a product and ran out of cash.

This failure cost me a six figure investment. Fortunately, my venture capital investing benefited from very lucky timing, riding the best part of the dot-com wave. The three other companies in which I had invested were acquired for a total $2 billion -- more than offsetting my losses from the failures.

Nevertheless, that venture's failure stuck with me and it offers four lessons that could help others looking to invest in startups themselves:

1. Understand the business model.
I should have probed more deeply into exactly who would buy the product, how much they would pay, whether the venture would sell software or a service, if there were competitors -- and if so, how fast they were growing. I never really understood the venture's business model.

Asking these questions, I would have realized quickly that the founders did not really know the answers or they might have said that what they were doing was so new, there was no established market.

2. Evaluate whether the venture meets an unmet need.
I now know that one of the most common, but important, elements left out of business plans is detailed customer research. Customer interviews are important because customers are generally reluctant to do business with a startup. The reason is simple: most startups fail. There is little incentive for customers to change their habits or business processes in order to work with a startup that might disappear eight months later.

But most entrepreneurs, like the ones whose faulty venture I'd invested in, do not reflect this in their business plans. They present market-size and growth statistics that are generally based on assumptions from research analysts that they don't understand.

3. Know why the founders care about the venture.
Startups generally lack the capital needed to pay above-market salaries that draw in talent. If they are going to build great teams, they must offer potential employees an exciting work environment that flows from the founder's passion for the business.

In my case, the CEO of this failed startup did not care deeply about the problem his company was out to solve. As a result, the venture flailed without direction and could not raise additional capital after the dot-com bubble burst.

4. Invest with your mind, not your heart.
What is clear to me now is that I invested without thinking clearly. I was swept up in my belief in the founders and the then high odds of success for dot-com startups.

The bigger lesson from my failed investment is that during boom periods, it is very difficult to resist the strong emotional pull of the general economic environment. But it is precisely during those times that applying a disciplined approach to investing is most important.

Ironically, my investment mistake took place at the same time that I was writing e-Stocks: Finding the Hidden Blue Chips Among the Internet Impostors (HarperBusiness, 2001).

I should have known better.

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