How to Invest for Equity in a Startup
When making an equity investment in a startup, there are many issues to consider.
The U.S. Securities and Exchange Commission is expected to release its final JOBS Act equity crowdfunding rules, and entrepreneurs will be allowed to sell equity in their companies through online crowdfunding portals to more than just accredited investors. The law promises to be a game changer for startups. As a result, investors will have easily accessible investment choices at their fingertips.
Here are 10 questions to raise about making an equity investment in a startup company. I pass these along from my personal experience as an investor, as well as my 25-year history as an attorney helping people start and fund businesses:
Related: Our Progress Report on the JOBS Act
1. Is the investment for equity or a convertible note?
An investor needs to know what he or she is getting in exchange for the cash infusion. Will it be equity (shares of ownership of the company) or a convertible note? The note means that the investor loaned money to the company with the right to either be paid back or to turn the loan into equity as some later date.
2. How and when does the investor get the money back?
When an investor buys an equity stake in a startup, usually those shares cannot be sold or traded for several years. If the investment is a convertible debt, figure out the conversion date. This is when the company either pays the money back or the investor can convert the money loaned into equity according to the terms of the convertible note.
3. How will the business make money?
I am amazed when I see business plans that don't describe a visible means of monetization. If a company has not yet started generating revenue (like most startups), look at how the enterprise plans to make money. If the company has indeed started generating revenue, examine how it's making money. Consider if the model makes sense and is sustainable. Is the model scalable?
4. How can the investor profit from an investment?
Equity shareholders should find out if they will receive dividends or distributions, how much and when. What happens if the company is sold, merges or goes public? Convertible note holders need to know their interest payment schedules and ask what happens in the case of a sale, merger or IPO.
5. What rights come with an investment?
Investors need to find out if they gain voting rights at the company and of what kind. Can the ownership percentage be diluted? Can the investment be sold or transferred to a third party? If so, how and when?
6. How will the investment money be used?
Research the "use of proceeds" and understand what, why, and how the startup intends to spend the money raised. The use of proceeds offers a good look inside the mind of the business owner. Is the amount being raised enough to reach profitability or is it just enough to arrive a the next financing round? Is everything the company is paying for seem reasonable?
7. Who are the founders and key personnel?
I often pay more attention to this aspect than just about anything else. I like to invest in companies with founders who know how to run a business and who have a track record of success. If the founder has no track record then he or she should surround herself with professionals with experience. A strong management team is no guarantee of success but is an important factor to consider.
8. What are the founders being paid?
I like to see the visionaries behind the business receiving a fair salary so that I know they will be focused on doing the work to make the company successful and not waiting tables at night to make ends meet. I generally make sure no salary seems out of line with market wages.
9. Are the sales projections and profit projections reasonable?
Nearly every company trying to raise money claims to be the next billion dollar company and usually has sales projections to back up some bold claims. Sales projections for startups are usually created with smoke and mirrors, so take them with a grain of salt. But examine the method of creating the numbers presented. Is there a reasonable basis for the projections?
10. What's the risk associated with investing in the startup?
Investors should not invest money that they cannot afford to lose. Investing in any new business involves risk. But it is really more risky than investing in the “safe” stock market? Ask people who bought Bank of America stock at $82 a share in 2004 how safe their investment was in that bluest of blue-chip stocks, now trading at $17.