The 7 Due Diligence Basics for Investing in a Startup
There is only so much an investor can due to reduce risk, so be sure to do all of it.
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Investing in startups is a risky endeavor. There's no checklist for success and more often than not, finding the right company to invest in comes down to good old-fashioned experience. Although there's no hard-and-fast science behind successful startup investing, there are some guidelines that every VC should follow in order to help eliminate risks and avoid failed investments. These are seven guidelines that can help venture capitalists get the most out of their investments.
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1. Keep in mind that three out of four startups will fail. Going into an investment, you should know that 75 percent of startups fail. As a result, it's important that you have an exit strategy for getting out of an investment in a failing company. Most businesses tend to fail within their first year, so having a means to liquidate your assets and bring back the initial investment is vitally important. With failure rates so high, it's important that you take every precaution to safeguard yourself and your capital.
2. Know when to harvest your investment. You can always choose to stick with a business for the long haul but a successful venture capitalist realizes that the market is a numbers game and a numbers game only. A business that is thriving one year could fail the next due to a fickle change in the marketplace.
Knowing this, always be on the look out for hot new trends and opportunities. Make sure that you re-invest in the products, services or brands that are up-and-coming to ensure an ever-increasing ROI.
3. Consider partners. Most successful venture capitalists have general partners who split their investment, risk and return. This helps spread the risk out evenly but also the rewards. If you go this route, pick partners who you trust and have outstanding financial or investment track records.
Related: The Three Questions Venture Capital Investors Will Ask
4. Only invest in promising brands. Most venture capital funds aren't harvested until the five- to seven-year mark. Venture funding is not a way to "get rich quick." It requires unwavering dedication and analytical prowess because even businesses that look promising in the early going can fail. You must be prepared for that.
A good way to alleviate the chance of failure is to look for businesses that not only have a great product or service, but that also have a great team, a clear-cut market and a plan for growth. Those are the types of businesses that have a real future.
5. Jump in at the right moment. Timing your investment is just as important as the quality of the brand that you choose to invest in.
You should invest your money a few years into the business's life span to help minimize your risk. Make sure the company has a bulletproof story, a plan to grow and proof that they've experienced positive progress already. A startup that's made it on their own in the early going is a company that can make it on their own in the future. It is much more likely to bring you a healthy return on your investment and then some.
6. Evaluate your market. Look to invest in businesses that are going to address a real world desire or provide a solution to a problem that customers have. It's important that any business you invest in is a one-of-a-kind with a specific market cornered.
Look for proof that they are alone in their marketplace and have found success with a target market. If there's a competitor in the same space that offers a similar product or service, that company is likely to fail and your investment lost.
7. Choose what you know. Focus on companies that are in your specific area of expertise. By doing this, you will take on less risk and become emotionally invested in the company to go above-and-beyond to make sure that they succeed. Furthermore, when you invest in a niche that you're passionate about, you're in a better position to accurately predict a company's future, analyze their risks and find potential areas for growth, evolution or improvement.
There's no real science behind startup investing, but these seven guidelines will increase your chances for success as a venture capitalist. By following this list, you can identify which investment opportunities that are worth your time and money, and which are not.