The Mini Startup Investing Guide for Mom and Pop Investors

Let's say that one of your friends or family members decides to start or get involved with a new business and comes to you asking for an investment. What should you do and how should you evaluate the opportunity? One of the first innate instincts is to get "your friend's back" and to support him, but at the same time you have to reign in your emotional proclivities and apply some logic to an investment decision. The following abridged commentary is for non-financial professionals. If you are a private equity investor or investment banker, then the below is not for you. However, if you are like 99% of the rest of world, then the below information can help you not only evaluate your friend's startup, but can also potentially save a friendship by aligning your expectations with the risk of the investment.

Investment Philosophies with Friends

There are two schools of thought with investing with friends. The first belief is to never mix finances with friendships. Statistically, most startup investments won't end with profits, and even if the rare ventures are profitable, the investor / entrepreneur expectations' are rarely met. The result is that often both sides of this equation lead to a blowout and a ruined friendship. For example, sometimes an investor might have a relaxed personality in life, but can turn into a micromanager and a controlling dictator when it comes to his money. He might frequently ask the status of his investment, constantly provide nonconstructive advice, or feel that he is entitled to external benefits because he invested in you. Furthermore, sometimes when a startup fails, the investor cashes in on this inferred IOU, and will start "collecting" on a never-ending list of intangibles that are lorded over the entrepreneur's head. This lording of the failed investment over the entrepreneur's head can fracture a friendship. On the flip side, even if an investor behaves angelic and does not have any malice or regret about his investment, sometimes the entrepreneur becomes embarrassed from the failed venture and the loss of the investor's capital makes him feel guilty. The only way to reduce his cognitive dissonance is by distancing himself from the friend. Either way, these well played out scenarios are why some investors believe that no matter how promising a startup investment looks, they never invest in close friends or family.

The second contrary philosophy is that you have a moral obligation and an innate longing to support a friend's dreams. It can be a lot of fun to "bet" on a close friend as well as be a rewarding and fun bonding experience. Sometimes receiving investor updates or seeing pictures of a newly constructed site can allow an investor to take pride in knowing that he is helping out a friend. In addition, I can assure you that every entrepreneur can recite all of his friends' names and investment amounts that backed him throughout his different ventures. It is a loyalty issue, a code of honor, which makes one prioritize this investment philosophy. The below guidelines are applicable for the investor who shares this latter philosophy.

Criteria

Assuming that you are open to investing in friends and family, it is still important to have certain financial guidelines in evaluating a startup opportunity. After all, unless money is no object to you, the below can help alleviate your risk while providing transparency on the investment dynamics. The first thing to keep in the back of your mind, is that statistically a startup will fail. The odds of failure are significantly much higher than 50%. Therefore, immediately, the odds of financial success are not in a startup investor's favor. This diversification is why angel and venture capital investors spread their capital around in so many different ventures. They understand that most of the ventures will be failures, yet they are banking on finding that diamond in the rough. These funds get sourced hundreds if not thousands of business plans and startup ideas and have a much greater selection on trying to maximize the odds of finding that business that contains all of the necessary variables of success. Conversely, as a non-finance professional, you might get sourced a handful of startup opportunities in your life. Nothing is guaranteed in life, but the following questions can help you make better educated decisions even if you are investing in a tech startup or a brick and mortar business. While you might not be able to have the opportunity to ask all of these questions, it still allows you to scan for any material showstoppers that could cripple your investment or your friendship.

Sample Questions to help evaluate a Startup Investment

Management (#1 Criteria):

The most important variable is who is running the company. You could have the best idea in the world or throw an unlimited amount of capital at an idea, but if management is inept, the idea won't be successful.

Some questions to ask are:

  • Are the team's skill sets and background relevant to this venture?

  • How do they know each other?
  • How long have they known each other?
  • How long have they been in this industry?
  • What is their track record? (even if they have done similar business models but in different industries)
  • Have they been involved with a startup before? If so what happened? What lessons did they learn from that experience?
  • How are their personalities? Are their personalities synergetic or divisive? Are the team's skill sets one dimensional or diverse?
  • How much of their own capital have they invested? If they did not invest, why have they not invested? If they did, why did they not invest more if they truly believe in this startup?
  • Are there any tangible milestones that are tied to fair economic incentives? If so, what are they?
  • Legal:

    It is exceptionally important to understand the legal documents of a business. For a further analysis you can refer to The Simplistic Importance of Shareholder Docs, yet the below can provide a quick and dirty checklist of what to be on the lookout for.

    • Is your friend the majority equity holder? If so, who else is in the capitalization table? What are the voting rights of the members as being the majority equity holder does not all the time (most but not always) guarantee unobstructed decision making

  • Is your friend a minority holder? If so, then you have to again understand the voting rights of the other shareholders. Are decisions dictated by majority or supermajority voting? Are their blocks of voting alliances? Finally, you have to understand that by investing in a minority equity holder's startup, your capital is most likely completely captive to the decisions of the majority.
  • Are all of the shareholder documents finalized and executed? If not, then do not invest until they are.
  • Does everyone have vesting schedules? If so, what are they? If not, then one partner could easily just walk away from the company and cripple the entire company.
  • Understanding the industry centric legal requirements. If this is a tech or research company, has the company filed patents and if so which ones? If it is a business that is claiming to have a large expected revenue stream from certain customers, then has that contract been conceptualized and executed or simply verbally expressed?
  • Financials:

    Clearly, this is quite an important dimension when analyzing any business.

    • Has management created financial projections? If they have not, then immediately do not invest until they have. They should have created a bear, base, and best case scenario analysis. Even though financial projections rarely translate into reality, the exercise forces the entrepreneur to plan out scenarios.

  • What are the salaries of management? Clearly, cash withdrawals should be nominal until the company has significantly proven itself.
  • How much capital has the company raised? Are you the first person investing or the last? What were the terms of the different investors? Are they the same or different? Why is that so? Are the investments being structured as debt, equity, or a convertible note?
  • What are you getting for your investment? How is the company evaluating this? How do these proposed returns stack up to other investment opportunities that you are looking at?
  • How long will this capital last? What is the company's monthly burn rate? When is it expected that the company reach profitability or break even?
  • Other:

    Non core, but still important questions to flush out.

    • Has this concept been done before? What is the competition like? What has the competition raised? (if those figures are available) What are the comparables to this business model or product? Is the market saturated?
    • Has management thought of a well proposed and realistic marketing plan? Have they tested their go-to-market strategy? If not, what is it going to cost to test it?

    Thus, it is important to ask yourself which philosophical bucket you fall into before engaging in conversations with your friends about investing in their startups. It is totally acceptable if you have an iron belief in not investing in friends as long as you are an equal opportunity denier. But, if you do wish to support your friends, the following should help you better evaluate the investment, potentially save a dear friendship, and quite possibly identify any deficiencies that your friends might be unware of.