Like anything in life, it’s important to approach new opportunities cautiously. Whether that’s deciding on what college to attend, taking a new job, or buying a new car, we must do our own due diligence to make sure we have the greatest chance of success. Investing in a start-up company is no different.
But what exactly is due diligence and how can you take steps to mitigate risk when investing in a new company?
In simple terms, due diligence is investigating into a potential investment to confirm facts. With facts, you can make informed choices, and informed choices increase your chances of securing a favorable outcome in the future.
To help you get started, we’ve pulled together five key considerations in undertaking due diligence for start-up investments.
1. Your Finances: Before making the decision to invest, it’s important to be aware of your financial situation. This means being honest and asking yourself whether you can actually afford to invest. If money is tight, or you would face financial hardship if the investment failed, it’s best to hold off.
2. Risk Tolerance: Everyone’s risk tolerance is different. One person may feel comfortable investing in a start-up venture. Others may prefer to put their money in safer investments. Therefore, when undertaking due diligence, it’s good to consider your tolerance to risk as that will help you choose investments most suited to your circumstances.
3. Company Financials: Undeniably, one of the most crucial elements of any investment is the strength of a company’s finances. The due diligence process should include very close scrutiny of the new venture’s balance sheet, profit and loss (income statement), and cash flow statement. If the company isn’t operational yet, look closely at the projected forecasts to see whether they are likely to reach profitability in the medium-term.
4. Competitors: Once you have a good grasp of the company’s financials, it's time to size up the industries and sectors it operates in. A good rule of thumb is to look at two or three peers to size up the competition. Ultimately, every company is defined by whom it competes with. By assessing the competition, you can determine whether this new venture really does have a unique selling point.
5. Legal Issues: By understanding the company’s finances, competitors, and the market at large, you have the foundation to make an investment decision. The final piece in the jigsaw puzzle, is to evaluate all the risks associated with the business. For example, are there any outstanding legal or regulatory issues? Are there any pending patents or licenses that haven’t been approved yet? By looking at the legal and regulatory risks holistically, you will be in a great position to make an informed decision.
*Nothing in this article should be considered legal or investment advice. Startup investments are always inherently risky and following the advice in this article will not necessarily reduce that risk.