What to Look for When Investing in Startups

If you want a safe bet with little risk, investing your money is easy. Just buy Treasury bonds. They carry practically no risk and are guaranteed by the full faith of the United States Government. However, in exchange for that safety, Treasury bonds return a small percentage of the investment that varies based on the Federal Reserve policy.

However, to have much higher returns, sometimes a multiple of the money you invested in the first place, there’s only one possible way to achieve those returns. That path is investing in more speculative vehicles, such as privately-held companies, also known as private equity.

The problem is this: unless you have a disciplined portfolio strategy, your one or two private equity bets may not work. The companies you invested in may fail. Statistically, this is likely to happen. Investing in private business is very risky, but you are rewarded when a company succeeds.

I am going to try to identify the key principles in deciding how to invest your money when it comes to private companies. In my career, I have done probably over 80 investments, and these principles have worked for me.

I wished I would have taken more risk and invested in more companies, but I was a little too conservative and thus passed on some very interesting companies who later grew into very successful businesses. Without further ado, here are my five things to look for when investing in startups:

#1: The Founders

When it comes to building a successful business, people come first. This means you want to evaluate how focused and passionate a founder or a group of founders are.

It is true that having a strong educational degree from a competitive school is important, but it is not as valuable when it comes to building a business from scratch. What you need to build a business is grit, the intersection of passion and resilience.

When the founders of a company quit, the business has little chance of success. Founders that demonstrate the right amount of passion for the mission are a huge advantage. They are not working for money. The right founders are on a campaign to change the world, to improve people’s lives or make an industry more efficient.

When the right founder talks about their company, it feels very personal, and listening to them speak will inspire anyone they get into contact with. I have heard many times that founders “John Smith and Jane Doe” are crazy because they are not willing to listen or take any advice from experienced professionals. I have also heard founders whose company was bankrupt every 6 months, and yet they never gave up. All of these traits are what you should expect from a very risky investment that becomes a success.

#2: The Team

Besides the founders, you want to see a team of people who complement the skills of the founder. Some founders are visionaries but terrible at managing people. Others are excellent managers but lack technical expertise to build the product they’re overseeing.

You should look for a team with expertise in the areas that the founders lack. Look into key areas of a business, such as product development, marketing and sales. Make sure that the team is well-balanced and has the right tool sets for growth and for building out the product they sold in their pitch.

Founders steer the ship, but the team provides the manpower. Without a dedicated, a startup won’t succeed.

#3: The Idea

When reading business plans, it’s common to see a great idea or innovation, but is it going to be commercially viable? Is the technology or solution going to work once it’s actually deployed? Is the business scalable? A successful business is far more than just an idea; it’s about execution and market-fit.

I like to see patents or proprietary technology which demonstrate the depth of knowledge and creativity from the founders or their technical team. For non-technical companies, I look for a strong sense of the customers and their needs. Sometimes the founders are themselves are the market they are trying to target.

#4: The Competition

It is important to understand the landscape of the competition. Is this idea being pursued by a number of companies? Is there a large business like Amazon poised to enter, or pivot to, the same space and destroy every startup innovator in sight?

Competition is actually important and should not be taken as an outright negative when considering a startup investment. In a way, competition serves as a proof of concept and demonstrates a marketplace and its viability.

No competition is actually very rare when you consider that every startup is disrupting something: Amazon disrupted book stores and then all of retail, Uber taxis, Airbnb hotels. When I was the founder of Acclaim, we built online video games to disrupt the existing video game industry from the 1990s. If a company doesn’t have direct competition in the form of another company trying to do the same thing, there is still the competition of whatever company has the attention of the consumers the startup wants to target.

However, while competition can be a healthy sign, in some circumstances it is negative. If the competition is against a large company that is also disrupting the same market, I become wary of the investment — though it’s not enough for me to discount the investment altogether.

Large companies simply have more resources to put into solving the problem, building the product and marketing it to consumers. These resources reduce the time it takes for a large company to get control over a segment of the market, which means the startup has less time to launch. In this scenario, companies who are not careful can be easily “Amazoned,” swallowed, and taken out of the market.

#5: The Money

I also look for founders who invest some of their own savings into their company, even if it is a small amount (though it is often a big financial commitment from them). Sometimes, the founders are not paying themselves until the business reaches some scale. This is a great sign of personal sacrifice and proof of “skin in the game.”

Good founders are also resourceful when it comes to securing capital. Some will go the traditional routes of VCs and banks. However, this route is hard for most founders because Venture Capitalists are only interested in a narrow segment of founders and ideas. They follow recent trends and require founders to have a high level education or strong expertise in the field they are pursuing as they are looking for the next unicorn valuation in order to deliver promised returns to their limited partners. However, only 5% of VCs provide returns to their investors, so whatever formula they use to predict the winners isn’t necessarily right.

Other founders will target angel investor networks or leverage their friends and family. Others will go to Kickstarter to test out their idea, and after they complete a successful campaign, the business has some capital as well as lots of eager customers. Still others will try equity crowdfunding, which in the 3 years of its existence in the US has helped over 1,500 companies raise capital.

Founders who are ready to explore new avenues for capital demonstrate a strong will to do whatever it takes to win.

Conclusion

Investing money is not easy and requires research and vetting, and there is no way to guarantee success. However, only those who risk can benefit from the next explosive company.

Our country has hundreds of examples of entrepreneurs who were bold enough to believe they could change the world, and they did. Your role as an investor is to back those dreamers, be part of the journey to success, and fund the future.

If I had to do it all over again, I would double down and pursued more entrepreneurs even after their first venture failed. It is never too late. This may be the best time to become an active investor when equity crowdfunding has opened up the gates for everyone to be a Venture Capitalist.

StartEngine is an equity crowdfunding platform. To discover companies raising capital on our platform, visit our Discover Investments page.

What to Look for When Investing in Startups was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.