Why Is Due Diligence Important?
Startups are inherently risky places for investors to put their money, as many fail before fully launching or don’t live up to the great expectations of their founders or backers. This means investors need to be fully aware of the risks they are taking on be placing their money in a startup before making a commitment. Conducting your own research about an investment opportunity can provide you with added protection and may alert you to dangers or opportunities a startup’s owners may have missed. Investors who don’t conduct due diligence before making a commitment can see a low ROI or even a total loss of their investment.
Is It Proprietary?
A startup might make a good coffee, but if their intellectual property isn’t proprietary, there’s nothing stopping another business from selling the same thing. Check out competitors, if there are any, and find out how the startup in question’s product or service differs from them. You’ll also want to ask the startup founders as much as you can about their product to determine if it can be easily replicated by another company or if it would be protected by copyright.
Check the Financials
One of the most important things to do is to ask about the financials of the startup in which you wish to invest. Not all startups are alike, and a promising startup in its early stages might have negative cash flow, whereas one that has moderate potential might have a robust balance sheet. You’ll want to consider how much risk you’re willing to stomach and what kinds of financials you’re willing to accept. If a startup lacks sufficient cash flow or is excessively leveraged, it could fold under financial pressure before you ever make a return on your investment.
Interview the Startup Founders
You can learn a lot about a startup’s prospects for success by simply interviewing the founders of the startups you want to invest in. If there is only one founder, do they have the skills to build a team that can see their vision to completion? For startups with multiple founders, how well do they work together and complement one another, and what are the contingency plans should some of them decide to exit? When you invest in a startup, you’re investing in the people at the top, so you want to have the utmost confidence in their ability to deliver.
Conduct Market Research
You might be enamored with a startup’s product or service, but that doesn’t mean others are. How strong is the demand for what the startup is offering? You could find that you struck gold, or you might find that the founders are over-optimistic. Once you have a better sense of the demand for the product, you can get an idea of how capable the startup is in scaling to fulfill it.
Ask About Their Marketing
Even if the startup has a dedicated team of founders with a product that has massive potential, they still need to be able to sell it. What are their plans to market their product? Do they know who their customers are, and do they have an effective strategy for reaching them? What is their plan for scaling to meet demand should business take off?
Talk About Long-Term Plans
Your relationship with the startup today might be on solid footing, but where will it be in six months, two years, five years, or even ten? What can you expect as a return on your investment, and how will the entry of more investors affect your position? What exit opportunities are there for you or the company, such as potential buyouts? You’ll want to make sure that your long-term vision is aligned with the founders before investing.