Once in a while I get the question “What do I need to know about investing in a startup?” The context is typically where Friend A has asked Friend B to invest in Friend A’s startup business. Then Friend B asks me the question. This happens multiple times a year.
It is a fair question. And one that is hard to answer definitively. But, here are some basic things that I would recommend to Friend B to start with:
- How much is Friend A looking to raise in total? Let’s pretend the target raise is $750,000.
- Is there a minimum amount needed to “close” the round of financing. This is a critical question. If Friend B wants to invest $25,000, then there better be some larger minimum amount going into to the company at the first closing. If Friend A took $25,000 from Friend B and nothing else, then Friend B has most likely just flushed $$ down the toilet. The company will be out of business as soon as the $25,000 is spent. So, in this made up scenario, Friend B should insist on a minimum closing amount that gives Friend A’s company at least 6 months (and ideally longer) of runway.
- Can Friend A produce a projection model? Does the projection model make sense? Does the projection model actually show how the funds being raised will be spent (in other words an understandable “use of proceeds”)? We all know that startup projections are essentially best guesses, but the model needs to tell a realistic narrative.
- Why type of legal entity does Friend A have set up? Typically will be either a corporation or LLC. BTW, I have a strong bias towards corporations when it comes to startups raising $$.
- What type of security is being sold? Typically will either be convertible debt or preferred stock (Series Seed or Series A). And does Friend B understand the terms of the security and the deal?
- Does Friend B know much about Friend A’s business and does Friend B truly trust Friend A?
- Finally, is Friend B ready to lose $25,000? Key question!
This is literally the tip of the iceberg. Please add your thoughts in the comments. Thanks.