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.
I’d recommend Friend B to ask about the company’s trademarks and other intellectual property. If the company has developed its brands then it should file an “intent to use” trademark registration application and make certain that their brand can be protected and also determine if there could be any TM infringement issues. Too often companies say they “have patents” – which could really mean that they have a draft of what could be turned into a provisional patent application. That means they’re 3+ years from an enforceable, issued patent, assuming they can even get one in a post-Alice decision world.
Sort of related to point #7 – is Friend B an accredited investor and is the company limiting the offering to only accredited investors? That could affect the company’s ability to claim exemptions under Regulation D, and even affect the company’s budgeting if it has to produce the financial statement disclosures under Rule 505.