3 Questions you must ask before investing in your buddy’s startup.

“Dude!  I’ve got a can’t miss opportunity!  I’m coming to you first because we’re bros!  It’s a home run!  When this thing goes public, we’re both going to be driving Maybachs and picking our teeth with unicorn horns!  A giant mutual fund is looking to get in.  They’re going to close the raise soon.  You won’t be able to get in later!”

If you have never encountered this before, you will at some point in your life.

I’m all for private capital raises.  If it were not for private money supporting great ideas, much of what we enjoy today would not exist.

But before you cash out your kid’s education fund and toss it at your buddy, ask these 3 questions…and then go and discuss it with your financial advisor.

1.  How am I going to get my money back out?  There’s no need to question them about the marketplace, competition or the ridiculous sales projections yet.  Just ask them when and how you will be able to cash out the profits. Here’s the thing about private investments; there’s no market place to sell your shares.  You may never be able to cash out.  At least not until the financing has been restructured down the road.  If your buddy tells you that you can cash out when he goes public, know that you have a better chance winning the grand-prize with those ‘scratch-em’ lotteries.  A properly structured financing will have clear exit plans for investors.  They may not be ideal or easy to achieve, but at least they’ve been considered.  And this is only if the company stays viable long enough to become profitable.

He told me they were going public on the Liberia exchange...

2.  Do you have any sales yet?  In most cases, the answer is ‘No’.  And that’s OK.  Because frankly, if he had sales in his startup, why would he need your money?  The key question to ask is ‘when’ does he expect to sell something.  Followed by ‘how’.  Everybody will tell you that they know someone in some big organization that’s going to be their first big buyer.  It might happen.  But most likely not.  There are no rules-of-thumbs for sales despite what experts tell you.  There are too many variables that go into the successful commercialization of a product or service.  Billions of venture capital dollars have vaporized from poor startup investment choices.  And these were critically assessed by accountants, bankers and people with lots of letters after their names.  So no, nobody knows anything with 100% certainty.  A properly prepared pitch will detail how, where and when sales will come but really, it’s just best guess efforts.  The marketplace ultimately dictates who wins, not a Power Point presentation.

3.  Do you have any other investors?  Will you be paying them off with my investment?  Look him right in the eyes and ask.  This happens sometimes, especially in unregulated private fund raisings.  This is illegal.  If your investment dollars are spent to pay the gains on other people’s investments, there’s a problem.  If your buddy is promising you investment returns without sales, there’s a problem.  The only way you can make money in a private company without sales is by finding a buyer for your shares.  If your buddy is stressing investment return over actual business fundamentals (i.e. the product itself), get a few other opinions or politely walk away.

But remember this…

Just because your buddy can’t answer the first two questions to your satisfaction,  it doesn’t mean he’s dishonest.  It just means he needs to do some more homework.  However, if his answer to #3 smells fishy, get more eyes on the deal.  Know your rights about private investments before you sign a cheque.

Never, ever feel pressured to invest in a private company.  If anybody tells you it’s a ‘once-in-a-lifetime’ opportunity, they might sincerely believe it.   But to be frank, if you have money, you can see three ‘once-in-a-lifetime’ opportunities before lunch every single day for as long as you want to.

The next Apple is definitely out there.  Just know the odds before you jump in.

M

P.S.  Some would argue that all of capitalism fundamentally works like #3.  I’ll leave that for people smarter than me to discuss.