Let’s say the company or project you’re evaluating has a solid financial model, the management background and experience is outstanding, and you believe there’s have a unique, and competitive edge to succeed.
Are you ready to write a check, and invest your hard earned money? Before your check soaks up any ink, ensure that the valuation and capital raise is as reasonable as the business plan you were presented. Here are the four questions any investor should know before writing a check:
#1 How much capital is being raised?
A well-thought-out, financial model should provide the necessary information to determine a “cash runway”. Is the capital raise, based on the goals and objectives of the company, able to reach a sustainable cash-flow to repay the principal of the investment? Or, does it look like the company will require additional capital raises? If there’s more money required, after the initial capital raise, you want to ensure the company can hit goals that will elevate the value of the company, and therefore your share of the invested capital.
It is always the question of whether the company is raising too much or too little. We found that most companies require additional funding, and thus must gain additional value to benefit your original investment. This doesn’t mean it must be reached in dollar amounts, or income in the beginning phase of an investment. It can be minimizing risks, proofing the concept, developing a go-to-market prototype, gaining followers and first-movers, or other forms of progress that presents value to you. In other words, you want to add the right amount of fuel to the engine knowing the car will reach the next gas station to fill up, or make it all the way home.
No matter the case, the company’s forecast and capital raise should offer concrete results and prove value for you as an investor.
#2 How long is my investment capital tied up for?
Time is money. For any investment, you need to know how long you’re committing to. A long-term investment (more than one year) has different tax implications than short-term investing. Nevertheless, most alternative investments are structured to be long-term to capitalize on the growth projections. Knowing how long your funds are with another company is part of what let’s you set a price tag on utilizing and holding those funds. What you’ll be getting in return (question #3) is the rest of the formula, which allows you to compare the investment to other investments alike.
Investors want to make sure their money is making more money. The longer the timeframe, the higher the chance of competition, economic climate changes, government regulations, or other variable that could affect the success of the venture. This increases the risk of the investment which will require more favorable terms and a better return on investment.
#3 What returns are being offering?
The return on investment (ROI) is the shiny object some investors tend to follow, instead of addressing the big picture. Nine out of ten times it is too good to be true. Those are some significant odds against you. High risk equals high reward makes sense only if the company you’re evaluating has a clear vision, a solid team to execute, and the resources to fulfill the tasks required to reach the goals. Just offering a great return isn’t enough to validate it will happen. Financial projections, and market size will shed some light on whether returns of “X” are reasonable both in achieving it through penetrating the market, but also without constraining the company’s cash-flow.
Here are the three ways to make money:
Debt / Interest: you’ll know exactly how much money you’re going to earn. You receive payments on the capital you invested, as long as the capital is in the hands of the company you invested with. It is very common to see a two or three year timeframe in which you’re receiving steady payments, and at the end your initial capital investment returned. This is often used by companies that have a steady income stream, but require additional capital to expand/grow the company. Investors that favor interest payments (debt option) look to receive residual income on their investment, and a return of their funds at a set date.
Equity / Dividends: you receive a share of what the company makes. If the company did well, you will do well. Unfortunately, also the other way around. Companies in early stages of developing their vision may only raise funds in exchange for ownership in the company. This allows the company to maximize their revenue, and grow the business, without incurring interest payments of a loan. Investors that favor dividends are interested in owning assets, growing with the company that they believe in, and equally prosper when the company succeeds.
In essence, it’s all based on risk vs. reward. The higher the uncertainty of the investment, the higher the return. Nevertheless, it’s critical to know the company you’re investing with has the foundation of a company that can succeed.
#4 What is the worst case scenario?
Obviously, any investment has bumps in the road and is constantly full of surprises. You want to know the company is aware of that, and can offer some insight on the worst case scenario.
In almost all instances the entire investment is at stake (don’t invest money you cannot afford to lose). There’s also the potential to regain value through assets a company has acquired or developed. Either way, the more you are aware of the various elements that can impact the company’s success, the more likely you are to make a sophisticated decision.
Any private placement memorandum will have risk factors, and all the variables that can come between the promises. That’s the legal explanation. If an investor knows the risk and understands all capital can be lost, it allows them to plan accordingly.
Ensure that the company you’re evaluating is able to gain additional value that contributes to your success as an investor. Clarify with yourself if you can afford the investment. Sometimes it is the time the funds are at work that hinders an investor to jump on an opportunity.
Back into the numbers on the financial model. Is the company able to reach greater value, or sustainable cash-flow, within a specific timeframe? Are the milestones reasonable and achievable? Each investor has different goals and objectives as to why they invest in the first place. Any investment you are evaluating should take you one step closer to achieving your ultimate goals. Always perform your own research and due diligence of a company. Don’t just believe what you read online is true. Validate things, and determine the credibility of the sources. At the end of the day, it is your hard earned money you are investing.
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