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Looking to Invest? How to Determine Whether an Investment Is Worth It

This article was originally posted on business.com on May 1, 2012.

Investing in a new venture can be exciting. In addition to the potential to make a profit, many people invest in start-ups for the thrill of being involved with helping a fledgling company make its mark. The possibility of funding a breakthrough company is enough to get many investors enticed, committed, and involved.

However, it’s also a fact of life that many, if not most, start-up companies fail. Alongside that, some investment opportunities are fraudulent, being promoted by people only looking to swindle you out of your money and then move on to pursue other ventures (and victims).

This can be the case even if it appears on paper that the company has a fantastic business model, an intricate plan, or even an extensive list of key assets. While not all promoters of start-up investment opportunities are out to do such a thing, the smart investor needs to gather important information before considering investing in a business – good or bad.

  • Determine if the Promoters are Legitimate: Conduct a Google search on the person promoting the opportunity. If the person is in the financial industry or works as a securities broker, check out his profile on brokercheck.finra.org. If you find any history of securities law violations, fraud, lawsuits, or criminal conduct, it should function as a huge red flag. A history of bad conduct means the company is likely to continue with such actions in future endeavors.
  • Ask for the Company’s Offering Memorandum or Financial Statements: If the company doesn’t have some kind of offering memorandum or due diligence packet, that’s a red flag, as it alerts you that the company either is unwilling to provide information to potential investors or simply lacks the patience to put in the work the goes into compiling such information. That being said, a small company may not have the money to produce a formal offering memorandum; in this case, you should ask for its financial statements. These should be prepared by an outside accountant in order to provide some degree of independent verification. The reliability of such documents is further enhanced if they’re audited. Finally, it’s also a good idea to require copies of past tax returns in order to verify their claims.
  • Obtain a Copy of the Company Business Plan: A company’s business plan is the ultimate road map that will guide a company to success. Not only does it provide the main objectives of the company, it also tells you the demographic they’re marketing their goods or services toward, along with the resources it will take to accomplish the company’s plans. Companies that take the time to prepare a business plan have demonstrated that they have put some thought into how they are going to use your investment to produce a profit.

As an investor, you should have an informal team consisting of a lawyer, an accountant, and an investment adviser (one who’s paid a fee to advise you, not a broker who receives a commission on the sale). Your lawyer(s) should specialize in business law – don’t use the family lawyer who wrote up your will. Having a team can be very important to you, as an investor, in several ways:

  • Negotiations between You and Company: If the deal is negotiated between you and the company, rather than a prepackaged securities offering made to a number of investors, a lawyer experienced in start-up finance can help you negotiate protections and better terms.
  • Understanding the Contents of Legal Documents and Disclosure: Your team also will be able to help you understand both the economics and the legal terms of the transaction. Having an investment team is important when it comes time to review the documents binding you to the start-up. If you don’t understand something, your team of advisers is there to help. You pay them to help you sort through confusing and complicated issues.
  • Establishing Credibility: Having a team is not only smart for legal reasons, but it also lends you a level of immediate respect. Parties without lawyers show they don’t take themselves seriously, or don’t have the means to prepare their documents in a professional manner. In addition, if the other party drafted the documents without a lawyer, the documents will likely contain serious problems and key issues will be overlooked.

If you’re an individual with a high net worth, it’s beneficial to join an angel investing group. These are local organizations comprised of individuals looking to invest in promising companies. Joining such a group is beneficial, as it allows you to compare your notes about the companies with other potential investors. It also allows you to invest more money as a group.

While investing in a start-up company can be a gamble, proper investigation and preparation, from researching the promoters to working with your investment team, will allow you to make smarter and more profitable investments. The better investments you make, the more likely you are to invest in that breakthrough company.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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