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Investing in a Startup business

Discussion in 'Other Asset Classes' started by Mumbai, 18th Sep, 2015.

  1. Mumbai

    Mumbai Well-Known Member

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    I have been following a startup business up closely and they seem to be doing good. They are now looking for a second round of investments and I am thinking of investing in it. I have 'googled' and checked for the 'things to know before investing in a startup'. I see the potential in the startup, but that is all i know at the moment.

    I am planning to meet the founders to go through the 'understanding' part first before I step into the 'investing' part. I know that I will need a lawyer sooner rather than later. But, even before engaging one, I want to decide whether it would be a good idea.

    The next part of the question is about actual investment funds. I have some equity built in IPs that I can use. I am not sure whether I can pull out the equity for this purpose. If yes, if this would be on the same rate/conditions as any other investment, Will it be tax deductible, etc.

    Have any of you invested in a startup with or without a successful outcome? Can you please share words of wisdom for my next steps?

    Thanks,
    Ra
     
  2. BuyersAgent

    BuyersAgent Well-Known Member Business Member

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    I am in various stages (very small actual amounts don't get too excited) of helping out 2 or 3 small startups, 1 with cash only, 1 with cash and ideas, 1 with cash and ideas and quite a bit of time. I would call myself a beginner in this arena. My early thoughts...

    1 - Study yourself. What is your attitude to risk? If you are afraid, and losing sleep over the possibility of losing cash its not for you.
    2 - Treat it as a learning exercise and fall in love with the due diligence process if you can.
    3 - The directors character is everything. Study that.
    4 - Their ability to manage and track little things like costs count to survival.
    5 - I need to see a willingness to generate actual cashflow, not just make art (even though it seems many startups are started by "artists" in their field)
    6 - It would appear that marketing is hugely important to success of an enterprise so if you can help them with this it might make or break them.
     
  3. Mumbai

    Mumbai Well-Known Member

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    Thanks Matt. As usual, your response was great. I am weighing pro's and con's and also assessing my appetite for risk at the moment.

    Anyone else has any experience or knowledge to share on this topic?
     
  4. larrylarry

    larrylarry Well-Known Member

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    Like what matt said. I'm a business owner and cashflow is very important. If start-ups cannot provide and support their sales projection and costs of running then I will not touch them. Always ask what's the worst scenario? Also what's the level of involvement you will have or allowed to have? It's not a set and forget thing.
     
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  5. The Y-man

    The Y-man Moderator Staff Member

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    @Mumbai

    When you say "they seem to be doing good", is this financially?
    Long before you get to the lawyer stage:
    1. Why are they needing the second round of finance? Is it planned or unplanned
    2. Obtain the financials (p/l, b/s, cfs) - how is it tracking to budget?
    3. What is the forecast for next 3~5 years?
    4. What is the current valuation of the business based on discounted cash flow?
    5. What is the equity stake being offered based on your investment? Is this amount fair based on the valuation and forward risk?
    6. Are there any plans in the future that may dilute your equity stake?
    7. What is the exit plan, and how long? What are the anticipated returns for you?
    8. What will you be liable for if the business fails?
    The Y-man
     
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  6. Mumbai

    Mumbai Well-Known Member

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    Thanks all.
     
  7. Mumbai

    Mumbai Well-Known Member

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    I have done the due diligence and found the startup worthy of investment. I am using the equity of one my IPs to fund this investment. Anything I need to be mindful of with regards to tax?
    Will the interest of this loan be tax deductible? Can anyone recommended a lawyer to get this contract validated?
     
  8. Player

    Player Well-Known Member

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    Hi Mumbai,

    in addition to Y-Man's excellent points above, you need to be prepared to lose your investment.
    Are you comfortable with this? Can you afford to lose your funds (cash or in your case equity)?

    Ideally whatever you are looking at you should be very familiar with the nature of the business (product or service) so you will actually have some input into the expertise of the domain/industry of this business. If you are merely a passive provider of funds and only looking at one investment of this nature, I don't consider it prudent.

    I have invested in three separate start-ups this year(all angel funding so early entry). My intent however is to have an eventual portfolio of 15-20 of these by adding to the stable slowly when the right thing comes along and I am comfortable with my due diligence and the people involved. The amounts I am putting in are small (circa 20 K). If one looks like a goer I would go harder at future funding rounds. I am only using cash that if I lost it.................no skin off my nose. If I were to put in larger amounts say 100-200 K I would need to have direct input into the business through adding to the skill/knowledge base. In that manner I would be able to keep my finger on the pulse. I haven't come across anything that fits this bill yet.

    I don't know what you overall net worth is, however using equity (which you could lose entirely) for one investment is extremely high risk and in the industry is called "stupid money." No offence, this isn't my terminology. Unless you are obtaining income from the equity position you take (which doesn't sound likely as your intended start up needs capital to grow), I doubt you could claim interest on the LOC or offset funds you use. Take this with a grain of salt however and seek professional advice. Also be very wary of what you sign by way of future dilution and other options and granting of shares that the founders/directors may have up their sleeve. You must read everything.

    Start up investing needs to be diversified and spread out so if one or two come home to be 10 or 20 or 50 baggers or more then it offsets the losers that may occur from the other (say) 10 in the portfolio.

    Hope this helps. It isn't for the faint of heart. The rewards can be high at angel and seed rounds and not too bad at further more advanced rounds but the risks must be matched with your comfort with loss. Also you must be comfortable with a lack of liquidity. If you are not so hungry for risk consider dividend paying stocks and maybe take a punt on a tech or biotech that looks like it might go places. Stocks generally offer liquidity.

    The above is not advice, merely my 0.02...................
     
    Last edited: 14th Oct, 2015
  9. Mumbai

    Mumbai Well-Known Member

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    Thanks Y-man and Player for your detailed responses.
    I did the DD based on the questions Y-man mentioned and decided that they have good fundamentals. However, while checking with my broker, talking to other people who have done this before, I got responses similar to Player's.
    As you can see, I am not planning to use my 'cash' to invest. I will be pulling out equity. This involves refinancing one of my IPs and then extracting equity. All this to enter into an uncharted territory (well, at least for me).
    I also checked with my tax accountant, that this is not tax deductible as it won't be generating any income (for a while).
    Based on these points above, I have again 'decided' not to go ahead at this point in time.

    I will still be going ahead with refinancing and looking to purchase IP4 by end of year. If there is still some surplus equity releases, I 'might' invest 20k to test the waters.

    Thanks all.
     
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  10. The Y-man

    The Y-man Moderator Staff Member

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    Good that you took the time to check carefully.

    The Y-man
     
  11. BuyersAgent

    BuyersAgent Well-Known Member Business Member

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    Thanks for updating us @Mumbai well done for thinking first whatever you end up doing later.
     
  12. Planning Permit

    Planning Permit Active Member

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    Be prepared- if its goes south you will be OK. If investing in India- do the DD thoroughly- over and over again. Idid not and paid a big price
     
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  13. Mumbai

    Mumbai Well-Known Member

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    Thanks AA. It was not in India and I have decided not to go ahead atm.
     
  14. MBowen

    MBowen Active Member

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    Sorry for my naïve question. How would it work for example? Would you lend the company say 50k for a share in the business or would you lend them the money and they pay you a hefty interest rate in return or both have a share and get some of your money back? I don't want to hijack the thread but my husbands parents offered us a loan to our company when we originally started up. It was just we needed to pay an extra 1.25% on the standard variable rate they were paying as they were extracting it from an IP. We didn't end up doing it as we weren't confident in the business and didn't want to get family involved alas it did go well :). Could we do it this way to buy property. For example if we bought a property out right with our profits and then our family lent us money and we secured the 1st property as security for them. Paid them a higher interest rate. With the money they gave we buy a second property and another family member could lend us money which they cold have the second property as security. The cons would be obviously a higher interest rate. You would Really need to pick a cashflow and capital growth property to make it work
     
  15. The Y-man

    The Y-man Moderator Staff Member

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    There's 2 types of financing for business: debt based and equity based.

    A "loan" is debt based (and appears on the balance sheet as debt). The company pays interest.

    An "equity investment" is where the investor gets shares. They may be paid dividends (share of profits) as determined by the directors. They may be able to sell out of the shares at a later stage. Basically, they may see no money back for years (but then they may see it big for example if it is listed).



    Completely different issue to above IMHO.

    You are just doing a normal loan with a non-bank lender.

    The Y-man
     
  16. The Falcon

    The Falcon Well-Known Member

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    And the other option is that the investors capital is treated as a loan, to be repaid from free cashflow at an agreed rate. The outstanding loans act as dividend blocker (set out in the shareholder agreement). After loans are repaid, the investor still holds the equity. I've been on both sides of this set up.
     
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  17. Pins

    Pins Well-Known Member

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    Hi @The Y-man @The Falcon and @Mumbai

    I have the potential opportunity to invest in the business that I work in probably through a mix of cash and foregoing of a % salary.

    I'm pretty involved in the business, but I haven't had a formal discussion in terms business valuation, financial etc. I've just discussed having the opportunity to review that kind of scenario.

    I am trying to work out how much cash I would be able to invest, but I wondering, how hard would it be more me to get a loan to help fund my investment in the business? I know you don't know anything about my financial situation, but I don't have any sense of whether this is something that's possible to secure? I know the business has had trouble securing bank funding but we are in the process of securing some private funding.

    I will get some formal advice on Monday but wondered if you guys had any thoughts here?
     
  18. The Y-man

    The Y-man Moderator Staff Member

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    Personal Loan and credit cards come to mind..... unfortunately very expensive.

    If the business had trouble securing finance, it's unlikely they will fund you against the shares. It would be good to find out why the funding was knocked back. While banks will be extremely risk averse in this sense, it would be good for you know the risk analysis they did - as they will become risks that you take on.

    Start also understanding concepts like options and convertible securities, as they may talk to you about them.

    The Y-man
     
  19. Player

    Player Well-Known Member

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    Are there any yellow flags you are missing or are unable to disclose to us here? I'd be thinking very carefully about what you're about to do. A short term equity contribution of cash or in kind from salary sacrifice might just be financing them to keep the motor running. Are you privy to all the financials?
     
  20. Pins

    Pins Well-Known Member

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    No its not like that. I'm not rushing into anything and its onlu an opportunity because I've asked for it as they are doing an investment round.