Five questions to ask before you invest

November 21, 2013, 2:55 pm David Koch Yahoo7

It's not unusual to be offered the opportunity to back a new business idea. Here's how to tell if it's a good one.

The Australian startup sector is really heating up, and with so many great new businesses beginning in garages, bedrooms and co-working spaces around the country, it’s not unusual to be offered the opportunity to invest in an idea.

And that’s great. Who knows, it might be the next News Corp, Twitter or Candy Crush your son/brother/friend/uncle/workmate is getting started.

However, investing in a new business is not as simple as loving the idea or a slick sales pitch and reaching into your pocket. Here are 5 questions to ask before investing in any new business.

What’s the exit strategy?

Every business should be planned with exit in mind. This might sound a bit downbeat, but it ensures the business is built with good processes and procedures that allow it to be efficiently run by any buyer. And when it comes to selling out of a business, this becomes crucial.

On that note, any business partnership or investment must include agreement on the procedure if one partner or investor wants to sell their stake. This clears up any valuation disputes down the track or potential sales to unwelcome investors.

Who are the key players?

The track record and reputation of the people at the wheel is very important. A great business can be run into the ground very quickly by poor management, so their ability is just as important as the business itself. You also want to see the founders keep some skin in the game with a decent chunk of ownership of the business – this helps keep everyone’s interests aligned.

It’s also worth looking into who the other investors are and what the ownership structure will look like after the business has finished getting investors. As a co-owner of the business, management is accountable to you and the other investors, so ensure they’re of good mind and reputation too.

Do the numbers work?

It’s a nice feeling to invest in the business of a friend or family member. But emotion and trust is not enough to make an investment decision. You’ll be wasting their time and your money if you fund a venture that’s bound to go belly up, so make a thorough check of the numbers before getting the wallet out.

This isn’t just seeing a short sales record and the potential for more... it’s a close look at whether the venture can provide a fair return for the risk you’re taking. A common way to weigh up financial projections (which any new or established business should have), is to look at whether the numbers work when sales are below expectations or costs blow out above what’s budgeted.

By making a conservative assessment of the base case for the investment decision, hopefully the only earnings surprise will be a positive one!

What’s the market plan, Stan?

A great product or service is of no value if people won’t pay for it, whether that’s in sales, sponsorship or licensing. So the other question to ask a business is what the market looks like and how they plan to capture it.

Again, this is basic information that every business should have on hand... customer profiles, competitor analysis, market positioning, marketing strategy... all evidence of exactly why their business will flourish.

A lot of this information forms the basis for the forecast numbers you’ve reviewed, so ticking off each of these inputs and the reasoning behind them is just as important as testing out the forecasts.

Do you know what you’re dealing with?

The fifth question to ask is of yourself. After looking at the opportunity and understanding exactly what the business involves, be sure that you understand what’s involved and the area the business is operating in.

For example, investing in an app building business makes no sense if you don’t own a smartphone, like buying into a pet shop is a poor call if animals aren’t your thing. As a potential business owner, a working knowledge of the area is crucial. An expert background is even better.

So when the next opportunity comes knocking at your door, don’t be swept away by the idea of quick riches on the back of the ‘next big thing’. Take the time to ask the right questions, and if you smell even a small rat, close the door.

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