Venture capital has emerged as one of the most popular asset classes in finance. Unlike energy, banking, transportation that require huge investments and are thus restricted to big players. Tech start-ups do not usually need more than a few million Dollars. This has opened up the field of equity to upper-middle-class investors and small and medium-sized private equity firms.
However, venture capital, unlike traditional investment vehicles is highly risky. Usually, returns are around 30X the initial investment or even higher. But, about 65% of start-ups fail. And it is not uncommon for private equity firms to make losses on 80% of their portfolio, covering for those losses with gains from the remaining 20%.
You should know though, that, making a profit on 20% of your portfolio does not happen by chance. You have to put in massive diligence to selecting every company in your portfolio. Below, I have written 3 of the most important checks that you have to do.
Conduct Due Diligence on the Founder’s Personal History
As we have seen with a lot of multi-Billion dollar companies, regardless of the brilliance of the idea, the founder’s personal qualities are very important to the success of the company. From Facebook to Apple and Tesla, the pattern has repeated itself enough to be taken as truth.
One example is Carly Fiorina’s tenure at HP. While she wasn’t exactly the founder, she was CEO which is basically what founders are at their start-ups. She led the company to merge with Compaq. An ill-thought merger that nearly tanked the company. And 30,000 employees had to be laid off, all of these while Fiorina took out heavy executive compensation for herself.
Due diligence on a potential portfolio company’s founder will uncover any tendencies inimical to the success of the start-up. Regardless of the brilliance of the idea, a founder without the right personal qualities will lose you money.
Check if they are Solving a Problem
The selling point of start-ups and capitalism, in general, is that ideas make money. Anyone with bright ideas for solving a problem gets rewarded for it.
Gerald, a maverick financial analyst with a private equity firm, was getting ready to sign off on a $1Million investment in what he thought was a brilliant start-up. He suddenly got the idea to call the start-up’s supposed clients to cross-check some information, only to discover inconsistencies in their stories.
The founder had already known the type of questions that would be asked by the equity firm and had set up a network of his friends and family to tell perfect lies. The sham came apart because Gerald thought to ask different questions.
Before you invest your money in a start-up, check that they are solving a problem. A lot of people set up bogus products to fleece investors. And even when there is a product, the product’s ability to solve a problem will determine how successful it will be on the market.
Ensure that the Company has the Technical Competence to do the Work
Anyone can have bright ideas. And if all you are watching for are bright ideas, you will lose money to founders who do not have the technical capacity to deliver on their bright ideas.
Anyone who talks about futuristic tech; electric vehicles, renewable energy, eco-friendly alternatives, and the like, will be hailed as visionary. However, as a portfolio manager or angel investor, you have to be sure that the founder and the start-up have the technical capacity to make working products.
One very recent example is Nikola. The company has presented only concepts of its zero-emission vehicles in its 4 years of existence. In a weird twist, the company is worth about $23 Billion, despite not having any revenues or even products. However, it is left to be seen for how long it is going to last.