Is this company worth investing in?

Thought I’ll just pen this down before I fly off to JAK this afternoon.

I get introduced to entreprenuers every now and then, aspiring people who are looking for someone to finance their startup. I have great respect for them. Its not easy to jump into the great blue unknown with little more than an idea and a belief, and its immensely more difficult to find a private individual who’s willing to stick his neck out to finance the venture.

So how do you tell if a business is worth investing in?

First a disclaimer. I’m still learning and can only express what I would do, which might be completely amatuerish by your standards. But again these are my amatuer thoughts nonetheless, not to be taken too seriously.

I look at 2 things – Risk and return. It sounds overly simple no doubt but so far, there’s nothing I’ve come across that doesn’t fall under one of these 2 categories.

Returns is how much money I will get back. If I put in $10, can I get say $12 after a year which is basically 20%. The higher this figure the better because after I’ve offset it against things like inflation, I have to ask myself if the returns are worth it. As an investor I will naturally shop around for the “best deal” i.e. an investment that gives me the highest possible return in the shortest possible time. All buying and selling in stock and capital markets work on this principle. If the business cannot generate significantly more than a bank’s fixed deposit rate, I might as well put my money in FD which carries zero risk.

Risk is slightly more complex to figure out. Simply put its my assessment of whether I will make or lose my money based on whether I feel the venture will succeed in a given environment. The questions I would ask are is this a rising or a falling sector? Who is the customer? What influences marketshare and profitability? What are the chances that legal or supplier problems might kill it? Is the management team competent? Is there a clear business plan? Is there an exit plan?

To put it another way, even if the promised returns are high, I will avoid putting money into companies that show these symptoms:

• Wants to enter an overcrowded or shrinking industry sector
• Questionable legitimacy (untested products, potential legal problems)
• Single point of failure (if the owner of the trade secret leaves, the whole business leaves with him)
• Very long period to commercialize
• Very long breakeven period
• Products have very short shelf life (fads)
• Cheap to copy
• Questionable management (eg poor attention span, unnecessarily lavish, combative, etc)

Again I’ll stress that I only apply these to small startup companies. For companies that have already gone public, it’ll be about buying stocks in an open market and I would look at a different set of things. I might blog about that later.

A final note. Investors have different risk appetites so what works for one may not work for another. Its not unusual for an extremely cautious investor to say I want some control of the business as part of the deal. Whether shareholder intervention is actually good for the business is debatable but its a reality that many entreprenuers have to live with.