[Editor's Note: This is a “Part II” guest post on the subject of high risk investing. I've written before on investments for accredited investors here and here. This is written by DJ Verret, MD, FACS, plastic surgeon. I have no financial relationship with Dr. Verret.]
When considering an accredited investment, due diligence is essential to determine if the investment is right for you. There is no set formula that will work for every company and even with the best diligence there is a still a reasonable risk that the investment will fail to return what is promised. The first step in the process starts before you even go looking for investments. Set up a framework to evaluate what investments you are looking for. Consider risk, area of investment, expected return, and timeframe for return. For instance, risk tolerance may be an issue so you want a relatively safe investment with recurrent dividends and 5-10% per year return. This thesis would be appropriate for real estate investment. On the other hand, if you have a high risk tolerance and want a 2-5 times return on investment in a 5-10 year timeframe, look for startups to invest in. Once you have decided on an investment objective, now it is time to evaluate potential investments. For this discussion we will consider equity type investments in non-real estate ventures.
When you go to buy a car you are looking for a reason to buy one car over another. In investing, even though you have made a decision to invest in a certain area, due diligence should lead you to why you should NOT make an investment and if there is any reasonable reason that you should not invest, don’t. There will be more opportunities around the corner.
When I look at equity investments, I consider four areas during first review: product, competition, management, and business plan.
For this discussion, product is a broad term which can mean an actual product or maybe a service that the company is offering. The product should be something this is desired and understood. When starting, look for investments in your field of expertise. This will make the product easier to understand and the potential market easier to determine. If it takes more than 30 seconds to understand what the company is trying to accomplish, move on. Unique ideas should seem unique on face and a company should not need to convince someone in the field that the product is a good idea.
If the product seems like a good idea then ask what is the barrier to entry for other products, basically what prevents a bigger company from doing the same thing once the product becomes known. The answer may lie in the intellectual property of the company, patents or trade secrets, or the particular knowledge of the founders. Beware if the answer is that the company relies on the special knowledge or ability of one person. In a solo doctor practice, if the doctor is incapacitated, the practice dies regardless of the previous size. Similarly if a key man is incapacitated in a company the company may not succeed.
If the product seems like a good idea, the next question is what is the market for the product? Consider who is going to be buying the product and how many might be bought? What is the potential market price for the product? Can the company make a profit given their cost of production and the potential sales price? Companies will invariably give a rosy picture of the market for the product but you have to ask yourself, “Is it even possible to capture that market?”
Competition is another part of any market evaluation. Competition may be someone who does exactly what the company does, like a restaurant, or it may be someone with a similar technology that achieves the same result. Determining the competition is important for a number of reasons including determining how difficult it will be to enter a market and who may be interested in buying the company once it is successful. Determining who and how strong the competition may be is only the first step. Next is to determine if the competition is a barrier to entry. For instance, Beverly Hills has a lot of plastic surgeons because there is a lot of demand for plastic surgeons. Could Beverly Hills support another plastic surgeon even with significant competition? Likely. On the other hand, there is no competition for plastic surgery in Pampa, Texas. Even without anyone there, could Pampa support a plastic surgeon? Not likely, and this explains why there is no competition.
Even with a great product, bad management will sink a company. Learn as much as you can about the management – previous experience, personal relationships – and like any job interview get and check references. Now with social networking programs like LinkedIn, contact associates for information about the person. Beware of inventor CEO’s and anyone who is not 100% committed to the company. If the person has a day job and only works for the company part time, run the other way.
Any good company will have a good business plan which outlines each step of the development process and ultimately how the company will repay its investors. When evaluating the business plan asks for specifics. Who is going to make introductions to target markets? Where are additional fund raises going to come from? What contacts will be able to make introductions to potential buyers? If the path to success is not clear, don’t invest.
Finally, when evaluating any investment, do your own homework and ask questions. Rely on the company and other people to a certain extent but do your own research. Search for competitors. Talk to market and scientific experts. Don’t trust that the company even knows everything about its market or potential opportunities. If company management does not want to be transparent about the operations, finances, or cannot answer questions about the business plan, don’t invest.
What do you think? What steps do you take when doing due diligence on an “accredited investor only,” small business, or start-up investment? How have you done on investments like this? Comment below!