Investing in other businesses can be profitable or unprofitable depending on how well you understand the basic investing rules. If you want to be a successful investor, here are the rules you have to follow to assure yourself success in your investment journey:
Understand your financing options before funding
We have three basic forms of funding that you can pursue as an investor. They include:
- Convertible debt
Each one of these methods has its own pros and cons, and there are situations where one is better than the others. As an investor, you have to examine all these options closely and determine which one is the best fit. Here’s a brief overview of what each one involves:
When you pursue equity financing, it means that you will get a stake in the company you’re investing in and its performance moving forward- in exchange for the money you provide now. The company sets a certain valuation of their company. Based on that valuation and the money you’ll be willing to spend, you get to own a certain percentage of the company’s stock. You’ll receive the appropriate compensation when the company sells.
This involves lending out money and receiving it later along with its interest. The company specifies the rate of interest and the time frame for the repayment. It also provides a viable collateral that you can take in the event the company goes under.
Essentially, a convertible loan is a mixture of equity and debt. The business borrows money from you, promising to pay the loan or turning it into a share at a later date. The specifics and details of how the debt is converted into equity are typically set during the initial loan. The company will offer you a form of incentive for you to convert your debt into equity, like a discount. Make sure the company gives you a clear convertible note definition in the context of their business at the outset.
Understand the potential downside
You have to appreciate the different outcomes you should expect. What is the chance that the business will fail or succeed? Under what circumstances would it happen? What is required for the company to break even? If the business requires additional cash in the future, will the cash be accessible or would it crumble due to lack of extra cash? Would you be willing to turn down a request to provide more funding and watch the business collapse?
Similarly, consider the potential tax consequences. Is it possible to structure the investment to offer you a tax benefit if it fails?
You should be wise enough to accept that anything can happen and be ready for it. Sometimes, it’s wise to invest money that you can lose.
Conduct due diligence
Don’t be blinded by enthusiasm when everything seems shiny. According to the U.S Securities and Exchange Commission, conducting due diligence ensures you avoid making poor decisions and increase your chances of success. After listening to their incredible pitch, go a step further, and assess other important details. Some of them include the following:
- How their cap table is formalized; perhaps there are many small or inactive shareholders?
- Whether the company has debts they cannot repay
- Whether there is a shareholder’s agreement that has a strong preference against dilution or liquidation
Answers to such questions would give you a better understanding of the business’ standing and odds of success.
While it’s great to have multiple investments, you’ll often find that some winning investments will outweigh the performance of others. You have to choose your investments right to avoid ending up in more losses than you can handle. Try diversifying across many industries to buffer yourself from potential fluctuations, but focus on promising individual companies. Put your energy and capital into fewer, meticulously chosen firms to add meaningful value to them and assure yourself good results.
Review their use of funds
To rest assured that you are making the right decision investing in the business, you have to know exactly how the business intends to use the money. This is important because it also gives you the company’s vision. You’ll also understand how much the employees and the founders are getting. In the process, you might discover that the funds the business is raising aren’t enough to complete critical milestones.
This information is important because it allows you to make a very specific assessment of the company before investing.
There are many things you could do to invest wisely. However, choosing the appropriate form of financing, conducting due diligence, diversifying wisely, reviewing their use of funds, and calculating the potential downside is enough to assure success.