What’s the most important thing any investor should think about when investing in an exciting early-stage company?
Sensible investors will answer “due diligence” every time. What does that mean? It means making sure that you have asked the right questions and received the right answers to those questions. For example, are you comfortable that the company is providing an innovative product or service that people will actually pay for, either because it solves genuine customer pain or delights them in some way?
It also means asking whether the company has the ability to build a strong competitive position in an attractive market. This could be a product that others won’t be able to copy easily, a genuine “first mover” advantage, or the ability to “fly under the radar” of more established competitors.
Does the company have a sustainable business model? How much does it cost to acquire a new customer, and how long will it take to earn back that cost? Businesses that earn recurring revenue from their customers, preferably paid for in advance, are some of the most attractive.
How about the management team? Do they have complementary skills and relevant experience that will help them to succeed in their chosen market? Are they trustworthy?
Is the valuation sensible given the company’s track record to date and its future prospects?
Ideally each investor would have the chance to spend time with management to get answers to these and other very important questions. For a variety of reasons this isn’t always possible, especially when investing relatively small amounts. Some investors with the means to be making these kinds of high risk/high reward investments lack the experience to do their own due diligence.
Unfortunately, for too many people the answer to the question I posed above is: “What are the tax benefits?”
In the UK we have one of the world’s best tax environments for investing in early stage companies. The EIS regime allows an individual to invest up to £1 million in EIS-eligible companies each year, to deduct 30% of the amount invested from their income, and to enjoy tax free gains and tax relief from losses. 80% of EIS investors consider these benefits to be the key driver when considering an investment. These investors risk falling into a trap: even the best tax breaks can’t turn a bad investment into a good one.
Sensible investors on the other hand take advantage of the generous tax advantages that EIS offers to make a great investment opportunity even better. Be a sensible investor, and don’t put the tax benefit cart ahead of the due diligence horse.