Approximately 500,000 new businesses are launched each year in the U.S., according to the Small Business Administration. It is often difficult for small businesses to obtain financing, so founders turn to family, friends and acquaintances for funding.
There are several factors that need to be considered when investing in a company, including:
1. Your Expertise
How much do you know about the company and its industry? Warren Buffet, Wall Street icon and CEO of Berkshire Hathaway, says to “never invest in a business you cannot understand.”
If you do not understand the ins and outs of the business, you may want to educate yourself or consider another investment opportunity.
2. The Structure
According to the Small Business Administration, about 50% of small businesses close within the first five years of operation. Depending on the business’s structure, investors could be held personally liable for debts if the business fails.
Investing in an LLC or corporation would limit liability, as investors and owners are not liable for company debts.
3. The Appropriate Protections
Does the business have the appropriate protections in place to limit liability, such as insurance? Issues like product liability can bankrupt a company without the appropriate protections. More than 900,000 people are injured due to power tool accidents and 150,000 are injured by home appliance accidents each year. These are just two of the many product categories that can cause injuries and result in potentially crippling lawsuits.
In addition to product liability insurance, businesses should also have general liability and commercial property insurance to limit liability and potential out-of-pocket costs.
4. The Potential Return
If you invest in a successful startup that turns a profit, it may still be years before any of those profits come your way. Startups need all of the cash they can get, and profits are typically reinvested back into the business.
It may be two or three years before you see a return.
If you’re keen on seeing a quicker return or have a timeframe in mind, consider investing in the form of a loan instead. A loan with a market-based interest rate and determined term can provide the investor with a steady income stream and guaranteed return of principal.
5. Financial Performance
The most obvious factor to consider is the financial performance of the company. Is the business profitable? Make sure that you view the business’s financial reports, including the tax returns, balance sheets, budgets, cash flow projections, profit and loss statements and current accounts receivables for the last three years.
6. Your Exit Plan
How will you get your money out of the business? Will it be through dividends? Consulting fees? Make sure that you have and consider your exit plan.
If you’re serious about investing in a company, put the agreement in writing. Do not rely on trust or oral promises, as they often do not pan out well.
Make copies of the agreement, and keep copies of these documents. If investing in a corporation, make sure that you keep copies of bylaws, minutes, shareholder agreements and articles of incorporation. If investing in an LLC or partnership, copies of the agreements should also be kept.
