According to the Small Business Administration, approx. 500,000 new businesses are started every year in the United States. Obtaining financing for small-business entrepreneurs is often hard and they tend to turn to friends, family or acquaintances for funding. When you face the opportunity to invest in a business, what are the things to look at?
- Business funding situation
The first question to ask yourself is why the opportunity is even available. Did the business try to raise money before, from who and why it didn’t go through – you have to find out the story behind it. While it could throw up a red flag, the inability for an entrepreneur or startup to obtain financing isn’t necessarily a sign that it’s doomed.
- Investment structure – equity vs loan
A starting business is going to need all the cash they can get so for the first few years the earnings are usually plowed back into the business. Investors might not see any returns for 5-10 years. So you need to decide on how you want to invest: into equity and wait for the company exit or use a loan structure. If an investor has a particular targeted time frame for a return of capital and a yield they’d like to earn, he/she should consider investing via a loan instead. It should be an official loan at a market-based interest rate with a determined term – this can give the investor a steady income stream and a more guaranteed return of principal. When choosing the investment structure, you also need to pay attention to the tax consequences.
- Have a strategy
Always select your investments, don’t blindly accept a friend’s or family member’s pitch. You have to establish your own investment goals and standards, which are your basis for assessing the opportunity. You should take part in investment opportunities that fit your criteria. You can always focus on specific fields that interest you or you are familiar with and keep an eye on the market situation – or you can always involve an expert to give you an opinion.
- Require a plan
You need to know if the entrepreneur has a plan – it is not always a written business plan but a detailed investor deck. Always ask questions about the future vision of the company – what is the next step, product, service? How will they grow and who they can work with? The entrepreneur also should have a clear understanding of how the business will make money and provide a return on investment to investors.
- Know your value
Get what is best for you: the investment structure and deal. Don’t overestimate the value of the founder’s management contribution or underestimate the value of your financial contribution. Always know the role you are playing: are you a key investor? Are you the only financial backer? If you are investing is an equity deal, make sure you have the voting power you need, and how will the dilution happen. Also, it is always good to know what influence you want to have in the business. If you are structuring the investment as a loan to an entity, which might cease to exist, insist on a personal guarantee – make sure the loan is secured by the most valuable assets of the business, and by assets of the guarantors.
- Founders also have something to lose
Don’t get into a business where the founders have nothing to lose. They have to be all-in: personal capital and time. The fear of failure should motivate them even when the possibility of success does not. That is why most investors always make sure that founders are running the business full time and have personal assets down. It is also important to make sure that founders know what they are doing. The way they present the business – the attention to detail, professionalism, and presentation of the business plan – all this should serve as a representation for how they might operate the business. If there is more than one founder, you also have to pay attention to the co-founder relationships and how they work together – you don’t want the business to fail simply because they couldn’t find a common ground on how to run it.
- Paperwork in order
Make sure all the paperwork is in order, even if you are investing in the business of a friend: the articles of incorporation, security interests, trademarks, patents, or copyrights, the security interests, financial reports, the books, and the facility. You should cover all important aspects of your arrangement in the written documents and keep copies of all paperwork for the entity.
- Plan to exit
How will you get money out of the business? And how will the distribution of profits happen? Is the business paying you dividends? Does your equity convert at the Qualified Financing round? What happens in the business gets acquired? You have to make sure there is a scenario for you getting your money out in a case of every development in the business.
- Be ready to lose all the money
Can you afford to lose your entire investment? Will any assets be left for you if the business fails? Don’t invest money you can’t lose or need access to. Many investments in small businesses are completely illiquid. Even if the business survives and does well, your funds may be tied up until a major event frees up your money (and the major event may never happen). Be careful investing in a business where your only exit strategy is an initial public offering.