12 Rules for Investing in Someone Else's Business
Here are twelve basic rules to use when considering an
investment in a small business:
1. Don't be "sold" investments.
You select your investments. Don't blindly accept a friend's
or family member's pitch. If you haven't established your
own investment goals, do not invest in anything until
you do so. Without your own goals or standards, you lack
a basis for assessing the opportunity. You leave yourself
vulnerable to the sales pitch that sounds good.
Only get into investments that meet your criteria. Check
out the business plan yourself. If you do not have the
ability to review the business plan, get help from someone
who does.
2. Require a business plan.
Insist on seeing the business plan of anyone proposing
that you invest in his or her business. Never even consider
an investment without a business plan. The business plan
should provide enough detail for you to determine whether
the business is feasible and is likely to succeed. It
should make clear how the business will make money and
provide a return on investment to investors.
3. Calculate your downside risk.
Determine what the various outcomes might be. Under what
circumstances will the business succeed? Under what circumstances
will it fail? What is needed for the business to break
even? If the business needs more money at some point,
will that money be available or will the business fail
for lack of additional cash? Will you be willing to refuse
to provide additional funding and see the business collapse?
Do not accept any representation that "that can't
happen." Determine for yourself what can happen.
Can you afford to lose your entire investment? Will any
assets be left for you if the business fails?
4. Consider tax consequences.
What are the tax consequences of this investment? Can
this investment be structured to provide a tax benefit
to you if it fails? Will the investment be a purchase
of stock in a small corporation under IRC 1244, allowing
you to get ordinary loss treatment on the sale of the
stock or failure of the business?
If the investment is structured as a loan, remember that
a loss on a loan to a business is treated by the IRS as
a non-business loss. Unless this capital loss can be utilized
to offset capital gains you have from other investments,
the maximum capital loss which can be deducted from your
ordinary income is $3,000 per year.
Is the entity an S corporation, LLC, or other pass-through
entity? If so, remember that the tax consequences will
be passed through to you. These tax consequences can be
profits, losses, capital gains, etc. Make sure you can
deal with these tax consequences.
You may find that you can't take advantage of losses
because they are passive losses, which can only be used
to offset passive income which you may not have.
Another potential problem is being taxed on profits that
are not distributed. In a pass-through entity you are
taxed on your portion of the taxable income, whether or
not any cash has been distributed to you.
Can you afford to be taxed on undistributed profits?
If profits are reinvested in the business there may be
no cash to distribute to the investors who must pay the
taxes.
5. Use your influence.
Get what is best for you. Have the investment structured
the way you want it, or don't invest. Are you a key investor?
Are you the only financial backer? If you are just one
of several investors, what power will you have to influence
the management of the business?
Don't overestimate the value of the founder's management
contribution or underestimate the value of your financial
contribution. Without your money, the founder may have
nothing. Without the founder, you would still have your
money and you would find another investment.
Have the investment structured to give you the control
you need to protect your investment. If your investment
is an equity investment, make sure you have the voting
power you need, and protection from dilution of voting
power.
Have the ability to elect the number of directors necessary
to control the Board of Directors, or at least have veto
power over certain actions by the Board. Don't fall for
the idea that the founder should have control of the business.
Do you prefer to provide a loan, instead of buying stock?
A loan is intended to be paid back with interest whether
the business does well or not. If the loan is 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.
6. Make sure the founders also have something to lose.
Don't get into a business where the founders have nothing
to lose. Make sure the founders will lose money or end
up in debt if the business fails. The fear of failure
should motivate them even when the possibility of success
does not.
The business needs to have incentives and disincentives
for management and the founders. Otherwise, they may be
willing to operate a worthless business as long as your
money provides income to them.
7. Do it right.
Make sure your paperwork is in order, even if you are
investing in the business of a friend. Check to see if
any of your rights as an investor must be covered in the
articles of incorporation in order to be valid. If necessary,
have the articles of incorporation amended.
Be sure to file your security interests in the right
places. If any of the assets to be used as collateral
are trademarks, patents, or copyrights, the security interests
must be filed with the appropriate federal offices. While
most security interests in assets are filed with the Secretary
of State, you must check the filing requirements for the
different types of assets you use as collateral.
If you are providing significant funding for a business,
you should insist on other rights which go beyond collateral.
You should have the right to receive financial reports
on a regular basis, to inspect the books and the facility,
and to audit the financial status of the company.
8. Get it in writing.
Cover all important aspects of your arrangement in the
written documents. Don't rely on oral promises or general
trust.
9. Keep copies of all documents.
Don't forget to keep copies of all paperwork for the
entity. For a corporation, keep copies of minutes, bylaws,
articles of incorporation, and shareholder agreements.
For partnerships and limited liability companies, keep
copies of the agreements which establish the entity. Keep
copies of all filings with the Secretary of State and
the IRS. Keep the original notes on your loans in a safe
place.
10. Plan to get money out.
How will you get money out of the business? Will you
be an employee? Will you spend enough time on the business
to justify the income you want? Will you be paid consulting
fees? Will you want dividends paid? Do you need to elect
S corporation status as a basis for distribution of profits
to you?
11. Don't invest money that you can't afford to lose.
Don't invest money you 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). Don't invest in a business where
your only "out" is an initial public offering.
12. Invest responsibly.
Even if you can afford to lose the money, and even if
the beneficiary of your investment is your child, don't
be reckless. Require even your child's business to meet
high standards of business planning. Irresponsible investing
encourages irresponsible business management. A business
out of control is a poor investment for you and a poor
training ground for your child.
By Mary Hanson
