Last Updated on April 1, 2022 by Carl Jensen
Investing in someone else’s business is a huge decision for many. As much as you are willing to invest, it would help if you still abide by the rules to avoid getting yourself in trouble (financially or otherwise). Outlined below are the 12 essential rules of investing in someone’s business.
1. Pick Your Investments Carefully
Do not accept an investment pitch before doing your due diligence and establishing investment goals. Only choose to put your money in a goal you’d be willing to work on/towards. Without a specific investment goal, every sales pitch will sound good enough, even when it’s not. Create a criterion for identifying potential investments you’d be interested in. The best way to identify a potentially great business idea is to check the business plan yourself or have someone qualified do it for you. Read more in this article from Henderson EuroTrust.
2. Always Ask for A Business Plan
Never promise to invest in a new business without seeing the business plan first. Everyone looking to woo you into investing in their business (including family members and friends) should be able to produce a business plan. The business plan needs to be comprehensive and detailed, which will allow you to determine if it is feasible and its likelihood to succeed. A well-written business plan should outline how the business will generate profits and returns on investment for investors.
3. Calculate Potential Risks
Don’t focus on the possibility of making profits alone; many small businesses have a greater risk of making nothing or even losses during startup. It would thus be advisable to consider the likelihood of making losses and how far you’d be willing to continue funding the business until it stabilizes. At what point would you decline to provide additional funding for the same? Some entrepreneurs may not factor in the likelihood of losses or will simply not want to think of it. Whatever the case, it would be advisable to invest in an amount you can afford to lose or have a recovery or backup plan in place.
4. Tax Consequences
Every investment will attract different tax consequences. You need to be aware of whatever options there are, especially if the business fails or you suffer losses. If, for example, the investment will be to buy stock for a small business under IRC 1244, you could then get ordinary loss treatment for the same.
If you choose to structure the investment as a loan, the IRS will treat it as a non-business loss should you incur losses. This means the amount invested will be taxable. That is unless the capital loss can be used to offset gains from any other investments, where only a maximum of $3000 can be deducted from your regular income.
The business’ identity is another factor to consider when structuring the investment plan. You thus should check to see and understand if the entity is an LLC, S corporation, or pass-through entity. If it falls under any of these, then tax consequences (capital gains, losses, profits, etc.) will be passed to you. Be sure you are comfortable with these tax consequences before moving ahead with the plan.
It’s worth noting that you’ll not be in a position to take advantage of losses, as these are considered passive. Your profits could also be taxed even before the cash has been disbursed to you – this is an issue you should be aware of first-hand. If you can afford to pay taxes on undistributed or reinvested profits, you then have nothing to worry about.
5. Go For What Is Best for You
What is your influence in the business? How many investors does the business have? Are you the only key/financial investor? If there are several other investors, what is your influence on the management of the business? Whichever the case is, you need to have the plan structured just how you want it. One thing is for sure when doing this, do not overestimate the founder’s management contribution nor underestimate your financial contribution and what it means to the business. Although the founder has the idea, you have the money to make their idea actionable, meaning they need you onboard.
These are some of the things to have in mind when at the negotiating table. The only way you can protect your investment is to have it structured such that you have control over it. You thus need to have voting power and protection from dilution of the same, especially for equity investments.
You also need to have a say on who gets to be on the Board of Directors and power over specific actions and privileges. Allowing the founder to have total control of the business will be like shooting yourself in the foot.
What do you prefer as investment, buying stocks or offering a loan? A loan, for example, is meant to be paid back (with interest) within a specified period whether the business thrives or not. If loaning an entity (which could cease to exist after some time), you should insist on getting a personal guarantee on loan. Ensure the loan is secured using the business’ most valuable assets and the guarantors’ assets as well.
6. Ensure The Founders Have Something to Lose Too
Just because you chose to fund an idea doesn’t mean you should risk it all. The founders, too, need to be liable if the business fails. They thus should invest in something or take up loans to help keep the business afloat. There should be disincentives and incentives for the founders and management. This way, the founders will be motivated to invest something in the business too.
7. Make Sure Everything Is in Order
Whether investing in a friend’s business or an entity, always ensure the paperwork is in order. Check to see the validity of all documents, and your rights as an investor are outlined in the incorporation articles. Be sure to insist on the articles of incorporation to be amended before signing any agreement with the founders.
Next, you’ll want to have your security interests filed with the proper federal offices. This includes anything that would be used as collateral for the investment, such as patents, trademarks, and copyrights. If bridge lending is required this should be in order. You’ll need an expert for this, as some of these filing requirements may be complicated and need a trained eye. Most of these are mostly filed with the Secretary of State.
Insist on rights that go beyond collateral if the funding is quite significant. These include the rights to inspect financial books and the facility, request an audit, and regularly receive financial reports. Have all these in writing as a way of protecting your overall investment.
8. Get Everything in Writing
Every aspect of the agreement, contract, and investment should be written and signed. Never invest your money based on general trust or oral promises.
9. Make A Copy of All the Documents
Make copies of all the paperwork of the business for safekeeping. You’ll, however, need to keep copies of everything from articles of incorporation, bylaws, minutes, and shareholder agreements if investing in a corporation. For LLCs and partnerships, have copies of all necessary agreements of the entity. Keep a copy of all filings with the IRS and the Secretary of State too. You’ll also want to keep all original notes of the loans safely.
10. Plan To Get Money Out
How will you benefit from investing in the business? Will you be getting income as an employee, or will you charge consultation fees? Do you want dividends paid out to you, or do you have to elect S corporation status for distribution of profits?
11. Never Invest What You Can’t Afford to Lose
Do not invest money you do not have. It might take a while for the small business to stabilize and generate income. That said, it wouldn’t be advisable to invest money you cannot afford to lose. In addition to this, it wouldn’t be wise to invest in a company where your only way out is a public offering.
12. Don’t Be Reckless
Whatever your reason is for investing in the business, be responsible about it. Even when investing in your child’s business, ensure their business plan is not only solid but are ready to work it out. The last thing you want is the business to spiral out of control due to your poor training background (of the founder/child) or poor investment.