According to the Small Business Administration, approximately 500,000 new businesses are started every year in the United States. Because it can be difficult to obtain financing, small-business entrepreneurs often turn to friends, family or acquaintances for funding. If you find yourself with the opportunity to invest in a business startup, tread carefully.
Think about liability, the valuation of the business, your timeline and your exit strategy. Before you even consider taking a partnership or jumping on board, here are some basics to know prior to investing in a new business.
It’s usually difficult for ordinary Americans to find a private business in which to invest. Unless you’re a known local business player and are in-tune with the business community, it’s unlikely you’ll be approached with an opportunity.
Gregg Landers, managing director of consulting and internal control services at CBIZ MHM, says most small-business investment opportunities come from friends, family or word of mouth. It could be a relative looking to open a restaurant or a friend planning to turn his or her bright idea into a business.
“You have to ask yourself why the opportunity is even available,” Landers says. “Usually they are trying to raise money, and it means they probably couldn’t get it from a bank. 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. Business valuation expert and CPA David Coffman of Harrisburg, Pa., says it’s very difficult for startups to obtain financing nowadays. Even new businesses that can show a couple of years’ sustainability can have problems if the bank isn’t willing to take a risk.
“Even though they want to lend to businesses, they’re just very wary. It’s just hard for many of them to get financing, so they’ll often turn to friends and family for capital,” he says.
Shannon Pratt of Shannon Pratt Valuations in Beaverton, Ore., says potential investors should carefully understand the business structure. It can determine how the IRS and legal system view liabilities and profits. Chances are strong that the business could fail — according to the Small Business Administration, approximately 50 percent of small businesses close within the first five years.
Depending on the structure of the business, you could be personally responsible for unpaid bills or liabilities in the event the business fails. Pratt stresses that investors should think hard about limiting their liability and recommends sticking with a limited liability corporation, or LLC. One of the most important attributes of an LLC is that owners are not usually liable for company debts.
“Without forming an LLC, if they go out of business and have liabilities, all of those stakeholders likely have the right to come after you (personally),” Landers says.
Coffman says people often make the mistake of investing in a friend’s or family member’s business with little more than a handshake. No matter how close a relationship you have, Coffman says drafting official documents and putting things in writing is essential.
“It’s often very informal, and there usually isn’t a lot of evaluation. If you want to do it properly, you need to have legal documents drawn up,” he says.
Assuming you invest in a startup that stays afloat and makes a profit, it could be years before any of those profits come your way.
“A startup is going to need all the cash they can get. Earnings are usually plowed back into the business (for the first few years). Any return might not be for three to five years, and there is no guarantee,” Coffman says.
If an investor has a particular targeted time frame for a return of capital and a yield they’d like to earn, Coffman says they should consider investing via a loan instead. Putting a large sum in a business based on trust and the hope for dividends later has no guarantee. But making an official loan to the entrepreneur or startup at a market-based interest rate with a determined term can give the investor a steady income stream and a more guaranteed return of principal.
Consider that offering a 10-year loan of $10,000 at 7 percent would net a payment of $116 per month and a total of almost $4,000 in interest over the life of the loan. Coffman says such loans might be a more common way to invest in a friend’s business but still recommends making it official with proper documentation and legal paperwork.
“Sometimes the loans are never repaid in these arrangements. If you really (want your money), you need to make it official,” he says.
When you invest in an untested startup, you could be tying up your money for a while. A new business could burn through your entire investment before opening its doors, then take years before it earns a solid revenue stream, Landers says.
But even if the enterprise is successful and you start getting dividends, it could be difficult to withdraw your initial investment. Pratt says a person should be prepared to wait a minimum of five years before he or she has any access to that capital or some kind of cash flow.
“There is almost never any kind of statement that says anything about expectations from an investment or any kind of guarantees,” says Pratt.
Landers says it is important to discuss some kind of “exit strategy,” which would include a way to liquidate the investment. Whether it’s set by time or return, he says there should be a plan laid out for how to sell off your stake in the business. Unlike a public company that trades on the open market, you can’t sell your stock in a private corporation with the click of a mouse.
“You have to ask yourself how you’re going to get the money back out. (Buying in) is one thing, but getting your equity out is another,” Landers says. “You want to understand the exit strategy. There really should be a plan in place by the owner to address it.”
Landers says you’ll want to know the background of everyone involved in the management of the business and have an understanding of the industry and competition. You should request a full written business plan complete with a business description, marketing plan, financial plan, market analysis and a SWOT (strengths, weaknesses, opportunities and threats) analysis. Landers says entrepreneurs often have visions of grandeur for their business but lack the plans to truly implement them in practice.
“Every entrepreneur believes their business is going to be the best thing since sliced bread and they’re going to be filthy rich. That rarely happens. Many go bankrupt,” he says.
Coffman says when a startup does have a business plan, there is usually “very little to go on.” The attention to detail, professionalism of the founders and presentation of their plan should serve as a representation for how they might operate when in business. Coffman says you should carefully analyze projections or representations made in the business plan and use outside sources to vet it.
“They may have fantastic projections on (projected cash flows), but they usually aren’t that credible,” Coffman says.
Pratt recommends that potential investors consult with their CPA or a business valuation expert before making the final decision to invest.