The safest advice you can get when investing in someone else's business is that you shouldn't do it unless you can afford to lose every penny of your investment. On the other hand, there aren't very many millionaires running around who didn't take some investment risk in getting to where they are.
Qualify the Investment
If you are investing in someone else's business, your investment will probably be of a passive nature and the chances are you are not going to be involved in the day-to-day operations. Thus, you are essentially investing in the abilities of other people to run a business and make a tidy profit.
Presumably, you are looking to make an investment in a great business idea. But how much do you really know about the business? Before making an investment, it is absolutely essential that you do your homework to find out everything you can about the business. This holds true even if you are dealing with a friend or a family member.
When considering an investment in a public company or a well-established business, there will be tons of information available for your review as part of your due diligence. The same level of information will probably not be available if you are investing in a privately held start-up venture. At a minimum, you should insist on reviewing a business plan, financial projections and an offering prospectus before agreeing to invest in someone else's business.
Inquire about how the investment is complying with state and federal securities laws. Generally speaking, the offering of stock or any other security must be registered with both the federal Securities and Exchange Commission, and the appropriate state agencies, unless the offering qualifies for applicable exemptions from registration.
You may be getting a lot of pressure to invest. You may even have a stockbroker who is recommending the investment. Nevertheless, give someone the opportunity to try to talk you out of the investment. Run it by your lawyer and your accountant.
If you think you still want to invest, be sure to have a very clear understanding about your rights as an investor. If you are putting up enough money, for example, you may not want to limit your role to one of being a passive investor. You may want to insist on having certain voting rights and having a right to be on the board of directors.
More Tips Before You Invest
- Anticipate losing money before you make money.
- Look at the tax treatment of your investment. If you are being promised extraordinary profits (or even write offs), it is probably too good to be true.
- Find out how your tax losses would be characterized. On small business investments, it is sometimes possible to claim a loss that you can offset against ordinary income (as opposed to capital gains). This may give you a better chance of at least realizing a better tax benefit even if you lose everything on an investment.
- Do a credit check on the promoters and the founders of the company.
- Find out who else is investing in the company. Ask if it is okay to talk to them. If not, why not?
- Look at your potential liability exposure. As a passive investor (e.g., a shareholder in a corporation), the goal is to limit your potential liability exposure to the extent of your investment. However, if you are on the board of directors, you could end up being sued and being held personally liable by creditors and even other shareholders. Is your potential upside worth this risk? Will the company indemnify you? Is there directors and officers liability insurance in place?
- Is there an exit strategy to get your money back? Keep in mind that investments in small companies are not liquid, so it is sometimes hard to get your money back out of a deal even under the best of circumstances.
Every investment you make should be clearly documented. State and federal securities laws generally require that all material facts need to be disclosed in connection with the offering of any security. Common sense dictates that any investment is probably too good to be true unless you have a bundle of documents in hand describing the potential downside risks of investing. You should insist on this even if you are dealing with a friend or a family member.
Questions for Your Attorney
Before investing in a company, it's important to review the investment offering and evaluate the investment risks. An attorney experienced in working with investors and small businesses can help you get a clear picture of the investment and its long-term potential.
Among the questions to consider asking your attorney:
- Do you have prior experience working with businesses and their investors?
- What are the advantages and disadvantages of the investment I'm considering?
- How much personal protection do I have if the company is sued?
- How much money could I potentially lose if my investment goes bad?
- What red flags do you see and how can they be avoided?
- How much do you charge for your services?