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.