Investing

4 Ways to Lower Your Risk When Investing in Other People's Businesses

4 Ways to Lower Your Risk When Investing in Other People's Businesses
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Making a minority investment in a privately-held company is risky, but we’ve done it successfully.

The first step is to make sure that the company is financially sound. However, even if this is true, the pitfalls are numerous. Before investing, follow these four tips:

1. Ensure the business has a sound strategy.

If you’ve read our columns, you might be familiar with the three questions that every successful business must answer:

  • Why should a prospective customer buy my product or service rather than a competitor’s?
  • Is there a segment of the market that values the thing that makes my offering different from the competition and is it large enough to support my business?
  • How will I cost effectively reach this segment of the market with my message?

Before you invest in a business, make sure that these three questions have been answered well. If they haven’t, you could see the value of your position decline precipitously.

Related: Entrepreneurs Can Pay It Forward Through Angel Investing

2. Know why the owner needs the money.

If the owner needs money to make payroll, we would suggest caution -- ensure that the business is financially sound. On the other hand, if the owner needs money for capital improvements to expand or to fund working capital for a rapidly growing enterprise, that’s a better situation. We’ve found good investment opportunities when the owner of a successful, growing business needed money for personal reasons (for example, to buy a house).

3. Verify that the majority owner is a good businessperson.

Remember, when you buy a minority interest in a small business that the majority shareholder runs, you are making a bet on that person. Good business plans are a wonderful thing, but in our experience, they always need to change. The person running the business will have to recognize changes to the competitive environment and pivot.

4. Make sure you will be compensated.

Without constraints, a minority interest in a privately-held business is only worth what the majority shareholder says it is worth. Consider this: You write a $100,000 check. The majority shareholder then proceeds to manage the company very successfully, generating a lot of cash.

However, the majority owner just sucks the cash out of the business by increasing his or her own compensation and never declares a dividend. Further, he or she never sells the business, but passes control to the next generation. You will never see a nickel from your investment. You might as well have flushed your money down the toilet.

Related: 3 Tips on How to Trade Stocks Without Spending a Penny

When making minority investments in privately-owned companies, insist on constraints:

  • The majority shareholder’s compensation must be formulaic. Raises in compensation are a function of growth and profitability. The majority owner can’t just increase his or her compensation at will. He or she has to declare a dividend to get cash out of the business. Obviously, when dividends are declared, you get paid.
  • Earnings may be retained in the business for only a limited time. If the business generates cash, dividends must be declared, unless you approve otherwise.
  • Control a myriad of other ways that the majority shareholder could get cash out of the business, such as paying a spouse $500,000 per year for being a receptionist or paying above-market rates for services to another company he or she owns.
  • The majority shareholder must devote his or her full effort to the enterprise. Don’t make an investment in a business and then have the majority partner take a full-time job at another company.
  • Protect yourself against dilution or sale. If the majority owner is going to sell shares, have a right of first refusal. This prevents him or her from issuing new shares and diluting your interest or from selling to a new owner with whom you do not wish to work with.

Finally, insist that your prospective on the business be considered. Admittedly, this is a “gentlemen’s agreement.” You can’t force the majority shareholder to listen to your point of view. However, do make it clear up front that you want to be heard.

Making minority investments in privately-held companies is risky business. The tips above are a good start, but this is a complex topic. If you aren’t experienced, reach out to experts before investing.

Related: This New Crowdfunding Startup Allows People to Buy Equity in Video Games