You can be on Entrepreneur’s cover!

4 Ways to Lower Your Risk When Investing in Other People's Businesses Making minority investments in privately-held companies is risky business, but it can be done successfully.

By Doug and Polly White

entrepreneur daily

Opinions expressed by Entrepreneur contributors are their own.

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

Doug and Polly White

Entrepreneurs, Small Business Experts, Consultants, Speakers

Doug and Polly White are small business experts, speakers and consultants who work with entrepreneurs through Whitestone Partners. They are also co-authors of the book Let Go to GROW, which focuses on growing your business.

Want to be an Entrepreneur Leadership Network contributor? Apply now to join.

Side Hustle

This Dad Started a Side Hustle to Save for His Daughter's College Fund — Then It Earned $1 Million and Caught Apple's Attention

In 2015, Greg Kerr, now owner of Alchemy Merch, was working as musician when he noticed a lucrative opportunity.

Business News

I Designed My Dream Home For Free With an AI Architect — Here's How It Works

The AI architect, Vitruvius, created three designs in minutes, complete with floor plans and pictures of the inside and outside of the house.

Business News

This Fan-Favorite Masters 2024 Item Is Still $1.50 as Tournament Menu Appears Unscathed by Inflation

The pimento cheese sandwich is a tradition almost as big as the tournament itself.

Business News

Here's One Thing Americans Would Take a Pay Cut For — Besides Remote Work

An Empower survey found a high percentage of respondents would take a pay cut for better retirement benefits and remote work options.

Business News

Disney World, Disneyland Will Now 'Permanently' Ban Guests Who Tell This Lie to Skip Lines

The company rolled out changes to its Disability Access Services earlier this week.

Business Ideas

7 Link-Building Tactics You Need to Know to Skyrocket Your Website's Rankings

An essential component of SEO, link building is not just a 'Set them and forget them' proposition, but a dance of skills and strategies.