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5 Things to Know Before Investing in a Small Business

On Behalf of | Mar 16, 2018 | Business Law, Contract Law

There are many reasons to invest in a start-up. Small-business investments have been one of the more popular ways individuals and families begin their journey to financial independence. The right investment, in the right company, at the right time can be very lucrative. That being said, there is a possibility of losing your entire investment without ever seeing a profit. Working with an investment broker is one way to go about the investment, but there are many investments that happen privately. Most small-business investment opportunities come from friends, family, colleagues, or by word-of-mouth. If you ever find yourself with an opportunity to invest in a business, we would suggest you tread carefully. Here are some things to remember when preparing to invest in a start-up company.

Question the opportunity. Always be cautious when investing in a fledgling business. If it is seeking investors, it likely couldn’t obtain financing with a bank and you’ll want to know why. The business will most likely not have many documents to analyze. A great way to get insight to a business would be to request a copy of the company’s prospectus, business plan, or operating agreement – if available. Analyze their plan; make sure it is laid out clearly with plenty of details. Consider the risk and reward while asking questions along the way. If the projections are too good to be true, they probably are.

Do Your Due Diligence. Do yourself a favor and do your homework. Since there will most likely be a small amount of information to go on, you’ll want to know the background of all parties involved. Understand the business dynamic they are trying to create with the members they have in place. Is this business a partnership, single-member LLC, or are there multiple members that own the company? The more members there are, the higher the possibility the business can collapse from within. Pay attention to detail. A well-thought-out business plan is something every serious entrepreneur will have in place. Ask questions if there are gaps within the plan and how they plan to address it.

What Type of Investment? If you get to a point where you’re confident about an investment, you’ll want to clarify the type of investment. Will you be buying an ownership stake of the business or is this a loan? Understand the difference between an equity investment and a debt investment. Each type of investment has its pros and cons. If you bought equity in Disney early on, you’d be rich. If you invest in a company that eventually fails, your best chance of coming out okay would be to own the debt – not the equity. There are other options out there, such as preferred stock, which should be considered. No matter what the terms of the investment are, you should always make sure they are in writing and signed by everyone involved.

Have a signed investor agreement! No matter how well you know the owner/s, you should always have an investor agreement set in place. The agreement should clearly state the terms of the investment but also the rights of the investor. Consult with a Nevada contract attorney to understand the local statutes and protect yourself against fraud. Know your rights as an investor! More often than not, investors settle for a “hand-shake” agreement and don’t realize they have limited options for recourse until it’s too late. Your investment will most likely be tied up for a long period of time so you’ll want to make sure you are at ease with the conditions of the agreement. This agreement should also have terms if you decide to abandon your investment.

Plan an exit strategy. There is no guarantee you will ever make a cent on any investment. However, if you do end up making a profit and you decide to leave your investment, you should definitely have a plan. Whether it is by time or by return on the investment, this should be laid out in the investor agreement.

Investing in a startup is exciting and can be extremely profitable. Make sure to be cautious every step of the way and always consider consulting with legal counsel before making the final decision on your investment.

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