According to the Small Business Administration, approximately 500,000 new businesses are started every year in the United States. Because it can be difficult to obtain financing, small-business entrepreneurs often turn to friends, family or acquaintances for funding. If you find yourself with the opportunity to invest in a business startup, tread carefully.
Think about liability, the valuation of the business, your timeline and your exit strategy. Before you even consider taking a partnership or jumping on board, here are some basics to know prior to investing in a new business.
Beware of the opportunity
It’s usually difficult for ordinary Americans to find a private business in which to invest. Unless you’re a known local business player and are in-tune with the business community, it’s unlikely you’ll be approached with an opportunity.
While it could throw up a red flag, the inability for an entrepreneur or startup to obtain financing isn’t necessarily a sign that it’s doomed. Even new businesses that can show a couple of years’ sustainability can have problems if the bank isn’t willing to take a risk.
Understand the structure
Potential investors should carefully understand the business structure. It can determine how the IRS and legal system view liabilities and profits. Chances are strong that the business could fail — according to the Small Business Administration, approximately 50 percent of small businesses close within the first five years.
You may not see returns for years
Assuming you invest in a startup that stays afloat and makes a profit, it could be years before any of those profits come your way.
If an investor has a particular targeted time frame for a return of capital and a yield they’d like to earn they should consider investing via a loan instead. Putting a large sum in a business based on trust and the hope for dividends later has no guarantee. But making an official loan to the entrepreneur or startup at a market-based interest rate with a determined term can give the investor a steady income stream and a more guaranteed return of principal.
Planning an exit strategy
When you invest in an untested startup, you could be tying up your money for a while. A new business could burn through your entire investment before opening its doors, then take years before it earns a solid revenue stream.
You’ll need to do your homework
You’ll want to know the background of everyone involved in the management of the business and have an understanding of the industry and competition. You should request a full written business plan complete with a business description, marketing plan, financial plan, market analysis and a SWOT (strengths, weaknesses, opportunities and threats) analysis.