According to the Small Business Administration (SBA), approximately 500,000 businesses are launched in the United States every year. Small-business owners often seek funding from friends, family, or acquaintances because it is difficult to get financing. Be careful if you are offered the chance to invest in an upcoming business.
Consider liability, the value of the business, timelines and exit strategies. Here are some basic things to consider before investing in a business.
Beware the opportunity
Most Americans find it difficult to find a business to invest in. If you are not a well-known local businessperson and you don’t know the community, you won’t be approached by a business opportunity.
Gregg Landers is the managing director for consulting and internal controls at CBIZ MHM. He says that most of the small business investment opportunities are generated by friends, family, or word-of-mouth. A relative might be looking to open a new restaurant, or a close friend may want to turn their bright idea into business.
Landers says, “You need to ask yourself the question of why this opportunity exists.” “Most of the time, they’re trying to raise funds and couldn’t have gotten it from a traditional bank. It’s important to know the background story.
The inability of an entrepreneur to secure financing could be a warning sign, but it doesn’t mean that the startup is doomed. CPA David Coffman, a business valuation expert from Harrisburg, Pa. says that it is very difficult to get financing for new businesses today. Banks may not be willing to risk taking on new businesses, even if they can demonstrate a few years of sustainability.
They are very cautious, even though they would like to lend money to small businesses. He says that it’s hard for them to obtain financing and they often ask their friends and families for money.
Understanding the structure
Shannon Pratt, of Shannon Pratt Valuations, Beaverton, Ore. says that potential investors need to understand the structure of a business. The IRS and legal system can view profits and liabilities differently. Small Business Administration reports that approximately 50% of small businesses fail within their first five years.
You could be held personally liable for any unpaid liabilities or bills in the event of a business failure, depending on how the business is structured. Pratt emphasizes that investors need to limit their liability. He recommends choosing a limited-liability corporation (LLC). An LLC’s most important attribute is that its owners are usually not liable for the company’s debts.
Landers says that without forming an LLC, the stakeholders may have the right to sue you personally if they fail and incur liabilities.
Coffman believes that people make the mistake of investing little more than a simple handshake in a family member or friend’s business. Coffman believes that putting everything in writing and drafting official documents is important, no matter how close your relationship may be.
“It is often informal and there’s not much evaluation.” “If you want to do this properly, then you should have legal documents prepared,” he says.
It may be years before you see any returns.
If you assume that your startup stays afloat, and earns a profit, then it may be many years before you see any profits.
“A startup will need as much cash as possible. In the early years, earnings are typically reinvested in the business. Coffman says that the return may not come for another three to five year and there’s no guarantee.
Coffman suggests that if an investor is looking for a specific timeframe to return capital and earn a certain yield, they should instead consider investing through a loan. A large investment in a company based on the trust of the owner and the expectation that dividends will be paid later is not guaranteed. A loan at a fixed rate of interest and for a specific term to an entrepreneur or startup can provide a stable income stream as well as a guaranteed return on the principal.
If you offer a loan for $10,000 over 10 years at 7 percent, the monthly payment would be $116. The total interest paid will amount to almost $4,000 during the term of the loan. Coffman believes that such loans are a common way for friends to invest in their business. However, he recommends making the loan official by obtaining legal documentation.
In these situations, the loan is not always repaid. “If you want your money, you have to be official about it,” he says.
Plan your exit strategy
You could tie up your money if you invest in a startup that has not been tested. Landers warns that a new business may burn through all of your investment before even opening its doors. It could then take many years for it to earn a steady revenue stream.
Even if your business is successful and you begin to receive dividends, withdrawing the initial investment may be difficult. Pratt advises that a person be prepared to wait at least five years to access the capital or cash flow.
Pratt says that there is rarely any statement about the investment’s expectations or guarantees.
Landers believes it’s important to have a “securities plan” that includes a method to liquidate your investment. He says that a plan should be laid out to determine how you will sell your share of the company, whether it is based on time or returns. You can’t click a button to sell your shares in a private company, unlike a public corporation that trades publicly.
You need to consider how you will get your money back. Landers says that buying in is one thing but getting equity out is quite another. You want to know the exit strategy. The owner should have a plan to deal with it.
Do your homework
Landers advises that you should know about the history of all the people involved in managing the business, as well as the competition and the industry. You should ask for a complete written business plan that includes a detailed business description, a marketing plan, a financial plan, a market analysis, and a SWOT analysis (strengths and weaknesses, opportunities, and threats). Landers says that entrepreneurs have grand visions for their businesses but do not have the plans necessary to put them into practice.
Every entrepreneur thinks their business will be the greatest thing since slicedbread and that they’ll be rich. This rarely happens. He says, “Many people go bankrupt.”
Coffman says that when a new business has a plan, it is “very little” to go on. The professionalism, attention to detail and presentation of the plan will serve as an indication of how the business might be run. Coffman suggests that you carefully examine the projections and representations in the business plan. You can also use external sources to verify it.
Coffman claims that “they may have fantastic projections of (projected) cash flows, but they are usually not very credible.”
Pratt suggests that investors seek the advice of their CPA, or an expert in business valuation before making a final investment decision.
Get these five pointers to make your path to investing in your business smoother!
Before investing in startups, consider these tips
According to the Small Business Administration (SBA), approximately 500,000 businesses are launched in the United States every year. Small-business owners often seek funding from friends, family, or acquaintances because it is difficult to get financing. Be careful if you are offered the chance to invest in an upcoming business.
Consider liability, the value of the business, timelines and exit strategies. Here are some basic things to consider before investing in a business.
Beware the opportunity
Most Americans find it difficult to find a business to invest in. If you are not a well-known local businessperson and you don’t know the community, you won’t be approached by a business opportunity.
Gregg Landers is the managing director for consulting and internal controls at CBIZ MHM. He says that most of the small business investment opportunities are generated by friends, family, or word-of-mouth. A relative might be looking to open a new restaurant, or a close friend may want to turn their bright idea into business.
Landers says, “You need to ask yourself the question of why this opportunity exists.” “Most of the time, they’re trying to raise funds and couldn’t have gotten it from a traditional bank. It’s important to know the background story.
The inability of an entrepreneur to secure financing could be a warning sign, but it doesn’t mean that the startup is doomed. CPA David Coffman, a business valuation expert from Harrisburg, Pa. says that it is very difficult to get financing for new businesses today. Banks may not be willing to risk taking on new businesses, even if they can demonstrate a few years of sustainability.
They are very cautious, even though they would like to lend money to small businesses. He says that it’s hard for them to obtain financing and they often ask their friends and families for money.
Understanding the structure
Shannon Pratt, of Shannon Pratt Valuations, Beaverton, Ore. says that potential investors need to understand the structure of a business. The IRS and legal system can view profits and liabilities differently. Small Business Administration reports that approximately 50% of small businesses fail within their first five years.
You could be held personally liable for any unpaid liabilities or bills in the event of a business failure, depending on how the business is structured. Pratt emphasizes that investors need to limit their liability. He recommends choosing a limited-liability corporation (LLC). An LLC’s most important attribute is that its owners are usually not liable for the company’s debts.
Landers says that without forming an LLC, the stakeholders may have the right to sue you personally if they fail and incur liabilities.
Coffman believes that people make the mistake of investing little more than a simple handshake in a family member or friend’s business. Coffman believes that putting everything in writing and drafting official documents is important, no matter how close your relationship may be.
“It is often informal and there’s not much evaluation.” “If you want to do this properly, then you should have legal documents prepared,” he says.
It may be years before you see any returns.
If you assume that your startup stays afloat, and earns a profit, then it may be many years before you see any profits.
“A startup will need as much cash as possible. In the early years, earnings are typically reinvested in the business. Coffman says that the return may not come for another three to five year and there’s no guarantee.
Coffman suggests that if an investor is looking for a specific timeframe to return capital and earn a certain yield, they should instead consider investing through a loan. A large investment in a company based on the trust of the owner and the expectation that dividends will be paid later is not guaranteed. A loan at a fixed rate of interest and for a specific term to an entrepreneur or startup can provide a stable income stream as well as a guaranteed return on the principal.
If you offer a loan for $10,000 over 10 years at 7 percent, the monthly payment would be $116. The total interest paid will amount to almost $4,000 during the term of the loan. Coffman believes that such loans are a common way for friends to invest in their business. However, he recommends making the loan official by obtaining legal documentation.
In these situations, the loan is not always repaid. “If you want your money, you have to be official about it,” he says.
Plan your exit strategy
You could tie up your money if you invest in a startup that has not been tested. Landers warns that a new business may burn through all of your investment before even opening its doors. It could then take many years for it to earn a steady revenue stream.
Even if your business is successful and you begin to receive dividends, withdrawing the initial investment may be difficult. Pratt advises that a person be prepared to wait at least five years to access the capital or cash flow.
Pratt says that there is rarely any statement about the investment’s expectations or guarantees.
Landers believes it’s important to have a “securities plan” that includes a method to liquidate your investment. He says that a plan should be laid out to determine how you will sell your share of the company, whether it is based on time or returns. You can’t click a button to sell your shares in a private company, unlike a public corporation that trades publicly.
You need to consider how you will get your money back. Landers says that buying in is one thing but getting equity out is quite another. You want to know the exit strategy. The owner should have a plan to deal with it.
Do your homework
Landers advises that you should know about the history of all the people involved in managing the business, as well as the competition and the industry. You should ask for a complete written business plan that includes a detailed business description, a marketing plan, a financial plan, a market analysis, and a SWOT analysis (strengths and weaknesses, opportunities, and threats). Landers says that entrepreneurs have grand visions for their businesses but do not have the plans necessary to put them into practice.
Every entrepreneur thinks their business will be the greatest thing since slicedbread and that they’ll be rich. This rarely happens. He says, “Many people go bankrupt.”
Coffman says that when a new business has a plan, it is “very little” to go on. The professionalism, attention to detail and presentation of the plan will serve as an indication of how the business might be run. Coffman suggests that you carefully examine the projections and representations in the business plan. You can also use external sources to verify it.
Coffman claims that “they may have fantastic projections of (projected) cash flows, but they are usually not very credible.”
Pratt suggests that investors seek the advice of their CPA, or an expert in business valuation before making a final investment decision.
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