Evaluating Small Business Investments

by James & Miel on March 23, 2010 · 1 comment

Hello Folks,

At some point you may have the personal finance basics covered – got your debt paid off and have an emergency fund built up – and may be looking to juice your bottom line beyond what vanilla investments like stocks and bonds can offer you. In this case, you may be considering investing in a small business.

Statistically, most small businesses fail within the first few years. Because of this small business investments are among the most risky that investors can make. Given the risk though, these types of investments can also be tremendously profitable. Here are some thoughts you might consider when determining whether you should make a small business investment.

1) Risks and investment strategy:

A basic principle of investing in a small business is: don’t investments that you cannot afford to lose! Its better not to use funds that may be needed for other purposes, such as college education, retirement, loan repayment, or medical expenses. Instead, use funds that would otherwise be used for a consumer purchase, such as a vacation or a down payment on a boat or a new car.

Legitimate securities offerings need to be registered with the proper state authorities. However, just because the state has registered the offering does not mean that the particular investment will be successful. The state does not evaluate or endorse any investments. If anyone suggests otherwise, its probably nonsense.

If you plan to invest a large amount of money in a small business, you should consider investing smaller amounts in several small businesses. A few highly successful investments can offset the unsuccessful ones. However, even when using this strategy, only invest money you can afford to lose.

2) Analyzing the investment:

Although there is no magic formula for making successful investment decisions, certain factors are considered important by professional venture investors. Some questions to consider are:

A) How long has the company been in business? If it is a start-up or has only a brief operating history, are you being asked to pay more than the shares are worth?

B) Consider whether management is dealing unfairly with investors by taking salaries or other benefits that are too large in view of the companies stage of development, or by retaining an inordinate amount of equity stock of the company compared with the amount investors will receive. For example, is the public putting up 80 percent of the money but only receiving 10 percent of the company shares?

C) How much experience does management have in the industry and in a small business? How successful were the managers in previous businesses?

D) Do you know enough about the industry to be able to evaluate the company and to make a wise investment?

E) Does the company have a realistic marketing plan and do they have the resources to market the product or service successfully?

F) How or when will you get a return on your investment?

3) Making money on your investment:

The two classic methods of making money on an investment in a small business are resale of stock in the public securities markets following a public offering, and receiving cash or marketable securities in a merger or other acquisition of the company.

If the company is not likely to go public or be sold out within a reasonable time (i.e., a family-owned or closely held corporation), it may not be a good investment for you despite its prospects for success because of the lack of opportunity to cash in on the investment. Management of a successful private company may receive a good return indefinitely through salaries and bonuses, but it is unlikely that there will be profits sufficient to pay dividends in proportion with the risk of the investment.

4) Other suggestions:

Investors must be provided with a disclosure document and a prospectus before making a final decision to invest. You need to read this material before investing – seriously. Read it.

Even the best small business venture offerings are highly risky. If you have a nagging sense of doubt, there is probably a good reason for it. Good investments are based on sound business criteria and not emotions. If you are not entirely comfortable, the best approach is usually not to invest. There will be many other opportunities. Especially if you are buying your small business through a sales person, don’t let them pressure you into making a decision.

It is generally a good idea to see management of the company face-to-face to size them up. Focus on experience and record of accomplishment rather than a smooth sales presentation. If possible, take a sophisticated businessperson with you to help in your analysis. Beware of any information that differs from, or is not included in the disclosure document. All significant information is required by law to be in the disclosure document. If anything looks fishy, it probably is.

Just to wrap this up, its possible to get in on the ground floor by investing in small businesses. When successful, these enterprises enhance the economy and provide jobs and can supercharged profits. But the advantages must be balanced against the highly risky nature of small business investments.

Best,

James



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