Making a minority investment in a privately-held company is risky, but it could be done successfully. But if you are not careful while making the decision to put your money in other people’s businesses, you could have your fingers burnt at the end of the day. The first red flag you should look for in the business you intend to invest is its financial soundness.
The following guidelines would help you avoid pitfalls that many encounter in the course of investing other people’s ventures:
Make sure the business has a sound strategy
Before you put your money into any business you must ask if a prospective customer should buy this product or service rather than a competitor’s. Is there a segment of the market that values the thing that makes the business you want to invest in that is different from the competition and is it large enough to support it? How would the business cost effectively reach this segment of the market with its 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.
Know why the owner needs the money
You must be interested in why the owner of the business wants to sell his equity. If it is because he needs money to make payroll, then you should be wary. 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. Just ensure that the business is financially sound.
Double check the majority owner
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.
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. So, take time to check out the integrity of the owner. Look at other businesses he or she has done in the past.
However, if 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.
To avoid this, the majority shareholder’s compensation must be formulaic. Raises in compensation are a function of growth and profitability. Ensure that 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.
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.