Whether you have chosen to start investing on your own or have been invited to invest in someone else's company, it is a significant financial move that requires careful thought. Putting your money into someone else's company is always a risk, and it can either produce a large return or result in a loss. Investing is not something you should get into without thinking very carefully about every eventuality.
With that in mind, here are some things to think about before you invest your hard-earned savings, your own business profits, or you decide to lend through your IRA into someone else's business.
Don't Let Someone Sell You An Investment
You choose your own investments. This is hugely important. Don't take a friend's or family member's pitch at face value. Do not invest in anything unless you have set your personal investing objectives and the investment matches them. You don't have a foundation for evaluating the opportunity if you don't have your own goals or criteria. You make yourself susceptible to a good-sounding sales presentation which could lead to a significant loss.
Make sure you examine the business plan for yourself. If you are unable to evaluate the business plan because you're not particularly business savvy, get assistance from someone who is.
Work Out The Risks
Determine the different possible results. Under what conditions will the company succeed? Under what conditions will it fail? What is required for the company to break even? Will more money be accessible if the company needs it at some time, or will the business collapse due to a lack of extra cash? Will you be prepared to turn down more financing and let the company fail or will you need to top up your initial investment?
Don't just accept a business owner's promise that everything will be fine. You need to work out the risk for yourself, and you need to know what is possible. Can you afford to lose all of your money? Will there be any assets left for you if the company fails?
Consider The Tax Implications
What are the tax implications of this investment? Is it possible to arrange this investment such that you get a tax advantage if it fails? Will the investment constitute a purchase of stock in a minor company under IRC 1244, enabling you to claim ordinary loss treatment if the stock is sold or the business collapses?
If the investment is structured as a loan, keep in mind that the IRS considers a loan to a company to be a non-business loss. The maximum capital loss that you can deduct from your ordinary income is $3,000 per year, unless you can use it to offset capital gains from other assets.
Use Your Influence
Choose what's best for you. If you don't want the investment organized the way the business owner wants it to be organized, don't invest. Are you a significant investor? Are you the only financial supporter? What power will you have to affect company management if you are just one of many investors?
Don't overestimate the founder's managerial contribution or undervalue your cash commitment. The founder may have nothing if you don't contribute. If the founder did not exist, you would still have your money, and you would find another investment. This means they need you a lot more than you need them, and you can use this fact to ensure that everything goes the way you want it to. Structure the investment such that you have the control you need to safeguard your investment.
Do It Right
Even if you are investing in a friend's company, be sure your documentation is in place. You'll need, at the very least, a legal contract. Check to determine whether any of your rights as an investor are required to be covered in the articles of incorporation in order for them to be legal. Have the articles of incorporation updated if needed.
If you provide substantial financing to a company, you should ask for rights other than collateral. You should be able to obtain financial reports regularly, examine the records and the facilities, and audit the company's financial situation. Being able to ask to see these things whenever you choose should all be a prerequisite of you investing any money, no matter how much or how little this might be.
Make Copies Of All Documents
Remember to keep duplicates of all documentation for the investment. Keep copies of minutes, bylaws, articles of formation, and shareholder agreements for the business. Keep copies of the agreements that create the entity for partnerships and limited liability corporations. Keep copies of all filings with the Secretary of State and the Internal Revenue Service. Keep the original loan notes in a secure location.
In other words, keep everything. These don't have to be physical documents; you can keep them in the cloud or digitally on a hard drive if that's easier (and it often is; losing these documents or finding somewhere to keep them would be potentially hugely problematic).
Make A Plan To Get Your Money Back
How will you make money from the business? Will you be a worker? Will you devote enough time to the company to warrant the desired income – or is that not needed and are you simply a silent partner? Will you get compensated for your services as a consultant? Do you want dividends paid to you?
There are many options around that will get you your money back, along with a good profit – that, after all, is why you're investing in the first place. Make sure you have a plan that will give you your money back at the very least, and ideally profits too.
Don't Use Money You Can't Afford To Lose
Don't invest money that you can't afford to lose. There are no guarantees for any kind of investment, and if the money you are using is really for something else, you shouldn't go ahead with your plan. Even if the company thrives, your funds could be locked away until a big event releases them (and the major event may never happen). Don't put your money into a company if your only exit is an initial public offering.
Ask To See The Business Plan
Be astute and request the business plan as soon as you think you might be interested in investing. The first stage in the process of intelligent investment planning is to request a business plan. Accepting an investment proposition without a business plan is a bad decision that could lead to financial catastrophe. A well-written business plan should be able to describe and highlight the company's potential. The investment strategy must be clear and explicit in terms of how it will generate investor returns and the anticipated duration.
In this way, you can see exactly where your money is going, what it will buy and pay for, and how and when any profits should be made in the business. This means you'll have a complete picture of the entire process of your investment from beginning to end.
Simply Be Careful
Don't be irresponsible, even if you can afford to lose the money or the benefit of your investment isn't you but your child in many decades to come, be careful. Irresponsible investment breeds irresponsible management. A poorly managed company is a bad investment for you and a poor training environment for everyone involved.
If you neglect to really investigate everything about the investment, you could be setting yourself up for failure.