When you are looking to invest your money, several ideas will pop up in your head. Perhaps, as a business owner, one of those ideas is to invest in another business; maybe a business smaller than yours. This is a great idea and can generate substantial rewards if everything goes the way it should. However, you can’t walk right into this without knowing what you are doing. You need to know how to invest in a business before you take such a move.
Luckily, this article has been written to teach you everything you need to know about investing in a business.
It will serve as a guide that will aid you in helping someone actualize the vision and goals they have for their business.
With that being said, let’s get right into it…
Ways You Can Invest in a Business – How to Invest in a Business
The first thing we need to look at in this guide is the ways you can invest in a business.
There are 2 types of investments you can make in a business.
You can make an equity investment or a debt investment.
Equity Investment – How to Invest in a Business
An equity investment allows you to buy a part (could be small or large depending on the size of your investment) of the business you want to invest in.
This means that you can decide to provide capital (most likely in cash) for the business you want to invest in.
And in return, you will get an agreed part of the business’s profits or even losses (in a case where a loss happens)
Equity investments can be made to new businesses that are yet to launch or businesses that are already operational and need money for certain operational costs.
Most times, the percentage of the profits/losses you are entitled to will be directly relative to the amount you invest.
So, let’s say you put 100,000 dollars into the business while other investors together invested a total of 900,000 dollars too.
That would make the total capital 1,000,000 dollars.
Meaning you invested 1/10th equity.
Therefore, your profit/losses percentage would be 10%.
But in some other cases, this may be different.
Some businesses may not contribute money to the capital and would only offer their expertise for the partnership.
And you may be the one to bring all the money needed for the business.
But you most likely won’t end up getting a 100% return despite this.
You may get say 70% while the business gets 30%.
So, it all boils down to the agreement you and the business owner make.
One thing you should know about equity investment is that it promises big gains and also more risk.
If the business you invested in becomes successful, you stand to benefit a lot.
But if things become bad, you may end up losing your investment.
Debt investment on the other hand is simply loaning the business money.
Unlike with equity investment, you are not going to get a share of the business in exchange.
All you’d be getting back is an interest income plus payment of the money loaned.
The good thing about debt investment is it protects your investment funds to a point.
Again, this is unlike equity investment.
How is your investment protected? Well, let’s say the business you invested in goes bankrupt, your money most likely would still get back to you.
This is especially true in the case of a mortgage secured bond.
In this case, collateral for example real estate is used to get the loan.
So, in the case where the company goes bankrupt, you can confiscate and then sell the collateral.
Doing this may take some effort, time, and even money, but in the end, you should get back the amount you invested in the company.
But in some cases, you may not get your money back when something happens to the business you invested in.
This is especially true if the loan you gave was a debenture.
A debenture is usually not protected by a specific asset.
The investor simply gives the business the loan based on the company’s credit or good name.
So, in a case where the company goes bankrupt, the investor has nothing to fall back on.
They can only hope that the business owner pays them back their investment.
Which Should You Go For?
The truth is that there’s no way to answer this question.
Both debt and equity investments come with their fair share of advantages and disadvantages.
For example, if you buy the equity of a company that ends up being very successful, you would be rich.
But if you’d simply lent money to the company, let’s say you bought bonds in the company, you’d simply get your investment and your ROI.
Likewise, if you buy equity in a company that ends up failing, you most likely would lose your investment.
But you can escape this if you had just made a debt investment.
So, what you decide to do lies chiefly in your hands and how much of a risk-taker you are.
Would you rather put it all on the line for a big profit or would you rather play it safe and ensure your investment is protected?
The choice is solely yours to make.
But before you do so, ensure you take your time to weigh your options and also analyze everything.
Risks Involved in Investing in a Business – How to Invest in a Business
Just like with any form of investment or business, investing in a business comes with its unique risks.
The level of risk may vary between both equity and debt investments.
But one thing remains sure, both of these types of investments are susceptible to certain risks.
So, before you invest in any business, make sure you take your time to know and understand these risks.
Key Person Risk
One of the most common risks people that invest in businesses face is key person risk.
This is especially true with equity investors.
As someone buying into a business, you now have a responsibility for the company’s growth.
You also get to bear some of the financial risks, because if the business were to run at loss, you’d also bear a percentage of this loss.
Also, if you invested in a friend’s or family’s business, there is a chance of the relationship going sour if things go south.
The company may run into certain internal challenges that may affect it.
These challenges can be anything from reputation issues to security concerns, business interruption, fraud, and so on.
These things may end up affecting not just the company’s growth but also its revenue stream.
This would in turn affect your investment.
You May Lose Your Investment – How to Invest in a Business
Perhaps the biggest risk you stand to encounter when investing in a business is that you could lose your investment.
Sometimes, this happens because investors fail to properly conduct their due diligence before investing their money in a business.
Due to this, they may fall prey to a scam or they may end up investing in a company that is already halfway buried.
This is why you should only invest in businesses and projects that you have properly vetted.
You can also go with your instincts when it comes to making investments.
If a particular investment opportunity does not sit well with you even after it must have passed through all the stages of assessment, it may be best to go with your guts.
Other times, the fault is not from the investor in any way.
Rather, it could happen because something extremely bad happened and the business had to close down.
Almost 1/3 of small businesses end up closing down 2 years or lesser after opening.
That alone shows how risky it is to invest your money in a small business.
So, when investing in any business, only invest an amount that you know won’t affect your finances to the point of you going bankrupt if the business eventually crashes down.
Investment Illiquidity – How to Invest in a Business
Finally, when you invest in a business, you are more or less tying down your money.
This can be for months, but this type of investment most times tends to span over a long period.
This means for this most likely long period your money is inaccessible.
It is not like having your money in your bank account or in stock where you can decide to sell it off fast to get some emergency funds.
With this kind of investment, getting your money before the end of the investment years is very unlikely.
This is why you need to invest an amount you can let stay tied for that long period.
Or better yet, always make sure you have another cash reserve somewhere where you can always fall back on in case of emergency or maybe another investment opportunity comes knocking.
Steps on How to Invest in a Business
Now that you have good knowledge about the types of investments you can make when investing in a business, it’s time to learn the steps involved in doing so.
1. Look for Worthwhile Deals – How to Invest in a Business
The first thing you need to do when looking to invest in a business is to look for businesses worth investing in.
Looking for where to invest your money can be hard and at the same time very easy to do.
But the first place to look is within your network (those around you).
If you have business owners and entrepreneurs as friends and family members, then find out if they are open to investments.
But you should be careful when doing business deals with family members or friends.
A lot of business people are often wary of mixing business with family and this is for good reasons.
If you decide to invest in the business of a close friend or family, know that your relationship might be tested at some point.
And you need to prepare yourself for this even before you make your investment.
Another way to look for worthwhile deals is by asking other investors.
You can also read publications to check for startups and local companies worth investing in.
Another place to look for investment opportunities is social media.
2. Have a Meeting with the Business Principals – How to Invest in a Business
When you find a business that you feel you can invest in, you have to meet its principals.
This is to make sure that they are truly worth your time and money.
Find out what they intend to use the money you are willing to invest in the business to do.
Do they want to expand their business?
Get new equipment?
Hire new employees?
Whatever the intended use is should be clear and straightforward.
If it’s a new business that is yet to be launched, then the money is most likely to go into kickstarting the business.
So, learn more about the business’s vision and goals.
What exactly do they intend to achieve and how do they plan on achieving these things?
This first meeting is also a great chance to feel the business vibe as well as, understand the behavioral traits of those leading it.
It’s not easy to gauge a person’s behavioral pattern with just one meeting.
But you should be able to decide if or not the leader(s) and the business itself are people/something you will like to work with based on your first impression of them.
3. Carry Out Due Diligence
Now that you have confirmed that you want to partner with this business, you now have to take your research a step deeper.
It will be silly to pour your money into a venture that you are not sure of.
This is why you need to do your due diligence.
At this stage, you need to closely scrutinize the business; take your time to assess its viability and financials.
Review their books; do they have outstanding loans? If they do, review them.
Evaluate their product and/or service and see how it is doing in the market.
Ask specific and important questions that will help you determine the legitimacy of the business.
Find out important things like:
- How long the company has been operational
- Their cash flow and revenue
- How do they intend to use the money you will invest
- What you should be expecting as returns
- How scalable the business is
- Their financial projections
- Risks the company faces or may face
Just ensure you find out everything you need to know before you invest your funds in the business.
It may also be a great idea to study the business owner and other leaders in the company; run credit and background checks on them and see whether they are trustworthy.
4. Learn About the Business Funding
This is another very important thing you need to look at when you are assessing the business you want to invest in.
Find out where the business stands when it comes to its funding, debts, and even its assets.
Businesses can get their funding via credit unions, banks, other financial entities, Angel investors, venture capitalists, Small Business Administration Loans, and so on.
Why is it important that you find out about the business funding?
Well, first of all, it will help you know where the business stands financially.
Secondly, you also get to find out the other options available to you; especially if you are going to make an equity investment.
You will find out the other funding alternatives the company had used in the past, how that funding went, or its current status.
This can help you decide on another investment option that will bring better benefits to you.
Once you are satisfied with your research and you are sure you can do business with the company, you then need to negotiate the investment terms.
This part is very crucial and you need to take it as such.
Compile an outline of your offer; ensure it is detailed yet clear.
Then, review your offer with the business owner and/or leader(s).
If you are making an equity investment, then a clear agreement should be reached about your profit or ownership percentage.
And if you are making a debt investment, negotiate the loan terms; especially the repayment terms.
6. Close the Deal – How to Invest in a Business
It is at this point you and every other party involved will sign agreements.
After the deal is sealed, you will give the business the capital which you promised.
They will in turn give you your company shares (in the case of equity investment) or sign the loan contracts (in the case of debt investment).
7. Follow Up – How to Invest in a Business
You won’t just close the deal and then be on your way while enjoying the benefits of your investments.
No, you need to follow up on the business, especially if you made an equity investment.
Things can just change at any time (and sometimes not for the better).
So, it’s advisable to stay involved with the company and be up-to-date with the current happenings around it.
Conclusion on How to Invest in a Business
Investing in a business, especially a startup is a great way to support the dreams of another business owner.
And at the same time make something out of it for yourself.
You can either choose to make equity or debt investment.
Both of which come with varying degrees of risks and interest.
Equity investments promise more profits but are quite risky.
While debt investments, on the other hand, do not come with as much interest but are way less risky than equity investments.
Despite this, you could suffer a huge loss and lose your investment with either debt or equity investment.
This is why you need to properly do your due diligence before investing in any business.
Take your time to carefully analyze the business and even its owner and leaders.
If you don’t get satisfactory results after your investigation, then it would be better to call off the deal than to be sorry later on.