Having the ability to help someone create their dream is why most people decide to invest in startups, while some just look for a good return on their investment money. With approximately 500,000 new businesses starting up every year, it can sometimes be difficult to identify the right investment opportunity. You want to be sure that the startup you choose to invest in is valued properly, that you have an exit strategy and that your liability is minimized should something go wrong. No matter what reason you may have for investing in a new company, these tips can help you choose the right startup and protect your investment.
But these tips are also valuable to all the business owners out there, whether you invest or not, as these are also good ways that you can attract investors to your business.
Identify the Opportunity
As odd as it may sound, it is sometimes difficult for those who wish to invest in new businesses to find an opportunity to do so. If you are a well-known investor in the business community, you may be approached about investment opportunities. But for the most part, entrepreneurs don’t advertise their need for startup capital. Most of the time, investors learn of the possibility of a startup investment from family, friends, or their network of colleagues.
Know Why the Startup Needs Investment
Most times, startups are trying to raise money from investors because they are unable to get financing through traditional sources, such as a bank loan. It is important to learn why the entrepreneur is not seeking traditional financing. However, it is also important to remember that just because a startup isn’t using traditional financing does not mean that the company cannot succeed. Financing for startups is extremely difficult to obtain and even businesses who have been operating well for several years report difficulty with bank financing. In addition, some business owners try to avoid starting the company with too much debt, believing that investors may provide them with more reasonable financial backing than a loan with high interest.
Consider the Business Structure
In order to protect your liability, it’s important to understand the different IRS and legal structures of a new company. If a small business fails, an investor could be liable for unpaid bills or liabilities. Because small businesses do fail with some frequency, it is important to protect yourself from liability for these expenses. However, you can consider creating a limited liability corporation (LLC) in order to protect personal assets should the business fail. Never invest in a business based on a handshake, no matter how close you are to the person you are going into business with. Always draft official documents and put things in writing to protect yourself and the other party.
Recognize That Returns May Be Slow
Keep in mind that when you invest in a company, you may not see returns on that investment for many years. When a business starts, they need as much cash on hand as possible, which means that earnings are reinvested or returned back to the company for the first few years. If you need to see a return on your investment quickly, consider lending the company the money rather than doing it as an investment. Because the loan is between individuals, you can set fairly reasonable terms so that it does not cause a hardship on the startup. Be sure to put all loan terms in writing to provide you with legal recourse should the loan not be repaid.
Have an Exit Strategy
One of the most important things to keep in mind when investing in a startup is to have an exit strategy. A startup company could use all of your capital investment even before the doors open and it could take years before they begin turning a profit. Even when the company is successful and you begin receiving dividends, you may have difficulty withdrawing the original investment. Therefore, when preparing to invest in a startup, discuss what your exit strategy may be. An exit strategy not only protects your investment but also protects the company owner from damages should you decide you no longer want to be part of the business. An exit strategy may stipulate who you may sell your stake of the company to — approval by the company owner of any future investor — or it may state how long you must wait before you can request a refund of your initial capital.
You can find good startup investments and protect yourself from liability or financial difficulty should the company fail. By entering into the agreement in a businesslike, legal manner, both you and the business owner will benefit greatly.
Murray Newlands is an entrepreneur, investor, business advisor and a columnist at BusinessInsider.com, Inc.com and Entrepreneur.com. He runs San Francisco-based PR agency Influence People and is the author of How to Get PR for Your Startup: Traction
The Young Entrepreneur Council (YEC) is an invite-only organization comprised of the world’s most promising young entrepreneurs. In partnership with Citi, YEC recently launched StartupCollective, a free virtual mentorship program that helps millions of entrepreneurs start and grow businesses.