Investing in businesses, whether they are start-ups or seasoned, is not for the faint of heart. There are many perils for taking on such high-risk ventures. Here are some ideas on how to do it well and how to avoid the pitfalls.
Business Plan
Failing to plan is planning to fail, an axiom that clearly holds true in business investing. Any entrepreneur who does not have a business plan is going to have serious trouble operating his/her business. Therefore, do not put any of your money into a business that has no written plan on how to succeed. The fact that the entrepreneur is unwilling to spend about forty hours of time to really think through the business management side should serve as a warning to stay away from this entrepreneur. Let them gamble with someone else’s money – not yours!v
Financial Statements
The financial statements of a business must be reviewed and analyzed on a regular basis (e.g., quarterly, if not monthly). The reports must be prepared on time. Late filings are a clear signal that something within the company is not going right. Do not ignore the warning signs. The financial statements must include an income statement, balance sheet, and a cash flow statement. Too much information is better than too little information. Ask questions about anything on the financial statements that you do not understand.
The financial statements, especially the income statement, should show growth, year over year, greater than 5%. If not, the business is missing important opportunities to service their customers/clients.
Capital Requirements
The capital requirements of a start-up business must be measured against those alternative usages of the cash. The questions to ask include: What is the annualized return on investment (ROI) that the business will produce, especially when compared to other alternatives of similar risk? What is the payback period, i.e., how long does it take for me to get my principal back? The longer the payback period, the worse the investment. Before one can get to a payback period, one needs to know the breakeven period (i.e., the period when operating revenue equals operating costs). If the business hasn’t even hit breakeven, then there’s no realistic way for you to get a good payback period.
Who Does What & When?
Be sure to examine each of the key members of the business and find out what each of their duties are and when they are to be done. Overlapping duties cause confusion and are a waste of resources. Duties should be clearly delineated and, of course, written via an organizational chart.
Know Your Business: The Principals
The principals of the business are who make the business work. Bad management can blow good money quickly. Make sure the principals have integrity, grit, experience in the field of endeavor (at a senior level), and are committed to doing the business on a full-time basis! Part-time efforts yield part-time results!
Know Your Returns
Do you want part-time results? Or do you want each dollar you invest to work to maximum capacity? Again, part-time efforts can only yield part-time results. Is the company hitting its projected profit numbers as per the business plan? If not, ascertain what the rate of return is and compare it to the company’s peers. If your company is doing better than its peers in financial performances, stay put. If not, examine what needs to be done to get your returns higher or prepare to get out of the company.
How to Get Out & When
Before investing in a business, decide the requirements necessary for you to exit the investment and how that will be done. Will the principals buy you out? Will you be allowed to sell your interest in the business to another person? In either case, you must know the terms and conditions for such a transaction to occur. Consider getting out when the growth prospects of the business have hit a point of inflection and the management team has no plan on how to get further significant growth. If the business revenue stays flat for six consecutive periods, then get out: Management is in over their heads and can no longer run the business. If the senior management is fighting between themselves, get out: A house divided cannot stand.
