One of the things I like about owning a business—and I’m sure you’ll agree with me—is building something from scratch. That sense of accomplishment is really unmatched.
And at some point, if you’re successful in your own business ventures, you might be approached by another budding entrepreneur who has an idea he just knows you’ll want to be a part of. Maybe it’s a new restaurant, the next social network or a product that promises to revolutionize its industry. Either way, if your interest is peaked, you’re going to have to make a big decision: Do you want to invest in another business?
Here are some tips for answering that question:
- Do your due diligence. This is fairly obvious: before you hand over any significant chunk of money to anyone, whether it’s for a business investment, a stock investment or a new television, you need to do a little research. But you’d be surprised by how many people skip this step. To cover your bases, you want to analyze the management—ask about their qualifications, credentials, background, previous experience and, most importantly, references—and the market the business is entering. To do that, says Bill Draper, a seasoned venture capitalist and author of The Startup Game: Inside the Partnership Between Venture Capitalists and Entrepreneurs, you can go to relevant associations or organizations for information, but you should also do some of your own research. “You can find out an awful lot these days by just Googling, and you can do a lot of research on markets that have a consumer bent by just talking to friends and family, and doing your own purchasing of the product or service, if it already exists.”
- Get out and about. Your best resource is this business’ customers, or, if it hasn’t launched yet, its potential customers. They are going to tell you whether the idea is viable, and if it should be tweaked in anyway. It's also the best way to get a sense of reputation—which you want to be pristine, not problematic. “Get on the phone or out and talk to people who are in that field. It’s not that hard to run down who the customers are. Ask them if they’ve used this product, if they need it, or if it’s just nice to have,” says Draper.
- Look at the financials. You don’t want to make any investment—even a small one—without looking at some audited financial statements. What are you looking for, exactly? Primarily the margin on the product or service, says Draper. “You don’t want a 20 percent margin; you want something like a 60 percent margin, because it costs a lot for a small company to run, and especially to get the word out—marketing costs can be very, very high.” This is a good measure of the company’s performance and a good predictor of future performance, provided the numbers are based on solid history or careful research. It helps to bring in an expert here, so have your accountant take a pass as well.
- Prepare to lose. Investing is risky and small businesses often fail. You need to go into this knowing that the odds are stacked against you. “Don’t put any money in that you can’t afford to lose because the odds of picking a small business that will succeed are slim,” warns Draper. (This is why I often lump investments like these into the same category with other dream investments. It's okay to take a flier with 5 or 10 percent of your personal portfolio, but no more.) If you want to minimize your risk, minimize your investment by going in with a few others. Maybe you each put $10,000 in to get the business off the ground. In this scenario, you’re sharing the risk.
- Understand your position. Draper says existing small business owners are well suited for investing in another business because they have a better sense of what makes a company successful—so you have a little bit of an edge. But remember that it’s important to diversify, which means you might want to spread your risk a bit by investing in a business that is very different from the one you already own. If you have two different luxury services—a hair salon and a massage parlor, maybe—you have to understand that in tough economic times, both are likely to take a hit. So maybe you have the hair salon, but for the second investment, you go for something a little more recession-proof, like a hyperlocal Groupon knock-off.
Jean Chatzky is financial editor of NBC's "Today" show, a contributing editor at More magazine and author of "Money 911: Your Most Pressing Money Questions Answered, Your Money Emergencies Solved." She recently launched the Jean Chatzky Score Builder in partnership with smartcredit.com. Check out her blog at jeanchatzky.com and follow her on Twitter and Facebook.
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