One of the positive developments of any economic downturn is the number of businesses which are started; young college graduates cannot find work and start a new business, laid-off employees use this as an opportunity to scratch their entrepreneurial itch and some find themselves as accidental entrepreneurs as a way to survive the downturn. Correspondingly, investors are burnt by the stock and real estate market and are looking for something “different” to invest their money in.

Start-up business in need of money meet the jaded investor. Match made in heaven? Maybe. Maybe not.

I saw a lot of businesses practicing law. Some great. Some middling and some that should have never started. For conflict of interest purposes, I never invested in them even though I was offered many times. The advice you give changes once you have an ownership stake. However, I would consider the p2p lending industry for business purposes an example of the growing trend towards investing money in private enterprises.

If you are thinking of investing in a “hot new start up” or some private businesses, there are a few things to consider:

• The best idea is not always the most profitable idea. I believe the most over-used terms I ever heard were “this is a great idea” or “I need to find a great idea in order to start a business.” Great ideas are not necessarily the most profitable ones. Take Apple for example. If you opened up an iPod, there’s nothing breath-taking in terms of its technology. Apple’s value is that it knows its market well and executes on getting the most out of that market. How an idea is executed is more important than the idea. An often quoted mantra in entrepreneurship is “better to have Grade A execution and a Grade B idea than a Grade A idea and Grade B execution. The lesson for the investor being don’t invest purely on how great the idea is, instead invest in …
• Good management who knows how to return cash back to investors. A friend of mine, a successful entrepreneur, said something interesting last month-”you can’t teach common sense in business.” Finding good management is an elusive task in publicly traded companies; think of how hard it is for start-ups or small private businesses. As an investor, you should spend a lot of time looking at management- do they have experience in the field (or are you providing seed money for them to make their mistakes), do they have a track record of success, do they have different skill sets or all they all in tech, sales etc.? What you are ideally looking for is management that has: (a) technical competence; (b) sales acumen; and (c) prior history building a business. If you have a management team that has all three, you have hit upon something. Ideally, ask yourself this question: “does this management team know more than I do about business?” If not, best to run away.
• Invest in businesses which are “scalable”. Venture capitalists use this term often. Scalable is really plain English for the concept that the business can be grown and “scaled” in size and revenue over time. As an investor, the greater the potential the business is scalable, the more likely you will get a better return on investment. An example of a scalable business would be a software company that develops applications for the masses (although tech companies die lots of terrible deaths), a mining company that has test results for a potentially large mine or someone building old age homes: there are lots of growth opportunities in these ventures. Examples of non-scalable businesses would include someone engaged in an arts and crafts business, someone buying a truck to deliver goods or someone opening a non-chain retail store. Chances are that these businesses will hit their peak very quickly and your investment return capped.
• What is the business’ exit strategy and how will you get your money back? This is what stumps most start-ups and private businesses- what exactly is its exit strategy? Is it being built to sell to a larger competitor? Is it going public? Or is it merely going to operate to pay the owner-managers well? As an investor, you need to know this going in just as you would investing in any publicly traded stock. If the exit strategy expectation is clearly set out, you won’t end up in a situation where you mistakenly thought the business was going public but it was instead built to give the owner-manager a comfortable life-style. The best place to find an exit strategy is in the business plan. I am not a big advocate of writing business plans for the sake of writing business plans but, if the business is trying to attract investor money, it better have a thorough plan setting out clearly how the investor will do if the assumptions are met.
• What rights do you have to get your money out? The issue with private-businesses is that it is very difficult to get your money out. There is no real market for your investment so you need to negotiate rights to request your money out when you want to. If you loaned the business money, this is an easy determination to make. At some point in time, the loan will mature. If you purchase shares in the company, this becomes more difficult. The easiest way is to negotiate a shareholders agreement (which is an agreement among the shareholders to govern the operation of the company and exit strategies) where you have a “put option” to ask for your money back plus interest at any particular period of time. You also want to make sure you have the ability to sell your shares without undue interference from the business. What you want to avoid is giving the business an option to buy you out at any particular period of time (unless it is at a premium to monies invested) or restrict your right to sell your interests in the company.

Investing in start-ups can be risky ventures but, with such risk, comes great reward. Remember to look very carefully at what you are investing in. It is your money so don’t be afraid to ask some probing questions. Good luck.