The risks of investing in a small business

Every investor needs to understand that investing is risky.This is even more so if you choose to invest in a small business. It is crucial to keep in mind that no matter how good the business seems, how structurally sound it is set up and how talented the management is there is still a good chance the business will fail.Historically small businesses in every industry have a high rate of failure.However this fact should not dissuade everyone from investing.What is important is that potential investors clearly understand the risks they are assuming when they invest in a small business.Here is what you should know about the risks of investing in a small business-

• Be prepared to lose everything-Just like any other investment you should not put any money into a new startup business that you cannot afford to lose. Money to buy a new home, fund an education or make another significant purchase in the next five years is not investment money. Some financial experts recommend that you invest no more then you would be willing to lose gambling because that is what investing in a small business is.
• Understand the risks-Before investing it is crucial to consult with people who understand investing and can consult with you about the specifics of your financial situation. Your attorney, tax consultant or a qualified financial advisor can all give you advice about the risks of your particular investment.
• Realize what ownership in the company means-Whether you own 10, 40 or 75% of the company you are assuming risks when you invest with a small business. What this means is that you may face risks that are directly associated with the activities of the company. For example, if the company is sued by a customer, you as a 40% owner should understand that you will likely be personally named in the lawsuit as well as the company and other owners. Other common risks are that all IRS trust taxes (payroll) are paid current. As an officer, director or owner (this usually means greater than 20% ownership), you will be held personally liable for any payroll taxes that are not remitted to the IRS in a timely manner. So as an owner, you should always see proof that the IRS 941 tax forms are filed on time and that payments are made.
• Understand your personal risk-Investors should understand that nearly all lenders will require personal guarantees of shareholders that have greater than 20% ownership so if you become a 50% shareholder of a small business and the business needs to borrow money, you will likely be asked to sign an unlimited personal guarantee. It is important to keep in mind that you will likely be jointly and severally liable for all obligations for which you guaranteed.
• Now that you understand some of the risks associated with investing in a small business here are some things you can do to minimize that risk. They include but are not limited to:
• Have clear documentation-The business no matter its size should have a set of bylaws or an operating agreement. The business should also be in good corporate standing with the secretary of state of the state the business is chartered in. There should be a written agreement between the investor and the business that is being invested in. This written agreement should specify all of the expectations of both the investor and the company invested in. This would include but is not limited to:use of invested funds, voting rights of the investor, etc. In many cases, state and federal securities rules and regulations require the investor to be "accredited." It is important to make sure there is a stock certificate issued in the investor's name, which represents the ownership interest.
• Have a clear valuation-It is crucial that any investor and the company being invested in agree on the pre-money and post money valuation of the company. An investor should also completely understand these terms before investing. Keep in mind that there are a number of ways to determine pre-money and post money valuations and their formulas can be found numerous places on the Internet. The bottom line is that the percentage of ownership is determined by the valuation and the impact of the dollars invested.