If you are not experienced in making investments in small private companies, you should know what your risks are before you make a decision to invest. This is especially true if you are not involved in the day to day operation of the company.
Having an attorney knowledgeable about your risks is the most important thing you can do before you begin the process. They can help you mitigate those risks with agreements as well as make sure you have the ability to monitor your investment once you make it.
Among some of the risks you face are:
Risk of loss of your capital
This is the most obvious risk you face. Many small companies (especially start-ups) don’t ever have a meaningful event (such as sale of the business) and many don’t survive very long. My rule of thumb is you should not invest any more in a small business than you are willing to loose in Las Vegas. Even with that caveat there are many people who have discretionary funds to do small business investing.
The legal structure of the entity should matter to a potential investor for a number of reasons. There are different tax consequences depending on the type entity you are investing in. A sole proprietorship should be avoided because all funds can be co-mingled with the sole owner’s. Chartered entities (corporations, LLCs, etc.) give you the most protection from potential liabilities because you are somewhat protected by the corporate shield.
There is a general rule with lenders that all 20% or greater owners in a company are required to sign a personal guarantee should the company borrow money. If you are not prepared to sign such a guarantee, you need to keep your ownership percentage below 20%. Shareholders who are officers and directors can also be exposed to certain kinds of liabilities that you should make yourself aware of. If you have a seat on the company’s board of directors and the company doesn’t make its required IRS employee withholding tax payments, the IRS can hold you personally responsible since it is a duty of the board of directors to make sure such taxes are paid in a timely manner. It is easy to mitigate these types of risks by making it a requirement that the company use a third party payroll service and requiring quarterly evidence that all required payments are made on time. Other potential contingent liabilities to be aware of include risk of not carrying enough product liability and worker’s compensation insurance and having a lawsuit result that names you if you are a major shareholder, officer, or director.
The company should have a set of bylaws or operating agreement. The company should be in good corporate standing with the secretary of state of the state the company is chartered in. There should be a written agreement between the investor and the company being invested in. The written agreement should specify all of the expectations of both the investor and the company invested in. This would include 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.” Make sure there is a stock certificate issued in the investor’s name, which represents the ownership interest. The corporation’s secretary should keep a stock transfer ledger and capitalization table showing exactly how many shares of a company are bought, sold and transferred during the company’s life.
If your small business becomes huge (think Facebook), and you start out with sloppy books and don’t keep good corporate records you may have someone show up at your doorstep when you get big and claim they were one of the original shareholders. Strong corporate governance will make any claim from a party that shows up after your company is worth a great deal of money difficult if not impossible to prove.
Ideally you would consider investing in a company that you have some industry knowledge of. If so, your advice to management can be very valuable. It is also a good practice to have the company surrounded by a good corporate attorney, certified public accountant, banker and a good commercial risk insurance agent. These trusted advisors can help insure the company operates with best business practices which in turn help protect your capital risk.
For the right type of investor, investing in a small company that has good upside potential can be very rewarding, but make sure you do your homework first.