Pros & Cons of Small Business Direct Investment

by Sam Ashe-Edmunds

    Buying into a small business can be exciting for a variety of reasons, including the opportunity to be part of the company’s planning and activities and the chance to make a big return on your investment. Direct investment includes options such as starting your own business, buying an existing one, becoming a partner or acting as an "angel" who provides startup or working capital. Being an active or silent partner comes with a variety of liabilities you should review and address when drawing up a contract.

    When you buy into a business, you often have the opportunity to earn a larger return on your investment than if you simply purchase stock. This is because a direct investment usually commands a larger percentage of ownership than you can afford with stock purchases. When investing in a business, evaluate what you might earn in potential returns if you invested your money elsewhere to help you compare what a direct business investment might offer.
    Review the owner's financial projections and negotiate you desired return on your investment, both in terms of the amount you expect and the deadline by which you would like it. Avoid open-ended, long-term profit-sharing agreements and limit the amount of money an owner can pay himself before you're paid, especially if you don't control the operations. Plan on recouping your initial investment within two years, depending on the size of the potential return on your investment.

    Investing in a small business can cost you your entire investment because, unlike a stock purchase, you can’t set a stop-loss on your shares and get out if things go bad. In addition, you might open yourself up to personal liability for problems stemming from the failure of the business, even if they are solely caused by your partners. If the business requires the expertise of one or two people to succeed and it has few other cash resources, you increase your exposure.

    One way to protect your investment is to negotiate a role as a general partner, which gives you say in how the business is operated. This can help you prevent others involved with the business from taking actions you think will hurt the company. As a general partner, you are vulnerable to injury and fraud lawsuits and fines, penalties and liens placed on your personal assets for defaults on contracts or taxes. Negotiating a role as a limited partner removes your ability to actively participate in the business, but it protects you from liability.

    Depending on how you negotiate your investment agreement, you can control more than just the management activities of the business. Your contract with your partners can include specific methods of dissolving the partnership, which could allow you to buy out your partners or prohibit them from selling to others without your approval. You can negotiate terms that let you dissolve the partnership and sell your share at any time without the approval of other partners. If you create a general partnership, your involvement can expand to the hands-on management of the business.

    If the business begins to sour, you might become more involved to try to save it. This can lead to a heavy workload that can negatively affect your other job or obligations. If you become an active owner working at the business, you might work long hours six or seven days a week. If you do not negotiate who is the boss when you invest, you might find yourself in frequent arguments and stalemates than can stall the progress of the business.

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    About the Author

    Sam Ashe-Edmunds has been writing and lecturing for more than 25 years, covering small business, health, fitness, cooking, nutrition and sports. He has worked in the corporate and nonprofit arenas as a C-Suite executive, serving on several nonprofit boards. He in an internationally traveled sport science writer and lecturer.

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