How to invest in a friend’s business

Investing in a large, publicly traded company can be very profitable. But there is something to be said for investing in a small business or an individual – it is the purpose incubators like Y Combinator and the thrill of online crowdsourcing tools like Kickstarter.

But not all companies are hot internet startups. There are tons of great companies that have little or nothing to do with technology.

I myself recently reviewed a car wash business owned by a friend, which got me thinking about the potential pros and cons of investing in these situations. What do you do to ensure a successful (and profitable) relationship when the owner of the business you want to invest in is your friend?

Above all: Invest in an operator
At the end of the day, in these situations, we invest in people, not companies. That being said, don’t just invest in your friend because he is your friend and you like him.

Invest in him as an operator, meaning someone who has successfully run this type of business before.

As a small business owner, I can tell you with certainty that there are a thousand things you would never have thought of as a beginning entrepreneur. These types of mistakes are essential to the entrepreneurial learning process, but they can cost you dearly as an investor.

So if you’re not a talent development specialist or looking to become an incubator fund, reduce your risk by investing in someone who already knows what they’re doing.

Invest in expansion
Rather than investing in a business from scratch, consider helping fund someone’s expansion.

It’s a lot less formalities: there is already an operational company, which means that many necessary systems (supplier orders, accounting, etc.) are already in place. It also gives you an indication that the person can produce credible results.

Of course, there is no doubt that extensions can also go wrong.

You will need to carefully consider the type of expansion in question and determine whether it may be over-expansion: is it a similar market in a different location or a complementary product? Or is it a major shift to a new industry or customer base? These types of questions will help you clarify the level of risk you face so you can decide whether or not to take the plunge.

Do your homework
Part of the reason you might want to invest in someone else, rather than starting a business from scratch yourself, is that the other person has experience and knowledge that miss you.

But that does not exempt you from doing your homework. The more research you do – about proposed expansion space, competitive pressures, clientele, and anything else you can think of – the better prepared you will be to ask questions. The more questions you ask, the better you will be able to determine if this is something you want to get involved in.

If your friend takes offense to your ideas, questions, and concerns, that’s a red flag. Even if you intended to go in as a silent partner, it is well within your rights and within reason to understand the business plan and the opportunity. Defensiveness isn’t just a bad sign from an investment perspective; it means that the partnership could run the risk of ruining your friendship.

paper it
Every partnership needs a good paper trail.

No one likes to talk about what would happen in the event of a fight or relationship breakdown, but when there’s money on the table, it’s unfortunately a necessity. If you want to withdraw or things don’t go as planned, you need to have an agreed contingency plan that will safeguard everyone’s interests.

So sit down over a cup of coffee or a glass of wine and talk about it. What do we do if things go wrong? “We’ll find out” isn’t the answer you want to achieve – rather, you want a set of procedures that you’d both be happy to sign with anyone: friend, stranger or foe.

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