Should you invest in somebody else’s business?

A newly ignited economy is a great environment in which to consider business expansion or creating a new business. So if you have any money at all, inevitably your child, your niece or nephew, or your friend or colleague will hit you up for equity financing to start up their new company.

What they offer you is a small share of their company in return for your money up front.

Should you go along with the request? Is it a good investment strategy?

No matter how much you care for the person asking you, you must remember from the start that this is a business decision, not an emotional one.

That means there are business matters to consider.

The first is why are they coming to you? Is it because they want your support and your expertise along with your money, or is it because they know they don’t stand a chance of getting a loan from the still-skittish banks? Refusal from traditional funding sources doesn’t mean they don’t deserve capital, but it does raise a caution flag.

Secondly, do you honestly think the business is valid and that the person starting the business has the skills and business acumen to make it work? Are they going to be open to your advice and take advantage of your expertise?

If all the boxes are checked okay, providing equity funding could be a wise decision. If the business succeeds magnificently, you will end up getting much more return on your money than if you had put your cash into a more traditional investment. If the company turns out to be the next Google or Apple, you may never have to work again.

But the risk is that you can lose every penny and there is no recourse for getting any of it back. And if the business you invested in is operated by someone you had emotional ties to, your relationship can suffer immeasurably.

Consider the case of those who provided equity financing for Apple when the late Steve Jobs and Stephen Wozniak co-founded it. There were so many shareholders who put financing into the business that when it hit troubled waters, they all got together and voted Jobs out.

Would you have the strength to do that if you had to? And while you are thinking about that, ask the start-up entrepreneurs how many other equity financiers he or she is looking to bring into the company. Are they people you can work with and make tough decisions if you feel you have to?

There is one more thing to consider before making your decision. Work out the company’s debt ratio by dividing the value of their assets into the amount of their debt.

The higher the percentage of debt, the riskier the venture, as a general rule. To be totally fair, compare its debt ratio to that of similar industries.

What is the bottom line? Providing equity financing isn’t a bad thing on the surface. In fact, many notable millionaires made it a regular part of their investment portfolio.

But is it right for you especially if your assets are limited? Do your homework and if you believe there is a reasonable chance for the new business to succeed, consider it. But don’t invest more than you are prepared to loose. 

Edith