Should I invest in a small business? Here are the numbers.

ANSWER: You are right to be concerned. Making a minority investment in a privately held company is risky, but we’ve done it successfully. We’ll share what we’ve learned about how to mitigate the risk. You’ve said that based on the company’s current value, it’s a sound financial investment. That’s a good first step. Still, the pitfalls are numerous. Before investing, follow these four tips:

1. Ensure the business has a sound strategy: If you read this column, you’re familiar with the three questions that every successful business must answer: Why should a prospective customer buy my product or service rather than a competitor’s? Is there a segment of the market that values ​​the thing that makes my offering different from the competition and is it big enough to support my business? How will I cost effectively reach this segment of the market with my message?

2. Know why the owner needs the money: If the owner needs money to make payroll, we would suggest caution. On the other hand, if the owner needs money for capital improvements to expand or to fund working capital for a rapidly growing enterprise, that’s a better situation.

3. Verify that the majority owner is a good business person: Remember, when you buy a minority interest in a small business that the majority shareholder runs, you are making a bet on that person.

4. Make sure you will be compensated – without constraints: A minority interest in a privately held business is worth only what the majority shareholder says it is worth. Consider this, you write a $100,000 check. The majority shareholder then proceeds to manage the company successfully, generating a lot of cash. However, the majority owner just sucks the cash out of the business by increasing his/her own compensation and never declares a dividend. Further, he/she never sells the business, but passes control to the next generation. You will never see a nickel from your investment.

When making minority investments in privately owned companies, we insist on constraints:

The majority shareholder’s compensation must be formulaic. If the business is successful, the majority owner can’t just increase his/her compensation at will. He/she has to declare a dividend to get cash out of the business. Obviously, when dividends are declared, we get paid.

Earnings may be retained in the business for only a limited time. If the business generates cash, dividends must be declared, unless we approve otherwise.

We control myriad other ways that the majority shareholder could get cash out of the business (for example, paying a spouse $500,000 per year for being a receptionist or paying above market rates for services to other companies he/she owns).

The majority shareholder must devote his/her full effort to the enterprise. We don’t want to make an investment in a business and then have the majority partner take a full-time job at another company.

We protect ourselves against dilution or sale. If the majority owner is going to sell shares, we have a right of first refusal. This prevents him/her from issuing new shares and diluting our interest or from selling to a new owner with whom we do not wish to work.

Finally, we insist that our prospective on the business be considered. Admittedly, this is a “gentlemen’s agreement.” We can’t force the majority shareholder to listen to our point of view. However, we do make it clear upfront what we want to be heard.

Making minority investments in privately held companies is a risky business. The tips above are a good start, but this is a complex topic. If you aren’t experienced, reach out to experts before investing.