Q: My friend asked me if I would be interested to invest in his business. The business looks promising but I don’t have any idea how good it really is. He said I could invest in his business either by buying an equity stake in the company or by loaning him at 12 percent per annum for their expansion. I am thinking that this may be a good way to start a business. Should I accept his offer? – Buenaflor via email
A: One of the benefits of investing in an established business rather than starting up a new one is track record of marketability. It is considered as less risky in the sense that the difficult part of starting a business has already been done and a customized system based on how to run the business is already in place.
When a business is already operating, you can assume that it already has existing customers that generate regular cash flows. By investing in the company, you can enjoy whatever good will that the business has already created in terms of relationship with suppliers, industry reputation and market position.
But not every established business is a good investment opportunity. Some businesses may not be performing that well anymore due to increased competition in the market. Some may offer you investment terms that may be too risky. What are the things that you need to evaluate in an investment offer before you decide to accept? How do you align your decision to invest with your personal financial goals? Here are the 5 common investing mistakes every aspiring entrepreneur must watch out for:
1. Not having a game plan
Every time you make the decision to invest, make sure that you always have a clear investment plan. Planning your investment means identifying your goal and objectives. What is it that you are trying to accomplish? Are you investing for your retirement? Are you investing for regular income from dividends or interest? Or are you investing to learn the business and be more involved in the management someday?
Part of your plan will be the rate of return that you want to achieve on your investment as well as your payback period. You also have to come up with a backup plan in case the business fails to meet your expectations.
There are various reasons for making an investment. It can be strategic or personal, but whatever it is, clarifying your investment goal is the first step to success.
2. Not understanding the business
Everything is risky when you don’t know what you are doing. You must be able to understand how the business makes money. Where is the cash flow coming from? How will the business pay back your loan? How will the business use your investment for expansion and pay your dividends? Knowing how the business plans to use your investment and where it is going helps you manage your risks.
Investing is all about taking some risks in exchange for returns. You don’t want to earn exceptionally high interest annually only to lose your capital in the end. You also don’t want to earn too little income only to lose so much business opportunities that you did not enter because your money is tied up to your investment.
When you understand how the business works before you invest, you will appreciate that the return you expect to earn always comes with risk. Manage your risk by managing your expected returns. For example, you may allocate only a small portion of your investment portfolio to a company at high interest rate if you think that the business is risky. Or you may invest more in a company that you consider as stable though at a relatively lower return.
3. Not doing due diligence
Just because a company may show you that it has track record of historical profitability in the past does not mean that it will do the same in the future. There is always a possibility that the company may underperform, and when this happens, the company may not be able to repay your loan or recover your investments on time.
In the same way, a company that has been losing for years may not mean that you should always avoid it. Though it may be risky, there is always a chance that it may turnaround in the future given the right opportunities.
Investing is about identifying potential values in a company. The only way to validate this is by reviewing the financials of the business, as well as its plans for the future. How likely is the company going to sustain its growth? What are the chances that it will fail? How much should you pay for your equity share in the company given the financial situation of the business?
4. Not making objective decisions
Investing can sometimes be emotional. If your friend is in need and asks you to help him by investing in his company, you may be persuaded to invest not realizing the risks that you may never get back your money in the future if his company is losing heavily.
You may also get too excited about investing in a company without conducting careful due diligence causing you to pay more than what your equity in the company is worth.
Making investment decisions must be based on objective criteria that are aligned to your personal goals. There is nothing wrong with being emotional when relating with friends or initial impressions, but when it comes to investing your hard-earned savings, it is always good to be a rational decision maker.
5. Not investing in financial education
One of the most common mistakes many entrepreneurs make when it comes to personal investing is relying on investment advisors to make all their decisions. While it is good to have an advisor to guide you, the best investment decision is always the one that you will make.
You can only make confident decisions if you have the experience and knowledge. If you feel that you need to hone your skills in investments, do not hesitate to enroll in special courses or take up some educational seminars to learn more. Learning must always be continuing. There is always something new to learn about investing. As Ben Franklin used to say, “An investment in knowledge always pays the best interest.”
Henry Ong, CMC, is president of Business Sense Financial Advisors. Email Henry for business advice firstname.lastname@example.org or follow him on Twitter @henryong888