Set Them; Never Break Them
During the DotCom era, I took up day trading. It seemed fun and exciting and a great learning opportunity.
It was all those things and it was draining. I learned that I liked to gamble. I liked the highs of winning a bet on a stock.
I also learned that I hated to lose. It would send me into an emotional low.
I eventually quit doing it right before the dotcom crash. I wish I could say I was prescient, but I was simply lucky to sell off when I did. Sure, I had clues that something wasn’t right in the tech/dotcom world, but the main reason I sold while I was up was that I couldn’t maintain an even emotional keel for day trading.
After that experience, I set rules to invest for the long term inside retirement accounts so that I couldn’t spend any of it. This has been a tremendous boon to me and saved me from my own crazy spending habits a decade ago (story for another time).
Now I’m building new rules for a new era of investing for me. I’m shifting current and near-future savings into small businesses that have solid growth potential.
In the past, I invested in a few small businesses. I had no rules, and learned some hard lessons. I’ll share those and how they are creating my new rules.
Lesson #1: What Have You Done For Me Lately?
A business owner may have agreed to take some money for a percentage of his company and agreed to pay out distributions, but…
Greed eventually pops up.
Owners start asking, “Why am I still paying you money?”
They begin to resent the investor who helped them out when they needed cash to grow. Once business is good, they decide paying out to the investor isn’t in their best interest.
Lesson #2: How Will I Get My Money Back?
Taking minority stakes in a business is risky. There isn’t any liquidity. The odds of a sale/acquisition are unlikely. Because of those issues, you must focus on how you’ll get your money back and how much profit you’ll make.
I learned this quickly when I didn’t get much money back. I’ve not “lost” per se, but I’ve not profited before.
So, I set up agreements where I get my money back + a percentage profit before I can be bought out. The buyout is also agreed upon before the investment. You might lose a little upside, but probably not much.
Lesson #3: Plan For 3 Years
Due to lessons 1 and 2, don’t think you’ll be in that investment long term.
If that business really does well, the major owner(s) are going to want to keep all the money. They’ll do the math and realize that if they buy you out now, it will cost them less than if they wait to buy you out later. Because of this tendency, I require a minimum return on my investment before I can be bought.
Lesson #4: Get Financial Control
Business owners can find all sorts of reasons to spend money, and many times, spending it unwisely. But the big one for an investor is salaries — specifically the owner’s salary.
The only way you’ll get your money back is through profits.
No profit, no ROI.
Back to lesson #1: greed always kicks in. One way an owner can make sure he doesn’t pay out to investors is to increase his salary.
If there is a cap on his salary, then he’ll hire his wife and kids and cousins and friends and whomever he has to so he doesn’t pay out to investors.
Greed is good… except when it is destructive. A really greedy owner will harm himself just to spite an investor.
You don’t need micromanager control over finances, but you do need to be able to veto some expenses, hires, and pay raises.
To get financial controls put in place, you need a legally binding agreement. You don’t need a majority ownership stake in the company.
Lesson #5: Invest In Owners Whom You’d Let Manage Your Checking Account
You have to trust the person you’re investing in.
Legal documents are for worst case scenarios. You must have them, but you should hopefully never have to enforce them.
You want to invest in people who would make sure your money is safe with them.
My Rules For Investing In Small Businesses With Growth Potential
These rules are not the same for stock markets, real estate, commodities, and definitely not for angel investing.
Rule #1: Cash flow is king. Invest for return, not for a sale.
Rule #2: Invest in companies that don’t need you or your money. This limits you to companies that want you and your money, but if they don’t have it they will succeed eventually anyway.
Rule #3: If you break rule #2, then own the company. Never take a minority stake in a business that will fail without you or your money.
Rule #4: Get financial controls in place. Make sure the owner can’t expense away all the profits. Remember, no profits = no return of investment.
Rule #5: Be a value-add. Your knowledge, experience, and/or network should add value to the business so that it has an even greater chance for growth (and you get your money back faster).
Rule #6: Invest for the long haul. Just because you’re unlikely to be in this business for more than 5 years doesn’t mean you shouldn’t treat it like a lifelong asset.
Rule #7: If any of the rules or lessons are broken — sell. Get the owner to sell the company or to buy you out. Don’t sit around hoping for profits. You’ll probably just get headaches.
If it makes sense, buy out the owner and put a manager in place.
Hopefully this is helpful in guiding you in making your own investments, if and only if, you are interested in small business investing.