How to invest in businesses
If you are considering investing in a business with the dream of perhaps finding the next big thing then you first of all need to be aware that there are risks.
You have to be prepared to lose money and the risk of losing is more likely with start-up businesses because of their limited trading history. However, with the right strategy in place the rewards can be exceptional and some government schemes have helped to reduce the amount of risk involved with investing in businesses. This article looks at how to go about investing in a business.
Finding the right business
Whether you have invested in multiple businesses already or are considering investing in your first business it's crucial that you make an informed decision about any business investment. In order to do this you need to carefully scrutinise the business to evaluate whether investing is a wise move.
One of the first aspects you should consider is the size of the market for the products or services offered by the business. If the market doesn't seem big enough the business is not likely to grow to a point where you would be able to take a return on the investment and you may even stand to lose a large portion of your investment.
If the market is big enough you should try to evaluate the business's team. You should be looking at their strengths and importantly find any weaknesses or areas that could be improved. Ideally there should be a strong management team who are passionate about the company, dedicated to serving the business's customers or clients and work hard to deliver results. If the business is what you are looking for as an investor but you find flaws you wish to address, although it is rare it can be possible to restructure the business.
You also need to establish how much investment the business is asking for and what stage the business has reached in terms of its growth. Essentially you need to ascertain whether the business is asking for a sufficient amount of investment in order for the company to reach the next stage of growth. Alarm bells might start ringing if you think the business is asking for too little or too much and this may lead you to question the judgement of the founders.
Additionally, you want to be sure that there are no personality clashes between you and the business's founders. You are likely to be working with them for a long time so it's important that you establish a strong and productive relationship from the outset. The right type of business owner should want to find out more information about the investor's background, business history and experience. Business owners who ask questions about you and your background are likely to be trying to establish whether you are a good fit for their business and indicates that they aren't just looking for a cash injection.
Getting the right deal for your investment
If you have found a business that you think is a good opportunity for investment you should focus your attention on negotiating the right deal. One of your first points will be the amount of equity shares you want in return for your investment. Usually an investor will pitch for their equity share to be between 15% - 30% but an investor can demand any percentage of equity share. However, businesses are likely to be put off by a pitch that leaves the investor with a majority share, usually 51% or more, because the investor would take control of the business from the current owners.
Investors may also wish to stipulate additional elements to the investment such as milestones and "lock-up" clauses. Supplementary clauses such as these can be used to protect your investment and strengthen the business's long term ambitions.
The recent economic environment led to a boom in new businesses and entrepreneurs which means the amount of investment opportunities has increased but finding the right business or businesses to invest in has become even more difficult. Furthermore, there is an increasing number of ways to invest. Small businesses are, arguably, the riskier to invest in than large, well established businesses. This is because a lot of small businesses fail and those that are successful often take time to grow and develop into a profitable business. This means an investor could make a substantial loss or potentially lose all of their investment. However, the government has made investing in businesses more attractive with tax break schemes for business investors to encourage economic growth.
Tax relief incentives through the Enterprise Investment Scheme (EIS), the Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trusts (VCT) were introduced to encourage wealthy individuals to invest in unlisted businesses. The tax relief incentive behind these schemes essentially provides investors with a buffer against the money they could potentially lose which reduces the amount of risk involved.
A separate platform for investment has also come about, namely crowdfunding. Crowdfunding is an online platform that allows businesses to raise capital. The most common form of crowdfunding is a reward based campaign where people are able to pre-pay for a product (usually at a discount) or are offered a perk in return for their financial contribution. However, businesses are also running equity based crowdfunding campaigns where people can invest in their business for as little as £5 in shares.
Enterprise Investment Scheme (EIS)
The Enterprise Investment Scheme has been available to investors since 2007 and is designed to make high risk investing in unlisted small businesses more attractive to investors who purchase new shares in these businesses. When investing using EIS, an investor is able to claim tax relief on profits or losses, although any dividends (money paid to a shareholder out of company profits) on the EIS are still taxable.
Investors using EIS are usually successful entrepreneurs who are more inclined to seek an active role within the businesses they invest in. This can be very beneficial for the business as they not only benefit from the capital investment but also from the investor's expertise.
Seed Enterprise Investment Scheme (SEIS)
The Seed Enterprise Investment Scheme (SEIS) was introduced in 2012. It is designed to help businesses raise capital at a very early stage by offering investors tax relief on new shares. SEIS was introduced in 2012 as a temporary measure to help start-up companies because banks were less likely to provide the capital these type of high risk businesses needed. Dividends will still be taxed on the SEIS.
Venture Capital Trusts (VCT)
A Venture Capital Trust is an approved HMRC company which has been set up for the specific purpose of investing in small unlisted companies. Venture Capital Trusts work slightly differently because the investors buy shares in their chosen VCT and the company itself invests in small unlisted businesses. A Venture Capital Trust can be the favoured option for investors who wish to build up an investment portfolio, rather than just investing in one business.
The VCT scheme allows these companies to benefit from certain tax reliefs. Unlike EIS & SEIS you cannot make an investment and claim tax relief in the previous tax year, but dividends are exempt from income tax although there is a maximum allowance.
Equity crowdfunding websites are growing in popularity because they allow companies to offer an investment opportunity to a lot of people. These individuals have the option of investing small or large amounts of money as equity shares and they can be more likely to invest small amounts in several businesses because the risk of losing a lot of money is less likely. However, a crowdfunding investor may have to invest in a number of businesses before finding a successful investment and if the investment is small the returns are also likely to be small. As above, the risks of losing the invested amount are high.
Company's who run equity crowdfunding campaigns might only offer a total of 10% of the company's shares and the investors are likely to be sharing this 10% with hundreds or even thousands of other investors. Additionally, crowd investors are not likely to have a say in how the company is run which might not suit every investor.
When planning an investment it is crucial that you protect the investment with a formal legal agreement between both parties. It can be very difficult for a business to find the right investor and in order to create and maintain a healthy working relationship the terms of the investment should be carefully negotiated, understood and never rushed. There are many aspects to an investment agreement that should be considered, so it is important you seek professional advice from a specialist legal team.
If you are considering investing in businesses, the experienced team at Rollingsons will be able assist you throughout the investment process to ensure the terms of the agreement are negotiated and agreed correctly and that your investment is properly protected through business ownership. We do not give generic investment advice, but instead give legal advice on the rights and responsibilities or investors and investees. For more information or to arrange an initial consultation, please contact us on 0207 7611 4848.