If you do not have the ability to review the business plan, get help from someone who does. Require a business plan. Insist on seeing the business plan of anyone proposing that you invest in his or her business.
Step 1: Demonstrate the profit potential of the business.
Never even consider an investment without a business plan. The business plan should provide enough detail for you to determine whether the business is feasible and is likely to succeed. It should make clear how the business will make money and provide a return on investment to investors. Calculate your downside risk. Determine what the various outcomes might be.
Under what circumstances will the business succeed? Under what circumstances will it fail?
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What is needed for the business to break even? If the business needs more money at some point, will that money be available or will the business fail for lack of additional cash?
Will you be willing to refuse to provide additional funding and see the business collapse? Do not accept any representation that “that can’t happen. Can you afford to lose your entire investment? Will any assets be left for you if the business fails? What are the tax consequences of this investment? Can this investment be structured to provide a tax benefit to you if it fails? Will the investment be a purchase of stock in a small corporation under IRCallowing you to get ordinary loss treatment on the sale of the stock or failure of the business?
If the investment is structured as a loan, remember that a loss on a loan to a business is treated by the IRS as a non-business loss. Is the entity an S corporation, LLC, or other pass-through entity?
If so, remember that the tax consequences will be passed through to you. These tax consequences can be profits, losses, capital gains, etc. Make sure you can deal with these tax consequences. You may find that you can’t take advantage of losses because they are passive losses, which can only be used to offset passive income which you may not have.
Another potential problem is being taxed on profits that are not distributed. In a pass-through entity you are taxed on your portion of the taxable income, whether or not any cash has been distributed to you.