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entrepreneur with open signQ. A friend asked me to buy 20% of his small business for $100,000. I’m sure that 20% of the company is worth that much today. Still, I’m worried. Are there things I should think about when it comes to making an investment like this one?

A. 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:

  • 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:

o Why should a prospective customer buy my product or service rather than a competitor’s?

o Is there a segment of the market that values the thing that makes my offering different from the competition and is it large enough to support my business?

o How will I cost effectively reach this segment of the market with my message?

Before you invest in a business, make sure that these three questions have been answered well. If they haven’t, you could see the value of your position decline precipitously.

  • 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. We’ve found good investment opportunities when the owner of a successful, growing business needs money for personal reasons (e.g., to buy a house).
  • Verify that the majority owner is a good businessperson – Remember, when you buy a minority interest in a small business that the majority shareholder runs, you are making a bet on that person. Good business plans are a wonderful thing, but in our experience, they always need to change. The person running the business will have to recognize changes to the competitive environment and pivot.
  • Make sure you will be compensated – Without constraints; a minority interest in a privately held business is only worth 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 very 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. You might as well have flushed your money down the toilet.

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

o 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.

o 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.

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

o 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.

o 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.

o 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 up front that we want to be heard.

Making minority investments in privately held companies is 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.

“I HIGHLY recommend Polly and Doug. They have wonderful insight to help small business owners prioritize and identify strategies for growth and improvement. Wish I had met them 20 years ago!”

Sharon MaderePresident / Premier Pet Products

My team and I have had the privilege of working with Polly on our business. Polly's keen business insight and savvy is something special. She was honest, direct, and tactful about her observations and recommendations for our team and how to grow our business. It was a pleasure having her help us and I would tell anyone that’s serious about growing their business to call Polly. She’s great!

John O’Reilly, Broker/OwnerBase Camp Realty

“Doug and Polly, I want to thank both of you! The past few months have been enlightening and overwhelming all at the same time. Your guidance, direction, wealth of knowledge, and wisdom have exceeded all my expectations. No words could ever completely describe just how amazing of a “dynamic duo” you two really are!”

Dawn Beninghove, RN, CCM, CRP, PNChief Executive Officer / Companion Extraordinaire Nursing Network, Inc.

“Doug White took on an unfocused operation (in the financial services sector) and created an efficient, centralized system dedicated to excellence. He did this not by driving change from the top down, but by helping the entire team see how their part of the process could be improved. Doug then mentored us toward effecting the changes ourselves. He taught us all how to bring our “A game,” and how to take ownership and pride in what we do.”

Donna LevinVice President of Operations / care.com

"I have had the privilege of working with Polly White for several years on a variety of projects. She consistently provides clear direction on how to resolve a wide range of employment-related issues. I look forward to my continued relationship with Polly."

Elizabeth WilkinsBusiness Manager / Manorhouse Management, Inc.

I have known Polly for more than ten years. As an HR Manager, I have utilized Polly’s training expertise at my former company and with my current company. Polly exceled at assessing the needs of our management teams and tailoring training programs that resulted in visible positive change. I also know I can count on Polly as a resource on any HR topic or bounce ideas off of her when I need a second opinion. Polly has been a mentor to me and I have always appreciated her willingness to listen and offer valuable advice and expertise.

Leigh McCullar, HR Business PartnerUniversity of Richmond

I am truly impressed with the abilities of Doug and Polly White, thank you! What a difference your expertise have made in helping Associates grow in their careers. Your dedication to excellence through empowering the individual and strengthening the Company is enlightening. I do and will continue to recommend Whitestone Partners to the Executive Market.

Suzanne Pittman, MEd VAMAC, Inc.
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