How to Invest in a Business

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There is a seemingly infinite number of approaches to the decision-making process used when investing in a business. One approach is focusing on delivering a superior product under the premise that the rest will fall into place. Another is to look at operations -- running a tight ship, practicing process optimization and bringing in industry expertise. Regardless of approach, consider investing in a business within the overall context of diversifying your portfolio.

Concentration Risk

Some people invest in a business with the objective of securing a job, preferably as a manager. While that can fulfill certain personal goals, investing in a firm that's already represented in your portfolio means you will be subject to higher concentration risk. Consider this factor and the possibility of divesting holdings subject to similar risk and return factors as the business providing your income.

Active and Passive

You can invest in a business -- even a small one -- as a passive as opposed to an active participant. However, there are serious extensions to this issue other than potential sacrifices of your leisure time. It is more common to invest passively in a company by taking a minority ownership position rather than a controlling stake. This can have a substantial effect on the value of your investment as the prerogatives of control can be quite valuable.

Security Type

Two common ways to invest in a business are by purchasing stock in it or by lending it money. If you become a lender there is a huge variety of debt instruments to consider. It is important that you manage risk by obtaining favorable terms with respect to collateral, interest rates and loan maturity among other terms. You can also invest using preferred stock or stock options. Again, consider asset-class diversification with respect to your portfolio.

Business Structure

Make sure you understand the various types of business entities. For example, many small businesses are incorporated as limited liability companies or sub-chapter S corporations. These types of businesses avoid the double taxation of corporate income by acting as pass-through entities that distribute the majority of income to shareholders. The legal structure of the firm you choose can affect decisions such as corporate strategy or the ability to liquidate your investment.

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