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When a friend invites you to invest in their business, it can be challenging to remove your personal feelings and desire to support your friend from the cold reality of the business case for investment. As a general rule, you should take some time to objectively and seriously consider the state of the business. No matter who has founded the business, you should conduct due diligence before you invest. While it is a good idea to get professional advice, there are also steps that you can take on your own. This article sets out three things to consider before investing in a friend’s business. They include: 

  • doing due diligence;
  • considering how the business is valued; and 
  • considering how your status as an investor could change your relationship with your friend.

Do Your Due Diligence

Whenever considering a significant investment, you should go through a due diligence process. Due diligence is where you research or investigate the business and its records and documentation. You want to check that the business’ documents and financial statements are accurate and reflect any predictions that your friend has given you. You should review all of the key documents in the business, including:

  • balance sheets;
  • profit and loss statements;
  • tax information;
  • bank statements;
  • calculations behind any revenue or other projections; and 
  • information about the business’ employees and staff.

You may not be familiar with the financial or legal processes that form due diligence. In that case, it is a good idea to get experts to review these documents.

While this may involve some expense, it is almost always worth it before making a significant investment. In the worst case, your accountant or lawyer will discover some issue with the business that you were not aware of previously. Or perhaps you uncover an issue that your friend had not disclosed. Consequently, you may not want to invest. However, if all is in order, you can invest with more confidence in your friend’s business.

Consider How the Business Is Valued

There are many ways to value a business, and you should understand the basis for your friend’s investment. You should make your own independent assessment about how much your friend’s business is worth and propose an investment accordingly. 

Some different types of valuing businesses include:

Valuation Method Description
Valuation Based on Net Worth The business’ assets less its liabilities. This is usually a useful method for businesses with significant tangible assets.
Valuation Based on Revenue or Net Profit Valuation by taking a business’ revenue or net profit and multiply it for a ratio that is standard for the relevant industry. This is less useful for pre-revenue businesses or those at an extremely early stage.
Discounted Cash Flow Involves valuing the intrinsic value of your friend’s business today based on future cash flow. This is a more complicated valuation method. There are many different factors and variables to consider, including how the discount is applied, the current and continuing value, amongst others.
Net Present Value The difference between the value of revenue flowing into your friend’s business compared to the value of expenses. This can help work out how much investment your friend may need to fund the business.

No matter what valuation methodology your friend has suggested, you should conduct your own analysis and get an independent valuation. Again, talking to external experts in valuation can be the best way to go about this process. 

Consider Your Relationship

Finally, reflect on whether your status as an investor in your friend’s business will complicate your relationship with your friend. Unfortunately, you risk losing your friendship if the business has issues. There is no easy answer to this consideration. Likewise, your decision will depend on the:

  • nature of your relationship; 
  • status of the business; and
  • size of your investment. 

It may be the case that becoming an investor allows you involvement with the business. In that case, ask your friend in advance how they would feel about this. While it is great to support a friend’s new venture, it is always worth thinking about some of the financial and personal risks.

Key Takeaways

It can be an exciting and potentially valuable opportunity when investing in your friend’s business. However, there are some essential considerations before committing. Overall, you should take an objective look at the financial and commercial state of your friend’s business. Further, consider seeking outside advice with due diligence and valuation questions. Your friend may have the best intentions and plans. However, you should still take careful steps to ensure you are making a good investment.

If you would like more information about investing in a friend’s business, contact LegalVision’s business lawyers on 0800 005 570 or complete the form on this page.

Frequently Asked Questions

Should you do due diligence if a friend asks you to invest in a new business?

Yes, you should always conduct due diligence when considering an investment. Even in a new business, there will be financial and other records to check. Ultimately, you want to ensure that the business’ documentation and records are in order and reflect what your friend is saying.

What is the best way to value a new business?

There is no single best way to value a new business. Likewise, it depends on the nature of the business and industry. However, popular valuation methods include discounted cash flow, net present value and valuations based on net worth.

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