I've helped friends start three companies so far, and helped another continue on for a bit before losing everything I put in. Here's a few things I've learned in my informal angel investing adventures.
- Only invest what you can afford to lose.
As with all investing, really. Investing in a single company is very risky; it's putting all your eggs in one basket. Investing in a startup is like putting all your eggs in a basket made of a new experimental material with properties unknown. It might be a nice titanium alloy, or it might end up being a new origami pattern that disintegrates in a bit of rain. It can be a decent place to put truly spare cash, though.
- Put the terms in writing.
There will be confusion on anything not in writing, and even then there could be some. Think the arrangement is trivial? Someone will remember it as an investment, and someone else will remember it as a loan. The small business owner is going to forget the need to pay out quarterly for estimated taxes (though, this isn't a problem until you are in a position to have to pay them -- earning so much on the side that you surpass your regular employment's withholding, or retired and not withholding anything). Questions will arise when new investors want to join. Does the owner get a salary paid off the top? Better to just write it down and amend things when new issues come up and are decided.
Do as I say, not as I do, on this one.
- Be wary of replacing a departing investor.
If you are being approached to provide capital to replace some that a departing investor pulled out, extra caution is warranted. Investors can cash out for plenty of legitimate reasons (retiring and buying a summer home, for example). But, it could also be a sign that they saw something wrong. If it's been long enough for an investor to pull out, it's probably an established business. That means they've been in business for awhile and have not built up enough reserve capital in all that time. It's an increased risk, for sure.
- Be wary of contributing only a portion of initial startup costs.
Let's say a company needs $100,000 to start up, but you can only afford to invest $50,000. Include a clause to cover the possibilities. Either they don't raise enough to start at all, in which case you want to make sure you get back whatever money you've already given them, or they find a cheaper way to start up. But in this latter scenario, the likelihood of needing to raise more capital increases, and you need to make sure you're fine with the consequences. You're going to have your share diluted, or you need to include a clause about where that dilution comes from, up to their initial capital raise goal, as an example. Or they fail to raise more capital and go out of business.
- Be prepared to do your taxes late.
K-1s almost always arrive late. The more businesses that you invest in, the higher the probability you will have to file an extension. Pretty much always, in my experience.
- Feel good about it.
This has two parts. Before you pull the trigger, have a generally good feeling about the investment. Trust your gut to whatever extent you normally do. Afterward, don't stress too much. If all else fails, you helped employ one or more people, and you helped someone try to achieve their dream. And since you followed #1, you can afford to fail economically. Silver linings!