Have you ever been approached by someone who said, “Do I have a deal for you!”

Perhaps you’ve been approached by a friend, family member, or colleague about a business idea they are trying to launch. They need investors, and they’re coming to you.

It might even sound appealing, and it can be difficult to say no to someone you care about.

But more times than not, saying no is probably the right decision.

Statistics back this up. According to the U.S. Bureau of Labor Statistics, only about half of small businesses make it at least five years, and only one-third survive ten years.

Here are some things to think about when deciding whether to invest in a business idea:

1. Affordability. Before entertaining any offers to invest, you first need to evaluate whether you can afford to. It is risky to allocate funds that would otherwise go toward other purposes, such as paying for your children’s college education or retirement. Any good salesperson can make a business idea sound promising, but most start-ups fail and even more never get past the idea stage. A good rule of thumb on how much money to invest is to put up only an amount you can afford to lose without affecting your ability to maintain your current lifestyle.
2. Knowledge about the business. Remember that someone looking for investors will emphasize the positive. They are unlikely to discuss or spend any meaningful time discussing the drawbacks. Keep in mind that if something sounds too good to be true, it probably is. Also, evaluating the success of a new business by yourself may be challenging to do. First, you may have an emotional attachment to the business idea or the individual bringing it to you, which could keep you from making the right decision. Second, not all good business ideas make for profitable businesses.

   An example of this is a business idea that sounds promising but is not protectable by a trademark and can be knocked off by someone else. Finally, the complexity of the business may preclude you from being able to evaluate the idea yourself. In that case, you should hire an advisor to assess the concept.

3. Additional capital is required. New businesses often need additional capital as the company grows and, hopefully, expands. This is partly due to the difficulty new companies may have in securing financing from a bank because of an unproven track record. Therefore, it is important to inquire whether additional capital will be needed and how your ownership equity will be affected if you do not contribute additional funds. A review of projected cash flows also may uncover future cash needs. Your ownership interest could likely become diluted if you do not contribute more money than the other owners do. For example, you may start as a 10 percent owner. Still, your ownership could be diluted to 1 – 2 percent after several rounds of additional capital contributions, which may not make the investment worthwhile.
4. Return on investment. It is not uncommon for many businesses to lose money in the first few years. That, in itself, should not necessarily deter you from investing in the business. A company should start to make money soon after that. But profitability alone should not be the yardstick. Instead, evaluate the potential return on your investment (ROI) to determine if it is high enough given the amount of risk you are taking by investing. If the ROI is not high enough, you may want to pass on the investment even though it is profitable. Keep in mind that until you receive all of your initial investment back, your ROI is negative. So, in evaluating the deal, you should inquire whether the cash flow projections allow for cash distributions to be made to the business owners. The longer it takes for this to happen, the riskier the investment. Keep in mind that there is a tradeoff between making distributions to owners and retaining cash to grow the business.

These are some things you need to consider when investing in a new business idea. Also, assess management’s reputation, cash flow projections, the viability of the product or service, legal constraints, and tax ramifications. While the excitement of investing in a new business may be enticing, a more unemotional review is necessary to help you make a more informed decision.