Evaluating Local Investments

This guide is about how to evaluate, make, and monitor local investments.  It is the fourth and final part of the Local Investing Resource Center’s How to Invest Locally course.  We recommend reading the first part of the course, Overview for Local Investors, for an introduction to local investing and many concepts that will be used in this guide.

Our Due Diligence for Local Investors Video Course (login required) is available as an alternative to reading this guide, for those that prefer learning that way.  The material presented in this guide is similar, but not identical, to the video course, so you can gain the most by experiencing both.

Table of Contents:
  1. Introduction
  2. Basic Principles of Due Diligence
  3. Investing Rules
  4. The Due Diligence Process
  5. Monitoring Investments
  6. A Quick Recap
  7. Resource List



Let’s say that you, as an investor, have found a local investment that you are interested in, perhaps because you discovered a local investing opportunity through your personal connections, or you attended a Local Business Showcase.  You like the idea of supporting this business.  You like the people that are behind it.  Should you just write them a check?  You certainly can, but how sure would you be that the investment would deliver as promised?  How sure would you be that the business would use your money effectively?  Shouldn’t you think carefully about the risks – what could go wrong or not according to plan?  If you don’t take the time to research your potential investment, identifying risks and making sure it’s an appropriate fit for your portfolio, then your investment might turn out to be more like a donation.  This is where the process of evaluating potential investments, called due diligence, comes in.  Due diligence is a way to identify risks, make better investment decisions, and maximize positive outcomes, both for you as an investor, and for the businesses you invest in.

Due diligence starts with understanding your own needs, goals, and tolerance for risk as an investor.  You’ll need to look at your big picture financial situation (possibly with the help of an advisor), taking into account things like your age, your cost of living, and how much income you need.  Is your current portfolio able to meet your needs, appropriately diversified, and within your tolerance for risk?  Do you have enough cash to cover emergencies and future needs?  You should identify any specific changes that are needed, and be on the lookout for investments that can help achieve them.  If your portfolio is already meeting your needs, then you can start looking for local investments that will help maintain that balance.

Once you’ve found a local investment that might be a good fit, research and evaluation will be needed to uncover potential issues and develop a more knowledgeable perspective. That process can include reviewing the business plan, looking at financial statements and projections, checking into references, and much more.  There is no standard for how thorough you need to be; rather, your process should simply match the relative importance and risk of the investment to you.  Ultimately, due diligence is much like detective work: start with a basic investigation and then follow the breadcrumbs, seeing where they lead.  Instead of taking an adversarial approach, though, use the process as an opportunity to develop a positive working relationship with your potential investee, sharing  your concerns with them (as appropriate), and working together to develop solutions, whether you ultimately invest or not.

As you get closer to making a final decision on investing, you’ll need to consider legalities.  Investments in securities issued by local businesses or nonprofits should always be done with a written legal agreement, which is often negotiated directly between the investor and investee.  These agreements spell out all the terms of the investment, including amounts, time frames, interest rates (if applicable), and any special conditions.  Agreements can even allow for creative elements such as receiving goods or services (blueberries, cheese, cider, bike repair, etc.) as part of your investment returns.  We’ll learn the basics of investment agreements in this guide.

After you’ve signed the agreement and written your check, don’t disengage!  Stay in touch periodically with the people you’ve invested in.  If you have entrepreneurial or other relevant skills to share, you can offer mentoring or support.  Review any updates that you receive, and ask questions. It’s wonderful when things work out as planned, but in reality, sometimes things do not work out as hoped, and sometimes completely unexpected events can dramatically change the situation.  When this happens, investors can play a role in mobilizing solutions that benefit the business as well as their investments.

Let’s face it: Evaluating, making, and monitoring your own local investments can be daunting, and some people believe that they are not well-suited for the task.  However, we’ve seen many people start from scratch and become very comfortable and even skillful with the process.  It helps that local investments are much simpler and easier to understand than Wall Street investments; after all, researching the business model of the corner store is far easier than evaluating a large multinational corporation!  Furthermore, due diligence encompasses a wide variety of skill sets.  Some people don’t know how to read financial statements, but they might be very good at evaluating a management team.  Plus, they can always learn how to read financial statements along the way; it’s not rocket science.  There’s also a role for intuition, or “gut feel” as well, which can be just as valuable as financial and personal skills in due diligence.

The best way to cover all the bases in due diligence, especially the ones you don’t excel at, is to team up with other people.  On a team, each person contributes their unique skills and perspectives, so the whole group can benefit from the more comprehensive job everyone can do together.  As part of a group, novices can learn quickly and are able to contribute more as time goes on.  Working together on due diligence is one of the reasons that investors across the country are forming and joining local investing groups.  These groups are reviving the almost-forgotten art of grassroots local investing and doing one’s own investment research and decision-making.

“Local investing groups... are reviving the almost-forgotten art of grassroots local investing and doing one’s own investment research and decision-making.”

One such group, the Whatcom Investing Network (WIN) from Bellingham, WA, was fortunate to have a former investment banker, Renata Kowalczyk, as a member, and ties to a like-minded local CPA, Siobhan Murphy, both of whom teamed up to create a due diligence course for local investors called U-WIN (University of WIN).  Many WIN members, novices to due diligence, attended the course, rapidly gained confidence and skills, and were soon asking great questions during meetings with local entrepreneurs.  This led to greater comfort levels with the businesses they were evaluating, and ultimately, to making their own local investments.  We teamed up with Renata and Siobhan to film a one hour Due Diligence for Local Investors Video Course, which is similar to this written guide, and available for free to registered users.  The introductory video is below.

Due Diligence for Local Investors Video Course

We offer these guides in hopes of helping local investors make better investment decisions.  Our goal is not to give you answers to your questions, but rather to help you ask your own great questions and learn to evaluate the answers you get back.


Basic Principles of Due Diligence

Good investment decision-making begins with knowing and following a few basic principles:

  1. Define your financial needs, goals, and risk tolerance, and only make investments that are a good match for you.  We’ll explore how to do this in greater depth in the next section, Investing Rules.

  2. Work with a team.  Two (or more) heads are better than one, especially when your money is on the line!  There are a few different kinds of due diligence teams, and you can use more than one to accomplish your goals.  The first consists of your fellow local investors.  If you are a member of a local investing group, you should have plenty of opportunities to join due diligence groups or committees that will focus on investments you are interested in.  The group can split up the various tasks so that at least two people are working on each part of the process.  These groups offer a diversity of knowledge and experience and generally don’t cost anything but the time you put in.  One very important caveat for local investing networks: each person in the group should agree in advance (ideally in writing, as part of the network’s Membership Agreement) that everyone will make their own investment decisions, and won’t hold anyone else liable for the consequences of their own decisions.  This does not apply to investment clubs, which make collective investment decisions.  For more on these groups, read our guide on Local Investing Clubs & Networks.

  3. The second type of due diligence team consists of your professional advisors.  Financial advisors, attorneys, accountants, bookkeepers, tax preparers, and bankers may be willing to help you evaluate local investments, even if it’s just offering a second opinion while you take the lead.  It might be difficult to find local professionals that are willing to help, and they will likely charge for their services, but if their assistance helps you earn a profit or avoid a loss, you may well come out ahead by paying a reasonable fee.

  4. The third kind of team consists of anyone with investment or entrepreneurial experience in your personal network of family and friends that is willing to work with you on a more informal basis.  You may need to offer some kind of exchange to secure their help, but having an experienced “personal mentor” can be an excellent way to learn about the process.

  5. Be patient.  Start by looking at a variety of deals, without any pressure to invest.  Don’t jump in until you get a better sense of what's out there, and what makes some opportunities more attractive to you than others.  It’s better to wait years for the right deal than it is to invest in the wrong one.

  6. Don’t let anyone rush you.  Any business that needs money as soon as possible has obviously not done a good job of planning, and may even want to avoid being under the due diligence microscope, so you should be highly skeptical of people that need money fast.  Ask as many questions as you need to fully understand every deal.  If a business person will not answer all of your questions to your satisfaction, regardless of how many you have, politely decline the opportunity to invest.

  7. Don't Cut Corners!Dig deep into the investment and the people behind it.  There is more at stake than just money, since you’re likely to have an ongoing relationship with these people outside your investment deal.  How will your relationship be if the investment does not turn out as planned and you lose your money?  What if that person’s life circumstances change, and they need to sell the business – what happens to your investment?  Take some time to anticipate the unexpected.  Often, business plans will feature rosy projections that are based on overly optimistic assumptions.  Figure out what those assumptions are and question them.  If you find yourself falling “in love” with a particular investing opportunity, and the temptation rises to skip the hard questions of due diligence and just pull out your checkbook, that is when you really need to slow down and commit to a thorough evaluation process.

  8. Think for yourself.  Investors are subject to the same types of crowd behavior as any other group of humans.  Every so often, when evaluating potential investments in a group setting, some investing opportunities will come up that everybody wants, and it seems like people are jumping over each other to invest.  Or you might see the opposite situation, in which no one appears to have any interest in an investment, even though some people might actually be interested but don’t want to seem naïve or out of sync with the consensus.  Sometimes, in a group, all it takes is one person with a loud voice or a big ego to drown out diverse, valuable opinions.  Be wary of these crowd phenomena, because almost every time, the group is collectively skipping out on a more rigorous due diligence process that could yield a better result.  These things happen because everyone assumes that everyone else has done their work and has their opinions for good reasons, but the reality is often that no one has done the appropriate work, and emotions like excitement or frustration have taken over.  In a group setting, when you notice crowd behavior, speak up.  Ask the group if there is an important perspective missing from the discussion, and try to find it.

  9. Trust your intuition.  Due diligence involves more than just logic and reason.  If you have done all the work, understand the risks as best you can, and something is still bothering you about a deal, don’t invest.  If possible, take the time to figure out what exactly is bothering you, and try to resolve the issue with the potential investee.  On the other hand, some investments just feel right, and these feelings can be valuable guides, as long as you’ve been diligent in your research.


Investing Rules

The first part of due diligence is evaluating your personal financial situation and setting guidelines for the types of investments that will help you meet your needs and goals, and honor your values, while staying within your tolerance for risk.  Financial advisors can be very helpful with this process, but you can also do it on your own.  Begin by looking at your big picture situation: How old are you, and how much risk are you comfortable taking?  What’s your cost of living, and how much income do you need from your investments?  How much cash do you need on hand for emergencies and large upcoming purchases?  With these things in mind, you can start creating investing rules that will guide the types of investments that will be the best fit for you and achieving your financial goals.  Consider writing down your rules for some or all of the following criteria, as you see fit:

  1. Diversification, also known as “Don’t put all your eggs in one basket,” means selecting a wide variety of investments for your portfolio in order to minimize the harm that any one bad investment, or category of investment, can cause to your overall financial situation.  You should diversify in many ways, not just one.  For example, you should diversify across asset classes (stocks, bonds/loans, real estate; this is called your asset allocation), across industries (retail, manufacturing, food, technology), geographically (local, domestic, international), and any other ways that feel right to you.  Most importantly, you should specify in advance the maximum amount you are willing to put into any one investment.  Your diversification rule could say something like “My asset allocation should be 40% stocks, 40% bonds, and 20% real estate (give or take 10% each).  I can invest up to 20% in any one industry.  I will invest 20% locally, 50% domestically, and 30% internationally (within 10%).  I will invest no more than 5% of my money in any single deal.”  Once you’ve decided on this investing rule, you’ll know how much money you can sensibly put into local investments.  For more on determining your diversification rule, see the next item.

  2. Risk tolerance is your ability to remain comfortable in the face of actually or potentially losing money.  It is closely related to diversification, because diversification lowers risk and can therefore make riskier investments more acceptable as a smaller portion of your overall portfolio.  For example, a conservative investor could reasonably invest in a very risky investment by putting less than 1% of his money in; a more risk-tolerant investor could be comfortable putting more in.  Investors with greater total assets can generally afford to be more tolerant of risk.  You should know the differences between riskier investments such as stocks and ownership in private companies, and more conservative investments such as bonds and loans.  You should also be able to distinguish conceptually between safe and risky loans, which depend on the borrower’s ability to pay you back.  For example, a US treasury bond is generally considered safe because the government has never failed to pay anyone back, whereas loaning money to a local startup without collateral would be considered risky.  The due diligence process is designed to reveal the various types of risk in an investment, so ideally, during the process, you should get a clear sense of whether or not you are willing to take those risks with any given investment.  The bottom line is that your diversification investing rule should be in line with your perceived risk tolerance.  For example, if you are less tolerant of risk, your diversification rule should require more bonds and loans, less stocks/equities, and a lower maximum amount in any single investment; and vice versa.

  3. Liquidity is how quickly and easily you can access cash, including by selling investments or borrowing.  You need cash to cover both expected and unexpected (emergency) expenses, so it’s important to have sufficient liquidity to meet your needs, both now and in the future.  Local investments tend to be illiquid; local businesses typically cannot repay loans ahead of schedule since they spend your investment money to buy things, refinance loans, hire people, etc., and have to generate cash flow to pay you back over time.  In the meantime, you’ll need other sources of liquidity, such as bank accounts, money market funds, publicly traded stocks, and mutual funds.  Ideally, your sources of liquidity should be diversified as well, so trouble in one part of your portfolio won’t make it difficult to raise cash when you need it.  Your liquidity rule could be “I will keep six months’ worth of expenses in cash at my local bank, and at least 30% of my portfolio will be in stocks or mutual funds I can sell at any time.”

  4. Time horizon is how long you expect to own an investment before it is sold or paid back.  You should choose investments with time horizons that match up with your future needs for liquidity and income.  For liquid investments, the time horizon can be quite flexible.  If you buy a publicly traded stock, for example, you can probably sell it a day later or 20 years later.  Illiquid local investments are less flexible in their time horizons, but may be longer or shorter than you initially expect.  For example, if you make a loan to a local small business, the agreement may be for them to pay you back in two years.  That investment would have an expected two year time horizon; however, the agreement could allow for you to be paid back early without penalty, resulting in a shorter horizon, or the business could run into trouble and not be able to pay you back on time, giving you a longer time horizon.  Be sure to understand what the time horizon of a given investment is, how it can vary unexpectedly, and how the time horizons of all your investments should work together to meet your financial needs.  Your time horizon investing rule could be “I can lend up to 60% of my local investment allocation for 5 to 10 years, and the rest should have a time horizon of 2 to 3 years.”

  5. Returns are how much you expect to earn on your investments.  “Gross returns” are how much an investment or portfolio earns, beyond what you put in.  “Net returns” are how much of the gross returns you keep after you pay all fees and taxes related to your investments.  If you require a certain level of returns in order to meet your future needs and goals (the financial planning process can help you determine that), then make sure that your portfolio, taken as a whole, is expected to generate those net returns over time, while staying diversified, liquid enough, and within your tolerance for risk.  The challenge with returns is that the expected future return for an investment is almost always a matter of probability rather than certainty.  For a local loan, for example, you may be expecting to receive 8% in interest, but if there is a small chance that the business will fail, then your expected return, taking into account the possibility of a loss, is lower than 8%.  Your returns rule could be “I need to make 4% returns per year on my local investments, after taking into account potential losses, taxes, and fees.”

  6. Taxes are assessed every year on interest, dividends, and realized gains from investments that you hold in your own name.  These investments are considered “taxable.”  Investments held in IRAs are not taxed on their income or gains every year; however, you will pay income tax on money that you withdraw from a Traditional IRA.  Roth IRAs are never taxed on gains or withdrawals, but you do pay tax on income that you put into them.  Generally, you cannot withdraw money from IRAs before age 59½ without significant penalties, so that naturally creates a longer-term time horizon for IRA money, especially for younger people.  You can use your IRA to invest locally, but relatively few IRA custodians offer the specialized product known as the Self-Directed IRA (SDIRA) that makes it possible.  SDIRA custodians are easy to find online, but fees and services vary widely.   SDIRAs are more expensive than regular IRAs, and require more paperwork, but they allow you to purchase promissory notes, ownership shares in private businesses, and other non-publicly traded forms of local investments for your IRA, not to mention other “unconventional” investments such as real estate.  Be aware that SDIRA fees offset your returns, so for smaller investments, the fees can actually exceed the returns, turning a profitable investment into a loser.  Therefore, it usually makes sense to invest relatively larger amounts through SDIRAs.  Overall, it is important to understand how your investments will be taxed, or not, and to make sure that your tax strategy (and any fees associated with it) fits with your net return goals.  Your tax rule could be “I can invest up to 10% of my taxable portfolio in local investments, and up to 20% of my IRA through a Self-Directed IRA.”

  7. Many people choose to make investments that are in alignment with their personal values, whether those are religious, social, or environmental, and avoid investing in companies that are working against, or are incompatible with, the values they believe in.  This type of investing was historically called Socially Responsible Investing (SRI), and more recently has been termed Sustainable, Responsible, and Impact (SRI) investing.  Impact investing refers to investments that are intended to have some kind of positive, measurable effect, or impact, on something, such as job creation or community development.  Most local investments are considered impact investments, because they can enable a local small business to hire people, open a store, add to the local economy through purchases of local goods and services, and generally create real tangible change in a community.  On the other hand, purchasing a publicly traded stock or mutual fund will hardly ever have measurable real-world impact, unless you or the fund uses shareholder advocacy effectively.  You should consider if specific values and/or impact are important to you, and if so, create a “values & impact” investing rule to guide your investment selection process.  An example could be “I will invest in impact investments as much as possible, especially focusing on renewable energy and sustainable agriculture, and I will avoid investments in industries that cause pollution.”

  8. Finnriver Farm- Locally Owned!Locality is where the impact of an investment is most felt.  Locality matters in local investing, so you should consider defining what “local” means to you.  Begin with a geographic area that feels local.  Ask yourself what parts of a business, such as ownership, staff, office location, and so forth, need to be located in the area for you to consider it a local investment.  For example, is an investment “local” if the employees and physical location are nearby, but it is owned by someone outside the area?  100% local small businesses are straightforward – they are either in your area or out of it.  Chain stores, franchises, and non-locally owned businesses are not as clear.  What matters to you in your local investments?  Who benefits?  Your answers can help you construct a locality investing rule.

  9. Control is how much power you have to affect decisions that are made at the business you've invested in.  Examples of control could include having a seat on the board of directors, having a majority of voting shares, or having the ability to approve or disapprove specific major business decisions such as borrowing money.  With publicly traded stocks, most people have virtually no control.  With local investments, more control can be negotiated for and written into the agreement, especially when investing larger amounts of money relative to the size of the business.  Sometimes, large investors can have more at stake in the business than the managers themselves, so control is viewed as a way to protect and enhance the value of a significant investment.  Still, it’s rare to have control in local investments.

  10. Leverage is how much you are borrowing relative to how much you own.  It’s common to have a leveraged home in the form of a mortgage.  Some people borrow money on margin in their brokerage accounts and use it to buy stocks, which is much riskier than buying stocks with cash.  The more debt you take on, the higher the risk that you could experience a cash flow crunch that prevents you from being able to make your interest payments, which could lead to forced sales of your assets or even bankruptcy.  Always be aware of how much you are borrowing and keep it within your tolerance for risk.  It is not recommended to borrow money in order to invest it locally.


The Due Diligence Process

Now that you have assessed your financial situation and written down your investing rules, you are ready to start evaluating investments to learn if they are good fit for you.  That process begins with gathering information on a potential investment, such as a business plan, offering documents, and financial statements.  Even at this early stage, you can learn valuable information about how prepared a business is to take on investors and execute their plan.  Do they have a business plan?  If not, consider referring them to a reputable business consultant, Small Business Development Center, or an independent expert with experience in their industry, and ask them to get back to you when they develop a more cohesive plan.  If they do have a business plan, is it well-written, well organized, and understandable?  Does it consider risks, competition, and downsides anywhere near as much as it focuses on upsides and rewards?  Was the business plan written with the help of, or reviewed by, someone outside the business that is qualified to do so?  If a business has not done these things, then there’s a significant likelihood the people behind it have not done a complete job of mapping out their strategy.  Many investors will not even consider investing in a business that does not have a clear and compelling business plan.

Next, does the business have a prospectus, private placement memorandum, or legal agreement for taking your investment?  There is not necessarily a right or wrong answer here, but at this point, simply take note of whether or not the business appears to have done their legal homework around accepting investments.  Some local small business people are not aware of securities laws, so you may be able to offer them basic guidance or referrals to help them address this area.

Once you have gathered this information, begin the process of reviewing it, developing questions that the materials do not address, asking them, adding the answers to your trove of due diligence information, and then repeating the process until no more questions remain.  Clearly, if at any point you decide not to invest, there’s no need to go any further.  Here is a basic map of the evaluation process.

Concept & Industry

First, start by exploring the overall concept of the business.  Be sure that you understand it, and that it makes sense to you.  Who does the business serve, and what needs does it meet?  How does it create value and make a profit, generally speaking?  Is it a new and unproven business, or an existing business with a demonstrable track record?  What contributions does it make to your community?

Second, look at the bigger picture of the industry that the business is a part of.  Is the business in an industry that you know and understand, or know nothing about?  Is that industry growing or stagnating?  Is it seasonal?

Management Team

Third, evaluate the management team.  Many people believe that management is the single most important part of any investment, since they are the people who will carry out the business plan, make the crucial decisions along the way, deal with the unexpected, and ultimately be accountable for your investment.  Who is on the management team?  Who selects the management team?  The owners or Board of Directors usually choose who manages a company, and therefore management can be replaced by them, which is good to know.  You can typically find this information in the business’ Operating Agreement (or similar legal agreement).  Next, identify any advisors, consultants, or other people that are influential to management, but not actually part of the management team, and make sure you are comfortable having them around.  Are there any advisors missing that could really improve the team?  If so, make suggestions.  The due diligence process provides an excellent opportunity to give your input to your potential investees.

Next, look into the background and track record of the management team.  Do they have prior experience directly related to what’s spelled out in the business plan?  Do they have business experience at all?  Can you verify their experience and general character by checking their references or credit history, or doing Internet searches?  Is their track record good and does it inspire your confidence?  Often, many different skill sets will be needed to execute a business plan, such as sales/marketing, retailing, operations/logistics, finance, and general management.  Does the management team have all the skill sets they need, or are any key skills missing?

Next, evaluate potential risks in the management team.  Is the team diversified with many people able to lead, or is there one primary leader on whom the success of the business depends?  Especially if an indispensable leader is older, is there a succession plan in place?  Does the company have “key man” life insurance on that person?  Would that insurance be used to pay back your investment?  What if the key person is disabled and cannot work?  Especially in small businesses, it’s important to consider a variety of potential scenarios when evaluating the management team, and what happens to your investment in those scenarios.

Financial Statements

Financial Statements don't have to be hard!Fourth, consider the financial side of the business.  You don’t need to be an accountant or banker to evaluate financial statements, but you do need a basic comfort with numbers.  If you’re not, consider getting help for this part.  Financial information comes in two forms: Historic numbers that report what actually happened in the past, and projected numbers that reflect assumptions about how the future will unfold.  Startup businesses may not have historic numbers, but existing businesses will, and you should review them to get to know the business from a financial perspective.

There are three main kinds of historic financial statements: Income statements that reflect what the business made and spent money on over time, a balance sheet that shows what the business owns (assets), owes (liabilities), and the difference between them (equity; the net worth of the business) at a single point in time (e.g., the end of the year), and cash flow statements which reflect how cash comes in and out of the business over time.  Tax returns can be another good source of historic financial information for those that can interpret them.  For basic due diligence purposes, you should obtain, at minimum, a recent balance sheet and the last few years of income statements.  Businesses that are taking care of their bookkeeping responsibilities should be able to promptly provide accurate, up-to-date financial statements.  Consider it a warning sign if this is not the case.

To learn about analyzing financial statements, check out the links to basic education on the topic listed in our Resource List.  Start by familiarizing yourself with the items you see on the statements, making sure you know what you’re looking at.  Can you tell how much cash the business has on hand?  How much debt?  How much profit it made in recent periods?  Often, these numbers don’t mean much on their own, but take on greater meaning when compared to other numbers in the form of financial ratios.  For example, the debt-equity ratio, which is total liabilities divided by total equity, gives an indication of how leveraged a company is, and therefore how much risk might be associated with its current level of debt.  For most financial ratios, there are no absolute levels that tell you if a company is financially healthy or not.  The best way to use them is to get a general sense of how the various financial aspects of the business compare with each other, and perhaps to other businesses, and to identify potential strengths and weaknesses that you can inquire further about.

Financial projections are the other type of financial information that you should be investigating.  Usually, they are presented as future, or pro forma, financial statements, such as future income statements and balance sheets.  The best projections use models, which separately forecast many of the factors that go into the ultimate result.  For example, a model-based financial projection might show assumptions about how many widgets the business will manufacture, how much they will sell for, and what the business’ various expenses will be over the coming years, in order to create a series of future income statements.  Projections that show the most important parts of the business, and how they contribute to the bottom line over time, can tell you a lot about how the management team believes the future will unfold for the business.  Review the projections, comparing them with historic statements, and ask management about anything significant that catches your eye, such as large one-time expenses, or changes in trends of ongoing expenses, like salaries, marketing, interest, travel, and so forth.  The answers can reveal how well they have thought out their business plan, their values, and more.  For example, if the business is spending a lot on salaries, how does that compare to other businesses in similar situations?  Here, watch out for businesses that intend to pay management generously with new investment money, rather than prioritizing investment in the parts of the business that drive future sales and profits.  If the business is spending a lot on marketing, does it have an actual marketing plan, and does the management have a proven track record with marketing?  If not, is a marketing consultant in the budget?  As you can see, financial projections are a rich area for generating questions to ask management and learn about what you are potentially investing in.

“When looking at projections, your purpose should be to uncover the assumptions that underlie the numbers, ask yourself if they make sense, and if not, ask management to explain them.”

As a potential investor, keep in mind two related points about projections.  The first is that they are based on assumptions.  When looking at projections, your purpose should be to uncover the assumptions that underlie the numbers, ask yourself if they make sense, and if not, ask management to explain them.  For example, many companies that are raising money will, optimistically enough, show rising revenues/sales in the coming years.  Since this is one of the easiest areas for a business to fall short of expectations, you should question what will drive that projected sales growth.  You would want to see sufficient marketing expenses to spread the word to potential customers and drive those rising sales.  As another example, let’s consider a startup company.  When are sales projected to begin?  Is it reasonable to assume they can start by then?  Will the company have enough cash to cover all its expenses until then?  Does it have enough extra cash to survive in case expenses are higher than expected, or sales take longer than expected to begin?  These are all major assumptions that affect a business’ ability to survive and thrive over time.

The second point to keep in mind about projections is that they are inherently uncertain, though to different degrees.  To illustrate, an established business should be able to use their current sales numbers and growth rates to develop a reasonably accurate set of projections based on their current reality, whereas a startup business will typically have little to no idea of how many widgets they will sell over time, although startups with thoroughly researched business plans should have a much better idea.  Without quality information to go on, businesses essentially have to make educated guesses.  Therefore, get a feel for how certain or uncertain the projections are by asking management to explain how they came up with them.  As you get to the bottom of the projections, you may get a sense of how conservative or optimistic they are.  Businesses with overly optimistic projections set themselves up for a greater likelihood of worse-than-expected results.  Because of that possibility, you’ll need to evaluate the impact on the business, and your investment, of future results that fall short of projections.  If sales miss expectations, and/or expenses end up higher than expected, then profits will be lower.  Will that leave enough money for you and other investors to be paid interest or dividends, or to get your principal back?  If not, is there a Plan B, both for the business, and for you personally?  Diligent businesses will do this work for you by presenting best-, worst-, and middle-case scenarios with a different set of projections for each.  Other times, you may have to do your own figuring.  The bottom line is that the worst-case scenario is something you need to be able to live with, given the amount of money you are considering investing.  In this way, the due diligence process can help you decide the optimal amount to invest, as you come to understand the risks of your potential investment better.

Deal Structure

Next, you’ll need to examine the terms under which you will be investing, which is called the deal structure.  All of these terms should be recorded in a legal agreement.  For Direct Public Offerings (DPO’s), this document will be called the prospectus.  For some private offerings, especially larger ones, it will be called the Private Placement Memorandum (PPM).  For most local private offerings, the agreement will need to be negotiated by the parties (which can include multiple investors, each investing separately under similar or different agreements) and written up by an attorney, or if everyone is comfortable with it, written by one of the parties to the investment.  Though it’s always recommended to have an attorney review legal agreements before signing, many local investors and local small businesses opt to write their own investment agreements, especially for smaller and more straightforward deals, such as promissory notes (i.e. loans).  Basic promissory note templates are available online for free, and we have a few sample links in our Resource List.  The main risks with doing it yourself are that an important term could be omitted, be written in a confusing or contradictory way, or conflict with existing laws or regulations.  The consequences of this could be nonexistent, or severe, depending on how things unfold.

The structure of a deal can, and generally should, include the following terms.  Be sure that all relevant details are addressed in the agreement.  For equity offerings, the company’s Operating Agreement is an additional document you’ll need to review for important details.

  1. Who are the parties to the agreement?  For loans, repayment security can be increased by including a cosigner in the agreement, who guarantees repayment of the loan.

  2. How much is being invested, and when?

  3. How will the investment be used by the company?  Are there any limitations on this?

  4. What kind of investment is being made?  For example, a loan, equity shares (ownership), revenue shares, etc.

  5. What kind of updates, such as financial statements, written reports, or meetings in person, are investors entitled to receive with regards to their investment, and how often?

  6. What payments will be received in return, and when?  Will they be in cash, goods and services, or both?

For loans:

  1. What is the interest rate, and does it change over time?

  2. How often does compounding (adding or “accruing” interest to the balance of the loan) occur?

  3. When do payments begin?  Sometimes, small businesses can benefit from not having to make payments for an initial period after the investment is made, so they can focus on building their business.  During that period, interest will accrue, but the investor will be paid afterwards.

  4. What constitutes default?  Default generally means a failure to make payments on time, or at all.  It is usually defined by the agreement as the borrower missing one or more payments for a certain number of days after they are due.

  5. What are the consequences of default?  This part is very important, as it gives the borrower an additional incentive (beyond just wanting to keep their word to you) to stay on track with payments.  Can the borrower “cure” the default by getting back on track with payments, and if so, how?

  6. Is the loan backed up by collateral?  Collateral is something of value that the lender keeps, or is entitled to receive, in the event of default, in order to compensate them for not receiving the payments they were promised in the agreement.  It’s common for real estate and equipment loans to be backed up by the real estate and equipment itself.  Otherwise, collateral is fairly rare in local loans.

For equity:

  1. How much will be paid out in dividends, and when?

  2. How many shares are being purchased, what percentage of the company does that represent, and how is the whole company being valued?

  3. What kind of voting powers (i.e. control) does the investor receive?

  4. Are there restrictions on transferring or selling your shares?  (Usually, there are.)

For revenue shares:

  1. How is “revenue” defined?

  2. How are the revenue share payments calculated?  Do they have a cumulative cap or time limit?

Look at the Big Picture

Once you’ve reviewed all the individual terms of your potential deal, consider the big picture of the deal, including other investors.  Here are some sample questions to consider:

  1. What’s the total amount of money being raised in this deal, from all investors?  What happens if the company raises only part of the funds they need?  Do early investors get their money back?  Sometimes the business’ situation can change dramatically depending on how much they are able to raise, so you should anticipate those different scenarios.

  2. How much debt and equity will be in the company after the deal is done?  In other words, what will the company’s balance sheet look like?  If debt will be very large relative to equity, perhaps the company is borrowing excessively.  If you are purchasing a portion of the company’s equity, is it being valued fairly relative to what the balance sheet shows?

  3. What is your expected annual return, after considering all the factors?

  4. Is the risk in line with the expected returns?  In other words, are you being compensated fairly for the risk you are taking?

  5. Are other investors receiving different returns than you?  If so, are their returns in line with yours, relative to the risks everyone is taking?

Finishing Up

If you’ve made it this far, congratulations!  You’ve gathered a lot of information and evaluated many different aspects of your potential investment, including the concept, industry, management, financials, and the deal structure.  If you’re still interested in making this investment, then it’s time to take a step back to look at the whole picture.

First, you’ve already looked at a variety of optimistic and pessimistic scenarios with regards to the management team, financial outcomes, and so forth.  Are there any other potential scenarios you have not considered yet?  What are the most likely outcomes, in your view?  Are unpleasant outcomes extremely unlikely, or not?  Are you comfortable accepting all the risks you’ve become aware of?

Next, circle back to your investing rules.  Is this potential investment a good fit for all of them?  Will you have enough liquidity after you make the investment?  How much of your total local investing allocation are you filling up with this one investment—are you leaving enough space for other local investments you may want to make in the future?  Will you be making the investment in a way that optimizes its tax consequences, such as through a Self-Directed IRA, or holding it directly in your name?  Is the investment in alignment with your values?

Do you have any remaining questions for the management team?  Have you developed a trusted relationship and good line of communication with them, and do you have confidence that this will continue during the term of your investment?  If not, how did you get this far in the process?

What do the other members of your due diligence team say about this investment?  Are they also investing?  Why or why not?  What do your professional advisors say?  If they are not supportive of the investment, why not?  If you plan to invest against the advice of an advisor, it may turn out fine, but be sure that you have addressed all their concerns carefully.

Shake on it!What does your intuition, or gut feel, say about the investment?  Imagine that you just signed the agreement and handed over the check.  Do you feel great?  Remember that it’s good to take risks in investing, as long as you can tolerate them and sleep at night.  If you are feeling really positive about the investment, are you being overly optimistic?  Are you following a group’s opinion instead of your own?

At this point, you should be able to make your decision.  If you’ve decided to proceed, make arrangements to sign the legal agreement and transfer your investment money.  You’re now a local investor – Welcome to the club!


Monitoring Investments

Once your investment is made, you should begin monitoring your investment.  There are a variety of reasons for this:

  1. If you maintain a good relationship with the investee, you can get updates on how things are going with the business.  You can share in the successes of the business, and offer help with the challenges.  Staying engaged early, when things are going more or less as hoped, helps build a foundation for continued communication and openness should the plans hit a shaky patch.

  2. If you receive periodic financial statements, you can see how actual business results compare to what you expected during due diligence.  This gives you a window into what’s happening at the business and how that can affect your investment.  Understanding how business results unfold over time also helps you get better at due diligence.

  3. If the business runs into trouble, hearing about it in a timely manner will help you mobilize a solution sooner.  It’s not necessarily your job to create solutions, but you may have connections, knowledge, or experience that can help.  The ability to directly affect your investment in a positive way is a unique aspect of local investing for most people.

  4. Make sure that the investee is living up to their side of the agreement.  You should be receiving payments on time, and in the correct amounts.  If you aren’t, reach out to find out what’s going on.  Usually, it’s not a big deal, but sometimes this can be an early warning sign.

“Business owners and managers are more motivated to make good on their investment agreements with local investors, compared to banks or credit card companies, because they are part of the same community, and often friends and neighbors.”

When things are good with an investment, life is easy, and when an investment gets in trouble, it can be challenging.  When a borrower isn’t able to generate the cash flow to make loan payments, they may have to default.  Generally speaking, it will be in your best interests to renegotiate a new, more sustainable payment plan that can work for the borrower.  This is called “restructuring” the loan.  It may involve delaying payments for a period of time, lowering the interest rate, and/or lowering the payment amounts.  Restructuring is likely to result in a loan that is less financially attractive for you as an investor.  Yet, if the business person is sincere about getting back on track, and their renegotiated obligations are truly workable (which is key), the results will almost certainly be better for you than turning to the legal system.  We have observed that business owners and managers are more motivated to make good on their investment agreements with local investors, compared to banks or credit card companies, because they are part of the same community, and often friends and neighbors.  This is an important factor that helps lower the risk of local investments in general, and makes the total loss of a local investment relatively rare.


A Quick Recap

To help you get started, here’s a quick recap of the process:

  1. Look at your big picture financial situation and make a list of your Investing rules, which tell you what kinds of local investments you should be looking for.

  2. Be patient while looking for investing opportunities.  Don’t jump on the first investment to come along, don’t let anyone rush you into investing quickly, and don’t worry if it takes a long time, even years, to find the right local investment.  Investing is a long-term proposition.

  3. Once you find a promising investment, recruit or join a team to help you with the due diligence process.  Your team can consist of other local investors, knowledgeable friends or family, and/or trusted professional advisors.  They can help you throughout the process, or review your work after you’ve done it.

  4. Do your due diligence.  Be sure that the concept of the investment makes sense to you.  Understand the industry that the business is a part of.  Research the management team, so that you know who is involved, their skills, experience, character, and reputation, and any risks there are with the team, such as dependence on a single key person.  Evaluate the financial aspects of the business, including both historical financial statements (when available) and projections, making sure you question the assumptions and the methods that were used to generate them.  Examine the deal structure, as evidenced by the investment legal agreement or prospectus, to ensure that the key terms and big picture are to your satisfaction.

  5. Do a final review, reflecting on all the information you’ve gathered and analyzed.  Have you considered all the relevant scenarios?  Does the investment fit with your investing rules?  Do you have any unanswered questions?  Do you have good communications with management?  What does your due diligence team think; are they investing?  What does your intuition say?

  6. Make your decision.  If you’re proceeding, sign the agreement and write the check.  Congratulations!

  7. Monitor your investment.  Stay in touch with the investee, review any financial statements and other updates you receive, and make sure you are receiving what’s due to you.  Offer support and be on the lookout for potential problems (and solutions) that you can help with.


Resource List

Modules in our How to Invest Locally course:

Local investing directories:

Due Diligence Tutorials:

Financial Statement Analysis:

Self-Directed IRA Resources:


Credits & Terms of Use

Created and curated by James Frazier of the Local Investing Resource Center.

Additional contributions by Siobhan Murphy of Thrive Business Group & Renata Kowalczyk

This material is subject to our site’s Terms of Use and Standard Content License. Please consult these documents and/or contact us if you wish to redistribute this material.

We welcome your constructive feedback, including helpful insights, clarifications, and corrections of errors and omissions.

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