How to Invest in a Friend's Business

Investing in a large, publicly traded company can be very profitable. But there's something to be said for investing in a small business or individual -- it's the raison d'etre of incubators like Y Combinator and the thrill of online crowdsourcing tools like Kickstarter.

But not all businesses are hot Internet start-ups. There are tons of good businesses out there that have little or nothing to do with tech.

I myself have recently been looking at a car wash business owned by a friend, which got me thinking about the benefits and potential drawbacks of investing in these situations. What do you do to help ensure a successful (and profitable) relationship when the owner of the business you want to invest in is your friend?

First and foremost: Invest in an operatorAt the end of the day in these situations, we are investing in people, not companies. That being said, don't just invest in your friend because he or she is your friend and you like that person.

Invest in him or her as an operator -- that is, someone who has successfully run this kind of business before.

As someone who runs a small enterprise, I can tell you with confidence that there are a thousand things you will have never thought about as a first-time entrepreneur. These types of mistakes are vital to the entrepreneurial learning process, but they can cost you dearly as an investor.

So if you're not a specialist of talent development or looking to become an incubator fund, reduce your risk by investing in someone who already knows what he or she is doing.

Invest in expansionRather than investing in a business from the ground up, consider helping to finance someone's expansion.

It's a lot less legwork: There's already a business up and running, meaning that a lot of the systems needed (supplier orders, bookkeeping, and so on) are already in place. It also gives you an indication that the person can credibly produce results.

Of course, there is no doubt that expansions can also go wrong.

You'll want to carefully consider the type of expansion in question and whether it might be over-reaching: Is it into a similar market in a different location, or into a complementary product? Or is it a major shift into a new line of business or customer base? These types of questions will help clarify the level of risk you're dealing with so that you can decide whether or not to take the plunge.

Do your homeworkPart of the reason you might want to invest in someone else, rather than starting a business from scratch yourself, is that the other person has experience and knowledge that you lack.

But that doesn't excuse you from doing your homework. The more research you do -- into the proposed expansion space, the competitive pressures, the customer base, and everything else you can think of -- the better prepared you'll be to ask questions. The more questions you ask, the better you'll be at sussing out whether this is something you'll want to be involved with.

If your friend takes offense at your ideas, questions, and concerns, that's a red flag. Even if you were planning on going in as a silent partner, it's well within your rights and the rules of reasonableness to understand the business plan and the opportunity. Defensiveness is not only a bad sign from an investment perspective; it means that the partnership could run the risk of ruining your friendship.

Paper it upEvery partnership needs a good paper trail.

No one likes to talk about what would happen in the event of a dispute or fractured relationship, but when there's money on the table it's unfortunately a necessity. If you want to pull out or if things aren't going as planned, you need to have an agreed-upon contingency plan that will preserve everyone's interests.

So sit down over a cup of coffee or a glass of wine and talk it out. What do we do if things go wrong? "We'll figure it out" is not the answer you want to reach -- rather, you want a set of procedures that you'd both be happy to sign with anyone: friend, stranger, or foe.

The article How to Invest in a Friend's Business originally appeared on Fool.com.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.