Q: I found an angel investor for my small business. He’s loaning me $10,000 to purchase inventory over two years at a low interest rate. What percentage of the net profits is acceptable to pay him during that time and after the loan is paid back? — A.B. Sacramento, Calif.

A: Let’s start with a more fundamental question: Are you really dealing with an angel? It sounds like this investor not only wants his loan repaid with interest but he also wants profit-sharing in your company after the loan matures. That’s a pretty sweet deal — for him. But it may not be so heavenly for you and your company.

Angel investors typically put money into young companies that they feel have tremendous potential but that also carry serious risk. Rather than expecting you to pay back the investment, they will want to own part of your company as compensation for the risk they’re taking, says Marshall Toplansky, founder and chairman of Core Strategies, a marketing-strategy and research firm based in Irvine, Calif. Typically, an angel investor is looking for a minimum of five times his money back in returns. and generally it’s more like 10 times. This may seem high, but it compensates the investors for all the losers they invest in, he explains.

Sometimes, equity investments are structured as convertible notes. A convertible note allows the business owner to take on the investment initially as debt, but includes the option to convert the note to a certain percentage of ownership in the company within a set time period, often at maturity, says Channing Chen, a venture consultant for the San Francisco Small Business Development Center. This structure provides some options to both parties. The investor can convert to an agreed-upon ownership percentage at or before maturity, or decide not to convert and demand repayment of the full loan amount plus interest at maturity. For the business owner, a convertible note eliminates the potentially drawn-out negotiation regarding valuation of the business at the time it receives the financing, she says.

But what if you were to ask a bank to fund the purchase of inventory? The bank wouldn’t ask for a percentage of your net profits. They would want interest on their loan and some collateral, which could be the inventory itself, assuming it has genuine market value. The loan could involve payments during the term of the loan, or it could be structured so that a balloon payment of principal and interest would be due at maturity.

COLD WATER. The second format would allow for maximum cash flow during the loan term, but you would have to plan for payback in full at the end of the term. If a bank won’t give you a loan because of your lack of credit history or financial assets, you might investigate using a home equity loan to fund your business expansion, Toplansky suggests: You get a better interest rate than you would get from a commercial loan, and you’ll only have to pay interest and principal on that loan — not give up a portion of your business.

If you’re looking for a relatively small amount of money, a loan may indeed be a better option than a private investor, Toplansky says. He offers this scenario: Let’s say your business is making $1,000 annually in net, after-tax profit today and your investor plans to put in $10,000 in new inventory. Let’s also say both you and he believe that your business plan projections, which call for the company to be making $100,000 annually after the investment, are realistic. Your investor will be looking to earn between $50,000 and $100,000 on his investment, meaning that you’ll need to give him between 10% and 20% of your profits over five years.

You need to splash some cold water on your face at this point, Toplansky says. If you don’t make your goals, do you really want an outside investor in your business? If the business turns sour during the five-year payback period, it could get ugly. And what if you actually do make your numbers? Under Toplansky’s scenario, you would be paying $100,000 to your investor — money you surely would rather put in your own pocket. He also points out that the interest on a bank loan for $10,000 over five years, if you don’t pay down any principal at all, is about $4,000, or $800 a year.

Talk to a professional, such as a small-business attorney, investment banker, or accountant, who can help you evaluate the deal that your angel is proposing. Private investors are sophisticated financial professionals — you should have someone just as sophisticated looking out for your best interests. If you don’t, you could find that your angel investment goes straight to hell.

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