Sandy thinks her friend Danny has a great business idea—an exciting, almost revolutionary new service. Now he wants her to make a significant investment in the corporation he’s starting in exchange for a 10% ownership stake.
Sandy is tempted. Why not help a friend see his vision to fruition, claim partial credit for launching the wave of the future, and potentially earn extremely handsome returns?
Though such opportunities may feel like the chance of a lifetime, there’s plenty that can go wrong. If there’s any rule of thumb for investing in a private venture as a minority owner, it’s that you should do it only with money you can live without.
Consider Danny’s corporation. With no market for its stock, Sandy’s capital is likely to be tied up for five to 10 years. That’s how long it may take to build a company that can go public or attract an acquirer. During the incubation period, Sandy must be prepared to rely solely on other assets to meet her financial commitments.
Then there’s the failure scenario. Unlike stock in a deteriorating public company that can usually be sold for something on the way down, private shares’ lack of marketability means the investor is strapped in for the full ride to zero.
There’s also the matter of taxes. Owners of S corporations as well as partnerships and most limited liability companies pay income tax on their share of the business’s earnings, even when those profits aren’t distributed. While she’s waiting to get her investment back, Sandy might have to spend more money on taxes.
Still another concern is share of ownership. Assume things go swimmingly and the company seeks to expand. Can Sandy remain a 10% owner? Depending on the laws of her state and the articles of incorporation, she and other shareholders may, or may not, be entitled to first crack at any new shares the corporation issues, in the same proportion as current ownership. (Partnership and LLC operating agreements, when properly drafted, indicate whether owners have the right to maintain their original percentage of ownership.) Without that promise, Sandy’s interest could be diluted and her take of the profits compromised.
Not just money but also relationships may be at risk. If the venture bombs, will Sandy blame Danny? Will their friendship suffer? If it does, will she mind? Even with a successful venture, resentment can arise if some of those involved feel others are prospering more than their contribution merits.
For all of these reasons, investing in a friend or relative’s business can present problems from the get-go. Sandy should obviously research the investment before diving in. But her friendship with Danny could hinder her ability to objectively analyze his business plan and his ability to execute it, and could make it awkward to quiz him about the plan’s marketing or financial assumptions.
Dream deals do sometimes come along. But what often separates successful capitalists from dreamers is finding the right reason to say “yes” or “no.” Before you make an investment in a friend or relative’s company, talk to us. We can help you analyze the numbers and evaluate the opportunity.