Op-ed: You have been requested to put money into a personal firm. This is when to say “sure” and when to stroll away
Tetra Images | Tetra Pictures | Getty Images
A few years ago a customer told me that he had invested in a fancy bowling alley – the new party hotspot in town. It has since shut down. Another customer announced that he had joined the board of a start-up and wanted to raise capital. He wants to find out the right dollar amount to invest.
Wealthy investors are often approached to put their money in a private company that wants to grow. The offerings come in all shapes and sizes: small businesses need capital to expand, start-ups often need multiple rounds of funding, and friends or family members with a “shark tank” -type idea want their dream to come true.
These investment ideas often sound exciting and exclusive, and seem to offer the potential for much higher returns than a traditional equity and bond portfolio. So how do you determine which ones to say yes to and when to leave?
More from the FA Playbook:
‘Investor Alpha’ is the main financial strategy for 2021
How to create a charitable trust as part of an estate plan
Here are 5 lessons the pandemic taught this financial advisor
Before you commit your money to any of these companies, do the following steps to make sure you make a good decision.
Create a financial plan: If you have a large amount of extra cash, first create a financial plan to determine your financial goals, such as: B. Paying off your mortgage or funding your children’s college accounts.
This step allows you to repay the amount that is left over for unplanned expenses and investments. You also have time to understand a quote and do due diligence on the company. You want to plan your investment carefully and not succumb to the pressure of the person asking for a commitment by a certain date.
You can also budget this investment properly with a financial plan. I recently explained to a client that investing in private business can be like planning a trip to Las Vegas. You should wager a certain amount of money that you want to roll the dice – and leave the ATM card at home.
Investigate the deal: These applicants will take many forms – a former business colleague, family member, or the company director. Start with the following information:
- How much of your personal money did you invest in this deal?
- What percentage of your total assets does it comprise?
- How long have you been associated with this company / start-up / opportunity?
A CEO or other executive looking for cash should invest a substantial amount in this company. Also, ask about conversations with other private investors and their experiences for unbiased information.
The public information is minimal so it is important that you do your homework. Since private company financial statements are not available, request an updated income statement and company balance sheet and carefully review their pitchbook for footnotes on the financials.
Next, look for a positive track record. How successful was this offer if the company had previously raised capital? What was the return and how long did it take to return the original capital to investors?
Understand that private funds do not always calculate performance using the same metrics as publicly traded investments. For example, they can use a metric called the Internal Rate or Return, or IRR, to represent an expected future rate of return.
Learn as much as you can about the business process and see if their growth strategy sounds appropriate with the right leadership. Check out the social media websites to see backgrounds and personal traits of key executives. Ask yourself what information you will receive about the company in the future. A member of the board of directors has more insight than someone who only receives an annual report.
Finally, understand why this company would want to borrow private dollars instead of getting a bank loan. Since every company strives for the lowest cost of capital, it is likely that paying 6% interest to a private investor will make more sense than the 10% a bank can charge. And a bank is also likely to limit lending to a company that is already high in debt.
Use a financial plan to decide how much cash to invest. It is important not to exceed this budget unless the initial investment is profitable and you decide to reinvest in future businesses. If your return is negative, stop investing money.
Equally important, understanding how each deal is structured. Since most private investments only have limited liquidity, the money must be tied up for long periods of time. Remember, there is no open market to sell your investment when you are no longer happy or in need of cash. Do you know these three elements:
- The company’s estimated time frame for the return of your funds;
- If there will be future capital calls that will require you to invest more money;
- Other liquidity constraints.
I once had a client whose brother took him into a private real estate business when he was 30. Years later he discovered that the only way to get your money back was to die. He immediately rated this investment as $ 0 on his personal balance sheet.
The limited liquidity aspect of these investments means that your assets needed to cover living expenses and taxes in retirement should generally be invested in a more liquid “core investment portfolio”.
Funds for private investments should primarily consist of funds that you won’t need to access for 10 years or more. Investors can usually afford a much higher allocation to private funds above the core portfolio.
Public versus private?
As a final step, consider getting a similar investment in the public market. In this case, you can eliminate the liquidity risk and have more control and transparency and usually lower fees.
Private funds often charge extremely high fees, including performance fees for generating a cheap return and sometimes upfront fees. Additionally, you will likely be provided with a K-1 tax form for income from a personal investment, which often means filing an extension of your tax return every year.
Investing in private companies can be fun and feel like you’re at the forefront of something big. While there is the possibility of above average returns, it can also jeopardize your entire financial life if you go too deep.
Weigh the risk factors, be on a budget, and enjoy the ride knowing that regardless of the outcome, you will still be comfortable financially.