Investing in a startup means risk no matter how near and dear you hold the business – or the business owner. Some business plans aren’t worth the paper they are printed on; others may deserve your more thorough review.
Our clients regularly ask for our opinion on offers to invest in private companies, typically business start-ups seeking support from friends, family and other so-called angel investors. Once it was a nephew launching an aeronautics technology company. Another time, a real estate interest in a cemetery. The list goes on.
Generally, risks of these investments outweigh the potential benefits. For one, the investments are generally illiquid and most people underestimate the value of getting their hands on cold hard cash in a pinch. Your money will be tied up much longer than you think. Second, these investments often encounter unforeseen accounting costs to untangle a web of business depreciation, K-1’s and capital gains – or, more typically, losses. You can say “Goodbye” to Turbo-Tax and “hello” to hefty accountant bills.
Most entrepreneurs also assume they’ll beat the long odds against startups succeeding. The most dangerous situations occur when the curtain of opportunity falls to reveal a pyramid scheme or another type of financial mirage.
The Securities and Exchange Commission (SEC) offers a modicum of regulations under the title “accredited investor” to protect informal investors from betting more chips than they can afford to lose. Those investing with a family member or friend, however, enjoy no such protections.
Private investments and returns that never materialize ruin many fortunes. David Marotta recommends eight safeguards to protect your investments assets ,including avoiding private investments altogether. Unless you plan to become a professional angel investor in these startups, don’t invest expecting to make money.
If you invest, consider your whole financial picture beforehand. Begin by viewing your savings in relation to your standard of living. You have excess capacity if your current and projected savings exceed what you require to maintain your standard of living for the rest of your life. After saving an adequate nest egg in liquid investment vehicles, do whatever you want with the excess. Some choose to donate charitably. Others want to invest prudently to maximize their estate. Still others seek more speculative investments with money they consider to be part of their aspirational assets in their climb up wealth’s ladder.
Investing in startups is usually motivated by reasons beyond projected returns and financial spreadsheets: Friends and family members often want to support the life and career of a loved one. For them, the relational returns outweigh the high probability of losing their money. But investing with friends and family members can become a sticky and a hotbed of resentments. I have written about conducting a premortem exercise before committing funds, taking an imaginary and detailed look at the remains of a startup after its demise months from now. Before writing that check, consider all of the possible strains to your relationships if this company fails and your investment disappears.
Not all investors need to shun these opportunities. As a financial advisor, I focus primarily on whether a complete loss would impair your standard of living and your retirement plans. I also advise you to look very hard before you take this investing leap.