Friend investing in a friend is among the common sources of funds for most startup businesses. Many people lean towards independent investors and banks only to be disappointed when such institutions don’t understand the risk-to-reward of the business.
A friend is someone close to you and believes in your potential even if they don’t understand the business. On the downside, the risks of investing in a friend are personal. Besides the fear of losing invested funds, you may develop strained relations or lose a friend to debt.
Many benefits can come from investing in a friend. While the relationship is informal, you should make it a formal affair when it comes to business.
This article will uncover what to do when a friend approaches you with a business idea. The steps you should take to ensure that the business is profitable and the friendship bond is still intact.
Understanding the Nature of the Investment
There are many ways of investing in a friend’s business. Among the primary ways are loans, gifts, or equity investments. For each of these methods, you will have some benefits and risks. Therefore, ensure that you keep records in writing, preferably binding legal documents.
If you decide to invest in a friend’s business in the form of a gift, it means you don’t expect the funds back. In this instance, your success is when your friend pursues and achieves their business idea and goals.
However, funds in the form of gifts don’t carry a potential return; hence you might not be willing to invest too much of your funds.
The problem with gifts as investments is that the gift may feel like a loan, especially if your friend’s business becomes successful. A legal document will protect both parties.
Loans are a financial cushion because you have repayment terms. Therefore, you can invest in a friend’s business expecting repayment after some period or wait until the business succeeds.
You can also discuss whether your friend will repay the business loan with some interest or not. But the most important concern is what happens if the business venture fails?
The downside of giving your friend a loan is that it takes time for the business to pay back since it interrupts cash flow. If you don’t need the funds anytime soon, you can consider giving your friend the loan.
You can structure the loan repayment terms through an attorney or a third party that acts as an intermediary at a fee.
When you invest in a friend’s business as an equity investment, it means you become a business partner. You will have claims to a stake in the company. Before you make an equity investment, ask yourself if you want your friend as a business partner.
Who will run the business venture, and what happens when the business doesn’t make profits or run as you want? On the upside, if your friend has entrepreneurial experience, you stand lots to gain when the business becomes successful.
Equity investments may need more legwork, and it is advisable to consider engaging a lawyer to draft the paperwork. It should be clear what percentage of the business you own and who has overall control.
Also, you may like to read, Types of Funding for Startups.
What to Consider Before Investing in A Friend
When a friend comes to you for help, you feel obliged to give them a hand. However, when it comes to making financial decisions, you must weigh down the qualities of your friend and scale the profitability of the proposed business venture.
The following guide will help you make a sound judgment.
Don’t Invest in A Friend but An Operator
When investing in a friend’s business, are you investing in the company or your friend?
The decision to invest in your friend shouldn’t be because of the bond you have with the person. It would be best if it’s because you see him/her as an operator. Someone that has previous success operating in that industry or business.
Startup entrepreneurs make some vital business mistakes because of inexperience. These mistakes are a learning process, but they can be costly to you as an investor. Investing in someone who already understands the business sheds away some of the business’s risks.
Invest in Expansion
Instead of investing in a friends’ business idea, consider helping them make expansions once they start. Let them take the initiative before you step in to offer your support. It is important that you let them follow the basic Startup 101 rule.
Let them tap into their personal finances first, as it shows their determination to keep the business going.
The advantage is that you have less legwork, and the business already has a direction which means that a system is already in place. It is also an indication that your friend is competent and can produce competent results with further funding.
However, business expansions are not failproof. Before going all-in and funding your friend’s expansion, look at the type of expansion it is. Does the expansion reach into the same market, or is it a complimentary product?
Are you shifting to another line of business that requires a new customer base? Asking yourself these questions lets you grasp the risk levels before you commit to your finances.
Do Your Research
Your friend’s business might be in an industry you are not familiar with. But because you are investing in someone else’s business and or starting one yourself, it doesn’t exclude you from doing your research.
The benefit of doing research is that you will gain some knowledge of what the business requires.
Before dipping into your pockets, find out the customer base, competitive pressure, and everything you need to know about the business. Become involved by asking questions on things you don’t understand, even if your friend finds it offensive.
Perhaps you want to become a silent partner and avoid the day-to-day running of the business. It is reasonable that you want to understand the opportunities and risks.
Ask for a business plan from your friend and let him/her pitch their ideas to a potential investor. Because you are a friend, it doesn’t mean that you should neglect the formalities. As a precaution, don’t invest if you are not convinced that the business idea or expansion is viable.
Consider the following checklist to determine if to invest in a friend or not.
- Does your friend operate alone or has other founding members? Who are they, and do they attract talent?
- What are the revenue forecasts of your friend’s business?
- Does your friend have a plan to attract customers?
- How will your friend bring the sales? (product or service)
- Who is funding the business, and is it already profitable?
- Are there existing legal documents that protect the business operations?
- What is the company’s status on tax compliance and obligations?
- Who owns the company assets (including intellectual property)?
- Does the business have insurance or require to take new ones?
- Does the business already have staff contracts?
Paper it Up
It is essential that you keep a paper trail even if your friend is now your business partner. It is in poor spirits to talk with your friend about what will happen if the business doesn’t succeed. However, it is necessary because the risk is tied to finances.
You need a contingency plan that can make you pull out if things aren’t going a planned. It is a way to protect everyone’s interests.
Reach out to your friend and put it on a paper, addressing what happens if the business venture collapses. The paperwork should contain a clause that anyone would be happy to sign and commit to whether they are strangers, foes, or friends.
What to Expect When You Invest in A Friend’s Business
1# The Downside Risk
Understand that there are two outcomes. Either your friend’s business succeeds or fails. Find out what circumstances will make the business venture successful and also why it may fail. When will the business need more money to make it break-even?
After the initial funding, will you need additional finances to keep the business ongoing? When your friend makes a pitch for you to invest in their business, ask questions. Determine for yourself what can happen and what wouldn’t. Any representation that the business is failproof is a fallacy unless you can prove it.
Also, determine what happens to the business assets in case the business fails. Are you willing to lose all your investment because your partner is a friend?
2# The Tax Consequences
There are many tax consequences of any business. Therefore, ask your friend to structure tax benefits for you in case the business fails. Are you investing in a purchase of stock that allows you the ordinary loss treatment on company stock sales or collapses?
Is the investment a loan? The IRS treats business losses on loans as a non-business loss. It means that you will have to accept the outcome with zero compensation on invested funds. However, you can utilize the capital loss to offset capital gains from your other investments. In such a scenario, the total capital loss deducted from ordinary income is only $3000 per annum.
Is your friend’s business an LLC or S corporation? Tax consequences of such entities will pass through you. Here tax consequences can be capital gains, losses, or profits. Before investing in a friend’s business, ensure you can handle the tax consequences.
A potential problem is when the business is taxed on undistributed profits. It applies in a pass-through entity where you are taxed according to the portion of your taxable income regardless of cash distribution or not.
Are you in a position to accept taxation on undistributed profits? For instance, the business may generate profits that need to be reinvested in the business. Therefore, the business may lack the cash to distribute, and the investors must still pay the taxes.
Another potential problem is being taxed on profits that are not distributed. In a pass-through entity, you are taxed on your portion of the taxable income, whether or not any cash has been distributed to you.
Can you afford to be taxed on undistributed profits? If profits are reinvested in the business, there may be no cash to distribute to the investors who must pay the taxes.
Remember that you are entering a business partnership and whether the other party is your friend has no business bearing. Get what you feel is right for you from the business. The investment structure should satisfy your demands.
Are you the only investor, or are there other investors? Will you have the power to influence decisions and the management process?
Even if you are just a financial backer, never underestimate your value. Without your financial contribution, the founder (your friend) may have no business to manage. Remember, with your money; you can find other investments.
The investment structure should define the control you have over the business to protect your financial investment. If you make an equity investment, ensure that you have voting power as it protects you from being sidelined with other investors.
The founder doesn’t need to have total control of the business. Your investment value should grant you a veto power to elect directors to the Board of Directors or control over specific aspects of the business management.
If you prefer, you can invest in your friend by offering them a loan instead of buying the company stocks. Loans have repayment plans that include interests regardless of the business’ success or failure.
When you loan funds to a friend, ensure that you get a personal guarantee by making the most valuable asset of the business your security.
You may like the following articles:
- What must an entrepreneur assume when starting a business?
- How much does an entrepreneur make in a year
- What should startup know before seeking funding?
- 9 Modern Ways to Get Funding for Your Startup In USA
- Is It Possible To Start A Tech Company With No Money?
When framing any funding into a business that doesn’t belong to you, make it a commercial relationship. Understand that most startup businesses fail, and even the successful ones can be illiquid (they don’t have dispensable cash).
Your friend’s startup business doesn’t attract a public market to sell shares. So, if the business is successful, it may take years before you get repaid or be able to sell shares.
The decision to invest in a friend’s business is determined by your ability to raise funds and patience to let the business grow. It is advisable to invest if you don’t need an immediate return on investments.
Bijay is an entrepreneur and start-up founder having more than 14 years of IT industry experience. He is the co-founder of TSInfo Technologies, a SharePoint development company.
A dedicated professional and very passionate about public speaking and also wrote thousands of technical blogs in various technologies. He also wrote a lots of blogs on entrepreneurship, investment, startup, business, manage money tips, etc.