Retirees as venture capitalists
How to approach investing in a relative's business
By Andrea Coombes , CBS.MarketWatch.com
Last Update: 5:36 PM ET Nov. 2, 2003
SAN FRANCISCO (CBS.MW) -- An improving economy usually signals a rise in entrepreneurial activity -- and that means an increasing number of older Americans will be tapped for start-up cash by a son, daughter or other relative.
Some 90 percent of small businesses are funded initially by family and friends, experts say, and those who get in early on the Amazon.com's of the world likely thank that move for their more luxurious retirements.
"If one hits, it can hit huge," said Andrew Zacharakis, professor of entrepreneurship at Babson College in Wellesley, Mass. One successful entrepreneur that Zacharakis knows "tells a story of walking into his parent's house and giving them a check for $600,000, on a $10,000 or $20,000 investment."
More retirees are likely to be approached by would-be entrepreneurs as the economic signals improve. "Typically, as the economy starts to turn around, more and more people will start to see a good opportunity," Zacharakis said.
About 18 million Americans invested in an entrepreneur's business in the last three years, with about $100 billion invested each year, Zacharakis said, based on the Global Entrepreneurship Monitor, a study conducted annually by Babson College.
Still, the success stories are rare. Sixty percent of businesses fail within six years, and 20 percent within the first year, Zacharakis said.
Given the chance for failure, retirees should only invest money that they can afford to lose. On an asset-allocation scale from most conservative to most aggressive, "this is out on the far end of the spectrum on the speculative end," said Dennis Reardon, an attorney and principal at Reardon &Associates in Wayne, Pa.
"The positive side is you have the chance to help somebody fulfill their dream, as long as you realize it's not at the cost of your own financial security," he said.
Also, investing in an adult child's business venture can be a way to share the wealth without simply doling out cash, while potentially offering a steady return in the form of loan repayments with interest or preferred-stock dividends.
Investment, loan or gift?
Figuring out whether to invest, lend or give the money depends in part on the business itself. A loan or gift might be best for those starting a small local business with no intention of expanding or being bought out.
"Those are lifestyle businesses where they make a nice living for the entrepreneur but they're never going to go anywhere," said Jim Arkebauer, principal at Venture Associates, a Denver-based investment banking firm. "That's more of a debt situation than an equity situation."
Others suggest convertible debt. "My general rule is that it's always convertible debt," said Zacharakis. "If it does fail, on a personal basis you'll get a better write-off on your taxes than you will on an equity investment." Offering deferred interest payments can help the entrepreneur's initial cash flow, he said.
While an equity investment or a loan offers a tax write-off should the business fail, there are also estate consequences to consider, said Michael Stewart, a lawyer, chartered financial analyst and a senior vice president at Dana Investment Advisors, in Brookfield Wis.
"From an estate-planning standpoint, the gift is better (than investing in stock) because it removes the assets from the estate," he said, reducing estate taxes, provided the giver lives at least three years after the gifting date. Owning shares that increase in value will only "compound their estate tax problem," he said.
However, placing stock in an irrevocable trust could pass any appreciation on to heirs, while offering a solution to the estate-tax problem, he said. "If they think this company has tremendous growth prospects ... they should hold those shares in some type of irrevocable trust, because that removes the assets from their estate," Stewart said.
A word of caution: Though a parent may want active control of a son or daughter's business venture, avoid direct ownership of the company so that other assets aren't at risk should the company fail, Stewart said. "Make sure that liability is limited. If liability is not limited, it doesn't matter how much return they get, their retirement could blow up."
Step back from the emotional
To protect the personal relationship, set out the terms of the investment ahead of time. "The common line of questioning from a family member should be: How much of my money do you want? What are you going to use it for? And how am I going to get it back?" Arkebauer said.
Request a business plan, and consider offering the money in stages, as specific goals are met. "You should go into this with your eyes open," Zacharakis said. "You want to support the people you love (and) that emotional basis is important, but if you have a little bit of a professional approach to it you establish the right expectations. If things don't go as well, it's not as damaging to the relationship."
Make sure an explicit exit arrangement is agreed to, Arkebauer said. "If the entrepreneur doesn't have some type of exit plan, then you really shouldn't be invested in the deal," he said. That plan may vary widely, but an example might be: "We're going to pay you back three times the amount you put in within a two-year period and then leave you with a carried interest in the deal," Arkebauer suggested.
Should the business prove successful, those agreed-upon terms can help mitigate conflict over profit taking. "You should be prepared to withstand loss," Reardon said. But "if it's profitable, that shouldn't flip, where the child isn't willing to allow you to share in the success financially. You should be treated no worse than a stranger if you put in a dollar and it turns out it makes $10."
While setting the terms, look closely at the entrepreneur's valuation of the business. "At least nine times out of ten, that entrepreneur feels their idea is worth a whole lot more than what it is in reality," Arkebauer said.
Buying an overvalued company can lead to surprises later, he said. A family member's 10 percent of company stock may be squashed down to 5 percent when the next round of investors, more likely to be professionals, insist that the company is worth less, Arkebauer said.
Before jumping in, consider getting outside advice on the viability of the business, he said. "See if you can't get some outside advice, somebody else whose business acumen you respect, and pass the idea by them." Andrea Coombes is a reporter for CBS.MarketWatch.com in San Francisco.
From: Taking a chance as a family venture capitalist http://cbs.marketwatch.com/news/print_story.asp?print=1&guid=%7B1E1267CD-32A4-4558-9F7E-40E4B7892D01%7D&siteid=mktw
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